ASSET ALLOCATION, AND INSURANCE ” Traditional MV analysis does not consider many risks that individual investors face throughout their lives.. These risks can be hedged through diversif
Trang 1ASSET ALLOCATION, AND INSURANCE ”
Traditional MV analysis does not consider many risks that individual investors face throughout their lives
Risk factors associated with HC include earnings, mortality & longevity risk
These risks can be hedged through diversification, life insurance, & lifetime payout annuity
Life insurance can be a perfect hedge to mortality risk (correlation =-1)
Life time-payout annuity is used to hedge longevity risk
MV = Mean Variance
HC = Human Capital
1 HUMAN CAPITAL AND ASSET ALLOCATION ADVICE
Risk tolerance depends on psychological attitude & financial situation of an individual
HC ⇒ economic PV of an investors’ future labor income
One must include HC in asset allocation decisions
In early stage of life cycle, financial capital is used to hedge HC
Optimal asset allocation depends on:
Risk-return characteristics of HC
Flexibility of HC
HC & Assets Allocation Modeling
= (ℎ௧)
(1 + ௧ି௫
௧ୀ௫ାଵ
HC can be calculated as:
where
x = current age
= human capital at age x ℎ௧ = earning for year t (inflation adjusted)
n = life expectancy
r = inflation adjusted risk free rate
v = discount rate
HC is considered as a stock (bond) if highly (less) correlated with financial market & more (less) volatile
If HC is riskless ⇒ investor should invest more in stocks
Equity-like HC ⇒ financial portfolio should be dominated by fixed income assets
Optimal allocation to the RF asset with initial wealth
Trang 22 HUMAN CAPITAL, LIFE INSURANCE, AND ASSET ALLOCATION
ఏೣఈೣ ௫ ௩௫ାଵ+௫ାଵ + ௫ௗௗ௫ାଵ+௫
The value of HC, the more life insurance the family demands
The optimal level of insurance depends on:
The expected value of HC
The risk-return characteristics of the insurance contract
Investor’s objective is to maximize overall utility (alive state & dead state) by choosing life insurance & making an allocation b/w risky &RF assets:
where:
௫ = amount of life insurance
௫ = allocation to the risky assets
D = relative strength of the utility of bequest
௫ = subjective probabilities of death (conditional on being alive)
௫ାଵ = wealth level at age x+1
௫ାଵ = human capital
The correlation b/w shocks to income & risky assets, the HC & demand for insurance
Survival probability, demand for life insurance
More financial wealth, the less life insurance one demands
As an investor ages, the demand for HC
Conservative investors buy more life insurance
3 RETIREMENT PORTFOLIO AND LONGEVITY RISK
Three Risk Factors in Retirement
Cause portfolio value to fluctuate
If market falls, the individual may be unable
to maintain desired life style
Can be reduced by using modern portfolio
theory
Risk of live longer than planned for &
outliving one’s assets
Can be hedged away through:
Longevity insurance provided by DB plans
Life time annuities
Risk of Spending Uncertainty
Inadequate savings to fund retirement portfolios
Can be minimized through save more tomorrow (SMarT)
Personal savings are used to fund retirement income in two ways:
invests & withdrawal from the portfolio
annuity
Trang 3Longevity Risk & Payout Annuities
Insurance product that converts an accumulated investment into income
Payout annuities are the opposite of life insurance
Types of Payout Annuities
Fixed nominal $ amount each period
In the value of payments over time due because of inflation
Not suitable for investors who prefer liquidity
If current IR is low, the investor would
be locked in these low rates
Payments are variable & depend on the performance of underlying
Variable disbursements can be a potential drawback
... insurance & making an allocation b/w risky &RF assets:where:
௫ = amount of life insurance
௫ = allocation to the risky assets
D = relative...
௫ାଵ = wealth level at age x+1
௫ାଵ = human capital
The correlation b/w shocks to income & risky assets, the HC & demand for insurance
Survival... portfolio
theory
Risk of live longer than planned for &
outliving one’s assets
Can be hedged away through:
Longevity insurance provided by DB plans