CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r12 risk management for individuals IFT notes

3.4 Individual Risk Exposures LO.e: Discuss risks earnings, premature death, longevity, property, liability, and health risks in relation to human and financial capital; 3.4.1 Earnings

Risk Management for Individuals

1 Introduction 3

2 Human Capital and Financial 3

2.1 Human Capital 3

2.2 Financial Capital 4

2.3 Net Wealth 5

3 A Framework for Individual Risk Management 5

3.2 Financial Stages of Life 6

3.3 The Individual Balance Sheet 8

3.4 Individual Risk Exposures 9

4 Insurance and Annuities 11

4.1 Life Insurance 11

4.2 Disability Income Insurance 16

4.3 Property Insurance 17

4.4 Health/Medical Insurance 18

4.5 Liability Insurance 19

4.6 Other Types of Insurance 19

4.7 Annuities 19

5 Implementation of Risk Management for Individuals 25

5.1 Determining the Optimal Risk Management Strategy 25

5.2 Analyzing an Insurance Program 26

5.3 The Effect of Human Capital on Asset Allocation Policy 28

5.4 Asset Allocation and Risk Reduction 29

Summary 31

Examples from the Curriculum 35

Example 1 Estimating Human Capital 35

Example 2 Comparing Financial and Human Capital 36

Example 3 Financial Stages of Life 36

Example 4 Traditional vs Economic Balance Sheet 36

Example 5 Changes in Human and Financial Capital 37

Example 6 Individual Risk Exposures (1) 37

Example 7 Individual Risk Exposures (2) 37

Example 8 Elements of a Life Insurance Policy 37

Example 9 Mortality Expectations 38

Example 10 Life Insurance Pricing 38

Example 11 Appropriateness of Life Insurance 38

Example 12 Comparing Annuities 39

Example 13 Risk Management Strategy 39

Example 14 Human Capital and Asset Allocation (1) 39

Example 15 Human Capital and Asset Allocation (2) 40

Example 16 Human Capital and Asset Allocation (3) 40 Example 17 Asset Allocation and Risk Reduction 40 Appendix A: Life Insurance Calculations 42

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

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1 Introduction

Section 2 of this reading outlines the concept of human capital Section 3 presents a framework for individual risk management Section 4 describes insurance and annuity products which can help individuals manage their risk Section 5 discusses the implementation of risk management

2 Human Capital and Financial

An individual’s overall wealth has two primary components, human capital and financial capital

2.1 Human Capital

Human capital is the “mortality-weighted net present value (NPV) of future expected labor income” In simple terms, it’s the present value of future cash flows which an individual is expected to generate from his labor income until he retires

LO.a: compare the characteristics of human capital and financial capital as components of an individual’s total wealth;

Human capital is a significant part of most working households’ total wealth From a risk management perspective, it is important to understand the following:

1 The approximate total monetary value of an individual’s human capital

2 The investment characteristics of an individual’s human capital i.e whether human capital is like (in case of an equity trader) or whether it is bond-like (in case of a university professor)

stock-3 The relationship between the value of an individual’s human capital and the value of his financial capital

Human capital can be estimated by using the following expression:

In the above expression, HCo is the value of human capital today, wt is the income from employment, r is the appropriate discount rate and N is the length of working life in years

If a person is expected to retire after three years, then the value of his human capital can simply be estimated by discounting his wages for the next three years using an appropriate discount rate and the aggregate of these PVs will be the total monetary value of his human capital

In order to refine our estimation further, elements such as probability of survival “p(st )”, annual wage

growth rate “gt” and occupational income volatility “y” can be added to arrive at a more accurate

estimate for the value of human capital

Example 1: Estimating the Present Value of Human Capital

John Adam is 60 years old and plans on retiring in 5 years Adam’s annual wage is currently $50,000 and

is expected to grow 2% per year The risk-free rate is 4% Adam works in a job with a moderate degree

of occupational risk; therefore, we assume a risk adjustment based on occupational income volatility of 3% There is a 99% probability that Adam survives the first year, a 98% probability that he survives the second year, and probabilities of 98%, 97%, and 96% for the following years, respectively Given this information, what is the present value of Adam’s human capital?

Solution:

The first step is to calculate the relevant discount rate which is the risk-free rate plus the income volatility adjustment: 4% + 3% = 7% = 0.07 Also recognize that the income growth rate is 2% Hence the income at the end of Year 1 will be 50,000 x 1.02, income at the end of Year 2 will be 50,000 x 1.022, and

Personal assets are:

• assets an individual consumes or uses in some form, such as a car, furniture, etc

• not expected to appreciate in value The primary purpose of acquiring such assets is to derive benefit through usage/consumption

• often worth more to the individual than their current fair market value

Investment assets:

• include tangible investment assets (such as stock portfolio) and less tangible assets (such as an accrued defined benefit pension)

• can be subdivided based on marketability i.e marketable and non-marketable assets

• marketable assets can be further subdivided into publicly traded marketable assets (such as bonds, stocks etc.) and non-publicly traded marketable assets (such as real estate, some types of annuities, cash-value life insurance, business assets, collectibles etc.)

• non-marketable assets include employer pension plan, government pensions etc

• Specifically in terms of pension plans, only vested pension benefits are considered part of financial assets Non-vested benefits are based on services which are likely to be performed in future and therefore are part of human capital

The value of vested defined benefit pension plan can be estimated by determining the

mortality-weighted net present value of future benefits

The expression given above is used to ascertain value of vested defined benefit pension plan such that,

mNPV0 = mortality-weighted net present value at Time 0, bt = future expected vested benefit, p(st) = the probability of surviving until year t and r = discount rate

Notice that the above expression is almost identical to the expression used to calculate the value of human capital The only one exception being that instead of discounting future wages, future benefits are being discounted here

Mixed assets have characteristics of both personal assets and investment assets Examples include real

estate, jewelry, artwork etc

Refer to Example 2 from the curriculum

2.3 Net Wealth

LO.b: discuss the relationships among human capital, financial capital and net wealth

The net worth of an individual is the difference between traditional assets and liabilities which are easy

to measure Examples of easy to measure assets include investment assets and personal property Easy

to measure liabilities include mortgages and other loans Net wealth expands the concept of net worth

to include human capital and the present value of pension benefits This material will be covered in more detail in Section 3.3

3 A Framework for Individual Risk Management

3.1 The Risk Management Strategy for Individuals

Risk management for individuals is the process of identifying risks and then developing an appropriate strategy for dealing with those risks There are typically four key steps in the risk management process:

3.1.1 Specify the Objective

The primary objective of risk management for individuals is to maximize their welfare This can only be achieved through an appropriate balance of risk and safety

3.1.2 Identify Risks

Individuals/households face a number of risks such as earnings risk, premature death, longevity risk, property risk, liability risk, health risk etc

3.1.3 Evaluate Risks and Select Appropriate Methods to Manage the Risks

This includes evaluating the magnitude and likelihood of a risk, and then in light of our assessment, selecting the most appropriate method for managing that risk There are four main techniques for managing risks:

i Risk avoidance: involves avoiding a risk altogether

ii Risk reduction: involves mitigating a risk by reducing its impact on an individual’s welfare (either by

lowering the likelihood that it will occur or by reducing the magnitude of expected loss)

iii Risk transfer: involves transferring the risk to a third party

iv Risk retention: involves retaining a risk This is best suited where the cost of managing or reducing

risks outweighs the benefits likely to be achieved from risk management

3.1.4 Monitor Outcomes and Risk Exposures and Make Appropriate Adjustments in Methods

Once the appropriate risk management method has been selected, the risks should be continuously monitored and updated with changes in the individual’s circumstances and/or the external

environment

3.2 Financial Stages of Life

LO.c: Discuss the financial stages of life for an individual

The financial stages of life for adults can be divided into seven periods:

3.2.2 Early Career

• This stage normally begins when an individual has completed his or her education and enters the workforce

• At this stage, financial capital is typically low whereas human capital is high

• Insurance is very valuable as human capital constitutes such a large proportion of overall wealth at this stage

3.2.3 Career Development

• This phase normally occurs during the 35-50 age range

• Income increases at a rapid pace

• Focus shifts more towards savings as individuals look to provide for children’s college education, as well as to plan for their own post-retirement needs

3.2.4 Peak Accumulation

• This phase generally occurs during the 51-60 age range

• Individuals’ earnings have either peaked or are close to their maximum level

• Focus continues to be towards retirement planning and wealth accumulation

• Investment strategies tend to become more conservative as investor preferences shift from income growth to income stability

• Minimizing taxes becomes a major concern

• Career risk is high If an individual loses his job, he may find it difficult to get another job which pays

as well

3.2.5 Pre-retirement

• This stage spans the last few years before retirement

• Individuals are at the pinnacle of their career and therefore earnings are at their maximum

• Portfolios allocations continue to shift towards low volatility, safe investments

• Increased emphasis on tax planning

3.2.6 Early Retirement

• This phase generally consists of the first 10 years after retirement

• As this is the most active period of post-retirement life, retirees either take part in activities that provide pleasure such as travelling and they may take on a job which they find enjoyable

• Individuals should continue to take some risk in order to continue asset growth in their portfolios This might be necessary as an individual’s retired life could extend to more than two decades, which may expose him/her to the risk of outliving resources (longevity risk)

3.2.7 Late Retirement

• This phase is unpredictable because the exact length of retirement is unknown

• If the late retirement phase is long, then an individual faces longevity risk

• Risk of financial mistakes increases due to cognitive decline and other health related issues

• Appointing a trusted financial adviser or investing in annuities can help avoid financial missteps Refer to Example 3 from the curriculum.

3.3 The Individual Balance Sheet

LO.d: Describe an economic (holistic) balance sheet

3.3.1 Traditional Balance Sheet

The traditional balance sheet shows assets (house, car, investments, etc.) and liabilities (mortgages, car loans, student loans, etc.) that can be valued easily but ignores other individual assets that are material, such as human capital and pension benefits By subtracting traditional assets from traditional liabilities,

we arrive at the “net worth” of an individual This is analogous to the equity of a company

3.3.2 Economic (Holistic) Balance Sheet

The economic balance sheet provides a more accurate picture of an individual’s overall financial health

by including all available marketable and non-marketable assets and liabilities on a balance sheet On the asset side it shows traditional assets as well as human capital and pension benefits On the liability side it shows traditional liabilities as well as the present value of future consumption needs and

bequests The difference between an economic balance sheet’s assets and liabilities is called the “net wealth” of an individual The economic balance sheet is particularly useful for younger households

where the total economic wealth is typically dominated by the value of human capital

Refer to Example 4 from the curriculum

3.3.3 Changes in Net Wealth

As individuals age, the relative value of their assets changes Below we discuss how four main assets of

an individual’s wealth portfolio (human capital, financial capital, real estate and pension wealth) are expected to change over time

Human capital is highest when an individual enters the workforce It gradually decreases as he/she approaches retirement At retirement, the human capital of an individual is zero Financial capital is

lowest when an individual begins his career as he has very little to no savings at that time As he

continues to work and progress upwards in his career, savings tend to accumulate at a more rapid pace, and as a result his financial capital increases over time The financial capital of an individual is at its maximum when he is close to retirement There is an inverse relationship between financial capital and human capital At young age, where human capital is at its peak, financial capital is at its lowest,

whereas at retirement, human capital is at its lowest and financial capital is at its maximum This

concept is illustrated in Example 5 and in the figure below

Refer to Example 5 from the curriculum

Real estate: As an individual goes through his lifecycle, the value of real estate in his economic balance

sheet is likely to increase over time because of two reasons:

i As an individual progresses in his career, earnings are likely to increase over time This will lead

to higher savings which will enhance his ability to purchase a home

ii The value of real estate appreciates over time

Pension wealth accrues as long as an individual keeps working Once he retires and starts receiving

benefits, pension wealth starts to decline

3.4 Individual Risk Exposures

LO.e: Discuss risks (earnings, premature death, longevity, property, liability, and health risks) in relation to human and financial capital;

3.4.1 Earnings Risk

Earnings risk refers to the risks associated with the earning potential of an individual In simple terms, it’s the risk that earnings in the future will be less than expected Health issues (such as illness,

disability), unemployment, under-employment (receiving a lower salary than what an individual

deserves based on his education and experience) are some of the factors which contribute to earnings risk

Impact on human capital: Earnings risk leads to reduction in future earnings As expected future

income drops, human capital also declines

Impact on financial capital: Reduction in future earnings leads to decrease in savings as well Therefore,

as savings decline, financial capital also deteriorates

3.4.2 Premature Death Risk

Premature death risk is also referred to as mortality risk It’s the risk that an individual (whose future earnings were expected to fulfill some or all financial needs of a household) dies earlier than

anticipated Premature death risk not only results in elimination of future earnings which the deceased individual was expected to earn, but it also leads to a reduction in the income of the surviving spouse as

some responsibilities of the deceased individual must now be performed by the surviving spouse

Impact on human capital: From an individual’s perspective, as a result of premature death, the human

capital drops to zero whereas from a household’s perspective, when an earning individual suffers

premature death, the present value of future earnings of the household will reduce

Impact on financial capital: Financial capital is also reduced by various expenses such as death expenses

(funeral and burial), transition expenses, estate settlement expenses etc

3.4.3 Longevity Risk

Longevity risk is the risk associated with living to an advanced age in retirement (e.g age 100), which leads to retiree’s resources depleting to the point where income and financial assets are not enough to meet his post-retirement consumption needs In simple terms, it’s the risk of an individual outliving his resources

Impact on human capital: Individuals who are concerned about longevity risk may choose to work

longer, which leads to them earning more than if they were to retire earlier As a result, their human capital increases as their future earnings increase

Impact on financial capital: As individuals are likely to work for a longer period, the increase in earnings

would lead to increase in financial capital

3.4.4 Property Risk

Property risk relates to the risk that a person’s property may be damaged, destroyed, stolen, or lost

Impact on human capital: If the property is used in business (such as car for a car rental company), then

any potential loss to the business property will result in a decrease in future earnings, and this will lead

to a reduction in human capital

Impact on financial capital: As property represents a financial asset, property risk leads to a decline in financial capital The potential loss caused by property risk can be subdivided into direct loss (such as loss due to car theft) and indirect loss (such as rent expense or purchase cost of a replacement car) 3.4.5 Liability Risk

Liability risk is the risk that an individual or household may be held legally liable for the financial costs associated with property damage, physical injury or other loss suffered by another person or entity

Impact on human capital: If the liability exceeds an individual’s financial capital, then it may result in the

confiscation of the wages or other income of the person found liable

Impact on financial capital: When an individual is held liable for the loss endured by another person or

entity, he is legally bound to compensate for that loss, which will lead to a reduction in his financial capital

3.4.6 Health Risk

Health risk refers to the risks and implications associated with illness or injury

Impact on human capital: Health risk leads to earnings risk because an illness or injury will reduce

future earnings This causes human capital to decline

Impact on financial capital: The healthcare costs associated with an illness or injury would not only

deplete the existing financial capital but it will also affect an individual’s ability to save and accumulate wealth in future

Refer to Example 6 from the curriculum

Refer to Example 7 from the curriculum

4 Insurance and Annuities

LO.f: describe types of insurance relevant to personal financial planning

LO.g: describe the basic elements of a life insurance policy and how insurers price a life

insurance

An individual has assets in the form of human capital and financial capital to fund current and future expenditures However, these assets carry risks of loss due to unforeseen events Other types of risks can result in higher future expenditures such that the individual’s assets are insufficient to meet those expenditures Insurance and annuities are products that can mitigate these risks

4.1 Life Insurance

Life insurance protects against the loss of human capital and future earnings The beneficiaries of a life insurance policy are those who depend on the future earnings of the insured party

4.1.1 Uses of Life Insurance

 Life insurance protects against the untimely death of an individual who is earning

 Life insurance can be used for estate planning as it can provide immediate liquidity to a

beneficiary after the death of an individual In contrast, the legal process of distributing and transferring assets can be lengthy and difficult, causing delays until the ultimate transfer of assets to beneficiaries

 Life insurance can be used as a tax-sheltered savings instrument, as certain life insurance

policies invest the excess premium over the current cost of providing insurance in a tax

advantaged account

4.1.2 Types of Life Insurance

1 Temporary life Insurance: Temporary life insurance provides life insurance up to a specified time period If the insured individual lives until the end of the time period, the insurance terminates unless it is renewed Over the term of the insurance, yearly premiums either remain stable or increase with time as mortality risk increases If the insured dies within the term of the

insurance, a death benefit is paid; however, if the insured survives through the term, then no benefit is paid upon the termination of the policy Generally, the longer the insurance period, the higher the cost of insurance, due to increasing mortality risk

2 Permanent life insurance: Permanent life insurance provides insurance over the lifetime of the individual, where (generally) fixed premiums are paid over the lifetime In permanent life

insurance, along with the death benefit there is also a savings component A portion of the premium is used to cover the insurance costs and a portion is invested for the purpose of wealth accumulation The invested portion of the premium is referred to as the cash value Two

common types of permanent life insurance are whole life insurance and universal life

insurance

Whole life insurance

 A non-cancellable insurance with fixed annual payments, although monthly, quarterly and semiannual payment options also exist

 Insurer may redeem cash value

 Whole life insurance can be participating or non-participating; participating whole life insurance allows growth at a rate higher than the guaranteed percentage based on the insurance company's profits whereas non-participating whole life insurance is not linked

to the insurance company's profits

Universal life insurance

 More flexible than whole life insurance

 Allows the owner more options for investing the cash value

 Allows for variable premium payments; the excess premiums paid over the cost of insurance are invested, and the surplus invested funds can be used to pay premiums as long as the cost of insurance remains covered

Additional clauses to life insurance policies:

 A 'non-forfeiture clause' is a common feature of permanent life insurance policies, whereby, if

premium payments are missed, the policy holder receives some of the benefits before the policy lapses

 'Riders' are special additions to insurance policies (both permanent and temporary) that add additional risk mitigation beyond that specified in the basic policy

Refer to Example 8 from the curriculum

4.1.3 Basic Elements of a Life Insurance Policy

The basic elements of a life insurance policy are:

 the term and type of the policy

 the amount of benefits in the policy

 limitations under which the death benefit could be withheld, such as committing suicide within

a specified time period

 the contestability period i.e the period during which the insurance company investigate claims

 the identity of the insured

 the policy owner

 the beneficiary

 the premium payment schedule

 modifications to coverage in any riders to the policy

 insurable interest of the policy owner in the life of the insured (when policy owner and the insured are different people)

The four parties involved in a life insurance policy are:

1 The insured i.e the person whose life is insured

2 The policy owner i.e the person who owns the life insurance policy and is responsible for paying premiums

3 The beneficiary i.e the person who receives the proceeds from the policy upon the death of the insured

4 The insurer i.e the insurance company to which premiums are paid; the insurer is responsible for paying the death benefit

4.1.4 How Life Insurance is Priced

There are three key factors to consider when pricing a life insurance policy:

Refer to Example 9 from the curriculum

Calculation of Net Premium and Gross Premium

Net premium: The net premium of a policy represents the cost of insurance It is the discounted value of the probability weighted future death benefit For instance, assume a one-year term policy which pays a death benefit of $50,000 The premium is collected at the beginning of the year and the death benefit payment is made at the end of the year The probability of the individual dying during the year is 10% Based on this information, the probability weighted death benefit is 0.1 x 50,000 = $5,000 Next, a discount rate is assumed which is the expected return on the insurance company’s portfolio Assuming the discount rate is 5%, the discounted value of the probability weighted death benefit is 5000

1.05 =

$4,761.9 This represents the net premium

Gross premium: The net premium reflects the cost of the insurance; however, there are other expenses associated with managing the life insurance policy as well such as sales commission, administrative overheads, expenses for recovering premiums on a timely basis etc For this reason, the insurance

company adds a load over the net premium, which includes an allowance for expenses and profit of the

insurance company The gross premium is the sum of the net premium and load

Refer to Example 10 from the curriculum

Categories of life insurers:

Life insurers can be categorized into:

 Stock companies: These are owned by shareholders and have a profit motive Therefore, stock

companies add a projected profit as part of their load while pricing their policies

 Mutual companies: These are owned by the policy owners and do not have a profit motive

However, mutual companies also charge a gross premium that includes a provision of profit in the load If the returns are better than expected, the excess of the gross premium over net

premium plus expenses is paid out to policy holders as a dividend

Level term policies vs annual renewable policies:

Level term policies generally have higher premiums than annually renewable policies during the early years However, during the later years of the policy, the premiums are lower for level term policies as those of annually renewable policies start to rise rapidly with increasing mortality risk

Cash Values and Policy Reserves

Cash value: In permanent life insurance policies, a portion of the premium is used to cover insurance cost and the rest is invested as savings This invested portion accumulates into the cash value that can

be withdrawn by the policy owner when the policy matures This amount can also be borrowed as a loan Typically, during the early years of the policy, the insurance company is covering the expenses of the policy and the insurance cost therefore the invested portion of premiums is smaller In later years, the invested portion of the premium increases The accumulation of cash value increases the wealth of

the policy owner

Policy reserves: Policy reserves are set aside by the insurance company to cover future claims These reserves are especially important in whole life insurance policies For these policies, the insurance company pays the policy’s face value (amount of death benefit) when the insured reaches a certain age (This assumes that the insured has not died by that time.)

Consumer comparisons of life insurance costs

Cost comparisons for term insurance are relatively straightforward as the first year premiums can be compared for two policies of the same size and no cash value or dividend payments are involved In permanent life insurance, however, the comparison becomes difficult as higher premiums can also imply higher dividend payments and faster accumulation of cash values

Two common indexes exist for the comparison of the costs of whole life insurance policies These indexes calculate the cost per year per thousand dollars of life insurance

The net payment index: The net payment index assumes that the insured person would die at the end of the specified period Cash value is not considered in this method The calculation methodology is:

A Calculate the future value of an annuity due of an amount equal to the premium Annuity due is used because premium payments are collected at the beginning of the period

B Calculate the future value of an ordinary annuity of an amount equal to the annual dividend, using the same discount rate and period as in A Ordinary annuity is used because dividend is paid at the end of the period

C Subtract B from A to get the net insurance cost over the period of the policy

D Calculate the periodic payments of an annuity due for the net insurance cost calculated in C using the same time period and discount rate as in A This is the interest adjusted cost per year

E Divide by the number of thousand dollars of face value

The surrender cost index: The surrender cost index assumes that the policy is surrendered at the end of the period and the cash value would be paid to the policy owner The calculation methodology is:

A Calculate the future value of an annuity due of an amount equal to the premium Annuity due is used because premium payments are collected at the beginning of the period

B Calculate the future value of an ordinary annuity of an amount equal to the annual dividend, using the same discount rate and period as in A Ordinary annuity is used because dividend is paid at the end of the period

C Subtract B and the cash value at the end of the period from A to get the net insurance cost over the period of the policy

D Calculate the periodic payments of an annuity due for the net insurance cost calculated in C using the same time period and discount rate as in A This is the interest adjusted cost per year

E Divide by the number of thousand dollars of face value

The cost per thousand dollars is useful in comparing different whole life insurance policies However, the actual cost may end up being higher or lower if the actual return, expenses and mortality are different from expectations

Calculating life insurance needs

Two common methods to calculate life insurance needs are:

Human Life value method: This method involves estimating the earnings that the insured would earn to contribute towards family financing over his or her lifetime and subtracting the additional expenses incurred during the insured’s lifetime The net yearly amounts are discounted back to the present to calculate the amount of insurance needed

Needs analysis method: This method involves estimating the necessary expenses of the family for a certain time period, generally up to adulthood of children or expected life of the surviving spouse The expenses include living expenses, education expenses, special expenses and final expenses The total amounts are discounted back to the present to calculate the insurance needed

4.1.5 How Much Life Insurance Does One Need?

How much life insurance an individual needs depends on the following factors:

 Number of dependents that the individual has; an individual with many dependents needs a larger amount of life insurance compared to an individual with few or no dependents

 Human capital of the individual; life insurance is meant to replace the present value of the individual’s future earnings; therefore, the amount of insurance is directly dependent on the individual’s human capital

 Immediate financial expenses; these are direct costs associated with death including legal

expenses, funeral expenses and short term wages lost

 Legacy goals; life insurance can be used to achieve legacy goals including gifts to family, gifts to charity and estate planning

The amount of life insurance needed is calculated as the present value of expected earnings if the individual were to stay alive less the additional expenses attributable to that individual

Refer to Example 11 from the curriculum

4.2 Disability Income Insurance

Disability income insurance reduces the risk that an individual would not be able to earn expected employment income due to a physical disability The definitions of disability include:

1 Inability to perform the important duties of one’s regular occupation

2 Inability to perform the important duties of any occupation for which one is suited by education and experience

3 Inability to perform the duties of any occupation

Policies using the first definition are the best for individuals specializing in a certain profession; however, such policies are expensive

Even in cases where the injury does not result in the individual becoming disabled as per the definition

of disability, insurance policies contain provisions for partial disability and residual disability:

Partial disability: This is when the individual cannot perform all the duties of his or her occupation but can still perform enough to remain employed

Residual disability: This is when the individual can perform all duties of his or her profession but cannot earn as much money as before For instance, due to not being able to give as much time as before to his

 Full coverage of lost compensation can increase chances of fraudulent claims

The significant features of disability income insurance include:

 The benefit period; how long insurance payments will be made; typically, till retirement age

 The elimination period or waiting period; the number of days the insured must be disabled before payments begin

 The rehabilitation clause provides payments for physical therapy such that the disabled person can recover and join work as soon as possible

 The waiver of premium clause states that premiums need not be paid if the insured becomes

disabled

 The option to purchase additional insurance rider allows the insured to increase the insurance coverage without further proof of insurability, although at a rate relevant to his or her current age

 A non-cancelable and guaranteed renewable policy is where it is guaranteed that the policy will

be renewed annually if premiums are paid regularly and there would be no change in premiums

or benefits until a specified age, usually 65

 A non-cancelable policy cannot be canceled as long as premium are paid but the insurer can

increase premiums for a particular underwriting class which can include the insured

 A cost of living rider adjusts benefits with a specified percentage every year for inflation or with

an acceptable index

4.3 Property Insurance

Property insurance protects against the loss of or damage to property There are several types of

property insurance discussed in the following sections

4.3.1 Homeowner’s Insurance

Homeowner’s insurance protects against the risk to home ownership and personal property and

liabilities Two specifications of homeowner’s insurance policy are:

i All-risks policy: Such a policy covers all risks except for those specified

ii Named-risks policy: Such a policy only covers the risks that are specified Named-risk policies are less expensive than all-risks policy

In addition, the policy can have two possible versions:

i Replacement cost: Such a policy would reimburse the current replacement cost of repairing a damaged item or replacing a destroyed/stolen item

ii Actual cash value: Such a policy will reimburse the current replacement cost less depreciation

A deductible is a portion of a loss that is borne by the insured individual before the insurance company

bears the loss For instance, a $100 deductible means that if loss is $500, the insured must first bear the loss of $100 and the remaining $400 will be borne by the insurance company Generally, higher the deductible, lower the premium

Homeowner’s insurance policies also contain provisions for liability coverage up to a specified amount The coverage excludes liabilities arising due to actions of other businesses and professionals and those arising due to deliberate actions

4.3.2 Automobile Insurance

Automobile insurance covers the loss of or damage to owned vehicles The pricing of the automobile policy generally depends on factors including the type of vehicle, age of vehicle, age of primary operator and driving record etc Insurance coverage is typically divided into two parts:

i) Collision coverage is for damage from vehicle accident, and

ii) Comprehensive coverage is for damage or loss from other sources such as weather or theft

The covered amount under the insurance is typically up to the replacement cost of the vehicle with one

of the same make, model and condition Provision for liability coverage is also generally included within the insurance policy up to a specified amount

4.4 Health/Medical Insurance

Health insurance hedges the insured individual against medical expenses Health insurance varies from country to country

In the United States, three common types of insurance plans exist:

i Indemnity plan: The insured can go to any service provider and pay a portion of the policy fees

ii Preferred provider organization: A large network of physicians and health service providers, who charge lower rates to individuals within the plan than to outside individuals

iii Health maintenance organization: They allow office visits at very low costs to encourage

individuals to seek medical help at early stages of the medical problems

Comprehensive major medical insurance covers most of the healthcare expenses including professional fees, hospitalization fees, medical test fees and any other expenses that are generally part of medical care These plans have several provisions attached, which are highlighted below:

 Deductibles are health care expenses that the insured individual must first bear in a given year

before the insurance company makes the payment

 Coinsurance is the percentage of the health care expense that the insurance company would

pay, with the remainder being borne by the individual

 Copayments are fixed payments that the insured pays for a particular service, such as a doctor’s

appointment

 Maximum out-of-pocket expense is the maximum expense in a given year which the insured

will pay and beyond which the insurance company will pay the full amount

 Maximum yearly benefit is the maximum amount that the insurance company will pay in a year

 Maximum lifetime benefit is the maximum amount that the insurance company will pay over

the individual’s lifetime

 Preexisting conditions are the insured individual’s health conditions at the time of applying for the insurance

 Preadmission certification is a condition where the insured is to take approval from the insurer before a non-emergency admission into hospital or treatment

All the mentioned factors affect the overall cost of the health insurance policy

4.5 Liability Insurance

Liability insurance covers the payments relating to an individual’s liabilities A personal umbrella liability insurance policy covers an individual’s liabilities that exceed those covered by homeowner’s insurance

or automobile insurance

4.6 Other Types of Insurance

Other types of insurance include:

 Title insurance to ensure the ownership of a property is not in doubt

 Insurance for unique personal vehicles such as watercraft or trailers

 Service and warranty contracts

4.7 Annuities

LO.h: discuss the use of annuities in personal financial planning

An annuity is a stream of periodic payments over regular intervals Annuities are used in individual risk

management in that they hedge against the risk of ‘longevity’

Individuals have a pool of assets for meeting future expenses and they allocate their resources over an expected lifetime The risk of an individual outliving his or her assets is known as ‘longevity risk’

The periodic payment paid in the annuity depends on factors such as the amount of money paid up front, the insurance company’s expected return and costs, age of the individual and health conditions

4.7.1 Parties to an Annuity

There are four parties to an annuity:

1 The insurer i.e the insurance company which sells the annuity and makes periodic payments

2 The annuitant i.e the individual who receives the annuity payments

3 The contract owner i.e the person who purchases the annuity

4 The beneficiary i.e the party who will receives any proceeds upon the death of the annuitant

4.7.2 Classification of Annuities

Two common ways of classifying annuities are:

1 Deferred versus immediate: An immediate annuity provides an individual with a specified amount in monthly payments against an upfront payment to the insurance company A deferred annuity provides a regular income stream which begins at a later date against an upfront

payment to the insurance company which is invested into a portfolio

2 Fixed versus variable: A fixed annuity provides a guaranteed fixed period return whereas a variable annuity provides a return that varies depending upon the performance of the portfolio

that the assets are invested in

Refer to Example 12 from the curriculum

Deferred Variable Annuities

Characteristics of a deferred variable annuity include:

 The individual pays a lump sum to the insurance company which is invested into a portfolio for

which the purchaser has a variety of investment options The payout from the annuity begins at

a later date

 As suggested by the name, the payout is variable depending upon the investment returns

 Can contain a death benefit The payment of a fixed death benefit creates risk for the insurance company for which the company can charge a fee

 In order to have lifetime payments, an individual can add a contract rider or convert the value of the annuity into an immediate payout annuity (annuitize the contract)

 In order to have a guaranteed minimum payment, the individual can add a contract rider to the annuity which guarantees a minimum return of a specified percentage

Deferred Fixed Annuities

 In a deferred fixed annuity, the individual pays a lump sum to the insurance company which is

invested into a portfolio The payout from the annuity begins at a later date

 As suggested by the name, the periodic payout is fixed

 The earlier the annuity is initiated, the lesser funds would be required per dollar of payout due

to a larger investment period

 At any point prior to the beginning of payouts, the individual can ‘cash out’ the value of the

annuity and terminate the contract against a payment of surrender charges to the insurance company

 When the time for payout comes (usually at retirement), the individual has the option to either cash out the annuity or start receiving the periodic payments

Immediate Variable Annuities

 In an immediate variable annuity, the individual pays a lump sum to the insurance company which is invested into a portfolio The payout from the annuity begins immediately

 As suggested by the name, the payout is variable depending upon the investment returns

 A contract rider can be added to the annuity that guarantees a minimum payment to the

individual

Immediate Fixed Annuities

 In an immediate fixed annuity, the individual pays a lump sum to the insurance company which

is invested into a portfolio The payout from the annuity begins immediately

 As suggested by the name, the periodic payout is fixed

 Can be a life-only annuity; which pays benefits only as long as the individual is alive, or a life annuity with a benefits guaranteed to last for a certain number of years at the least

 The periodic return (income yield) offered in the annuity would depend upon factors such as the age of the individual, the life expectancy of the individual and expected return on the insurance company’s investment portfolio in which the assets are invested

Advanced Life Deferred Annuities

 This type of annuity is a hybrid of deferred fixed annuity and immediate fixed annuity

 It is referred to as ‘pure longevity insurance’

 The individual pays a lump sum to the insurance company and starts receiving the periodic payment at a later age in life, such as at the age of 75 or above

 The cost is generally low due to three reasons:

1 The payments begin quite far in the future so the insurance company has ample time to earn returns on the lump payment

2 At the later stage of life, the life expectancy of an individual is low and therefore