2019 CFA level 3 qbank r 13 14 concentrated single asset risk management answers

Study Session 6, Module 14.2, LOS 14.e Related Material SchweserNotes - Book 2 Question #9 of 62 Factors that are positively related to the demand for life insurance include: A human cap

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Question #1 of 62

Which of the following statements regarding human capital is most accurate?

A) A person’s human capital continues after retirement.

B) For a young investor their human capital is equivalent to a large holding of an

illiquid asset

C) A person’s human capital is highest when they are born and trends downward after

that

Explanation

Young investors are at the peak of their human capital which is de ned as the present value

of all expected future income derived from their labor Human capital is illiquid because at

the beginning of their careers young investors cannot cash in their future earnings or

pension accounts which they have not earned yet A person's human capital is highest when

they have nished their training or education for their career and it steadily trends

downward from there At retirement when a person stops working and receives income from

a de ned pension plan derived from their past labor, this is considered nancial capital

(Study Session 6, Module 14.1, LOS 14.a)

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Health risk can lead to a direct loss of nancial capital to pay illness or injury-related

expenses It can also reduce human capital through diminished or inability to work Liability

risk refers to being legally responsible for damages and mainly reduces nancial capital;

there is no direct impact on human capital Longevity risk refers to individuals outliving their

nancial capital; the assumption is that in retirement there is no human capital and so there

A) Mortality tables are built to re ect past experiences of mortality.

B) Based on the assumed mortality rates, the insurance company estimates the net

premiums to charge for insurance based on the assumed rate of return on

C) For a level payment ve-year term policy, the level premium should be higher than

the year 5 premium for an annual term policy

Explanation

Based on the assumed mortality rates, the insurance company estimates the net premiums

to charge for insurance based on an assumed discount rate The discount rate is also the

assumed rate of return on investing the premiums At that discount rate, the premiums must

be su cient such that the present value of the premiums and payouts are equal so that the

premiums are su cient to pay future bene ts The level premium will be higher than the

year 1 and lower than the year 5 premium for annual term The premium is conceptually a

weighted average of ve sequential one-year term premiums Mortality tables are built to

re ect both past experiences and future projections of mortality

(Study Session 6, Module 14.4, LOS 14.g)

Related Material

SchweserNotes - Book 2

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To structure a limited partnership that would transfer tax burdens from the current owner of a

real estate investment while allowing the owner to control the property the current owner

should assume the role of:

A) general partner.

B) angel investor.

C) limited partner.

Explanation

As general partner the current owner will still make the business decisions and controls the

asset An angel investor is a term that can refer to the rst non-family member investor in a

The de nition of human capital is a measure of an individual's lifetime earning capacity It is

the present value of the individual's expected income from salary, wages, bonuses, etc

Employment-related retirement pension income is viewed as nancial capital Human and

nancial capital added together are called total wealth

(Study Session 6, Module 14.1, LOS 14.a)

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The owner of a real estate property who obtains a mortgage with recourse has done all of the

following EXCEPT:

A) retained control of the property.

B) e ectively bought a protective put on the property.

C) monetized the asset.

Explanation

Only a non-recourse loan would allow the owner to default on the loan and walk away from

the property without allowing the lender to pursue other means to force the borrower to pay

The mortgage is a monetization strategy and leaves the owner in control of the asset

(Study Session 6, Module 13.4, LOS 13.k)

Which of the following statements is least accurate regarding human capital?

A) When possible, one should maximize the correlation of human and nancial

capital

B) If an investor’s human capital is equity-like they should allocate a greater amount of

their nancial capital to xed income investments

C) The demand for life insurance will increase if human capital is bond-like.

Explanation

One should always o set the risk of their human capital with the risk of their nancial capital

and minimize the correlation between the two If an investor's human capital is equity-like

they should reduce the correlation with their nancial capital by allocating a greater amount

of their nancial capital to xed income investments and visa versa The demand for life

insurance will increase if human capital is bond-like and decrease if human capital is

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Financial wealth and the demand for life insurance have:

A) either a positive or a negative relationship depending upon the individual’s level of

wealth

B) a negative relationship.

C) a positive relationship.

Explanation

Financial wealth and the demand for life insurance have a negative relationship which means

if a person has a lot of nancial wealth their need for life insurance is small and visa versa

(Study Session 6, Module 14.2, LOS 14.e)

Factors that are positively related to the demand for life insurance include:

A) human capital volatility and risk aversion.

B) risk aversion and probability of death.

C) nancial wealth and probability of death.

Explanation

As either risk aversion or probability of death increase, so does the demand for life

insurance Human capital volatility and nancial wealth are both negatively correlated with

the demand for life insurance

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Which type of life insurance imposes premiums that best re ect the pure risk of death at any

particular point in time?

A) Universal life insurance.

B) Whole life insurance.

C) Term insurance.

Explanation

The premium for a term life policy primarily re ects the mortality risk to the individual for a

short, usually one year, period Generally speaking, term life premiums are lower at younger

ages and rise over time in line with the increasing risk of death Pricing for the other products

is more complex as the initial premiums are higher and re ect risk of death over the

expected (and longer term) of the policy and not just for a single period

(Study Session 6, Module 14.3, LOS 14.f)

The purpose of a personal line of credit secured by company stock for the owner of a private

business is generally to:

A) extract cash from the business so the owner can use the funds for personal

purposes

B) convert the remaining ownership position to public stock.

C) exit any responsibility for managing the business.

Explanation

This is a monetization strategy that provides the owner with funds to use for other objectives

The shares are still owned and the owner still has control of the company It does not convert

shares to public stock, an IPO might accomplish that

(Study Session 6, Module 13.4, LOS 13.j)

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Which of the following statements regarding annuities is least correct?

A) The premium for an advanced life deferred annuity would be lower than the

premium for an immediate life annuity (all else being equal)

B) The payout for a joint annuity will be lower than the payout for single-life annuity

(all else being equal)

C) The annual payout on a life annuity would be greater for a 60 year old female than

for a 60 year old male (all else being equal)

Explanation

All else the same, annuity payouts for females are lower (not greater) because females have a

longer life expectancy and will receive more payouts The other statements are true

Advanced life deferred annuities start their payout only after a long delay Therefore the

number of expected payouts is lower and the payout amount per period is higher Joint life

annuities are likely to pay longer and therefore the insurance company must set a lower

payout amount per period

(Study Session 6, Module 14.4, LOS 14.h)

By using an exchange fund it is most accurate to expect an investor can:

A) monetize the asset at a better LTV.

B) pay a smaller tax now to minimize future taxes.

C) defer and then escape future taxes.

Explanation

Is most accurate The exchange fund simply exchanges an undiversi ed single asset holding

for a share in a somewhat more diversi ed portfolio The tax basis in the new fund is the

same as before the exchange with no tax due currently and the unrealized tax liability is

unchanged With the increase in diversi cation the investor could seek a loan to monetize the

exchange fund holding and use the funds for even further diversi cation How much a lender

will loan against a relatively illiquid exchange fund is unclear but this is the best answer

choice o ered

(Study Session 6, Module 13.3, LOS 13.i)

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Karl and Karen Arlt are both thirty- ve years old and have two children, Noah and Jamie ages 5

and 7, respectively Karen is a tenured professor at the local state college and Karl is an

engineer working at an electrical utility company Together the Arlts have a combined income

of $150,000 per year The Arlts are meeting with a nancial consultant Katherine Ryals, CFA, for

the rst time who was recommended to them by Karl's brother who is also training with Ryals

to become a nancial consultant himself The four of them are meeting around the Arlt's dining

room table where Ryals is gathering information to determine an investment policy statement

for the Arlts who state they want to retire when they are 60 years old One of the questions

asks the Arlts about their general feelings of risk and Karen blurts out "the recent turmoil in the

nancial markets due to the mortgage crisis makes me sick to my stomach!" Up to this point in

their lives the Arlt's have not amassed a signi cant amount of nancial wealth nor have they

given much thought about leaving a bequest

It is now two weeks later and the Arlt's are meeting with Ryals and Karl's brother again Ryals

suggests that they purchase a million dollar variable universal life (VUL) policy whereby their

premium payments will go into mutual fund type investments resulting in equity-like returns

She states "because your incomes are stable your human capital is xed income-like thus to be

able to replace your steady income your demand for life insurance is high." She goes on to

state "since your incomes are stable your assets should be invested in more equity-like

investments like the ones found in the VUL thus it is the perfect investment vehicle for you."

Ryal's analysis reveals that to maintain their current $150,000 per year income when they retire

in 25 years at age 60 assuming a 3% increase in income per year would require an income

stream of about $314,000 per year This represents a portfolio worth approximately $3.3

million at retirement, assumes they live another 20 years during retirement, achieve a 7% rate

of return on their portfolio during retirement, and there is nothing left of the portfolio at the

end of 20 years Ryals goes on to further explain that to amass the equivalent of $3.3 million 25

years from now given they have no retirement savings now and assuming a 10% yearly rate of

return would require them to save roughly $2,500 per month

After careful consideration of their insurance needs the Arlts decide to purchase term

insurance on both of them and invest a portion of their after tax income into a deferred

variable annuity Upon retirement the Arlts are expecting to choose the largest cash out ow

possible from the annuity utilizing the "joint and survivor" payout option The Arlts also decide

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to purchase disability insurance that will pay them 80% of their salary in case either of them are

unable to perform their jobs due to an illness or condition

Based on the information regarding Karl and Karen's incomes the discount rate used to

determine their human capital would be:

A) low representing lower risk due to their stable incomes.

B) high because their incomes would have a low variability over time.

C) indeterminate since the discount rate is based on factors other than the variability

in their incomes

Explanation

Since the Arlts both have stable incomes with Karen being a tenured college professor and

Karl working in the utility industry, neither of which are closely tied to the economy, the risk

of their incomes is low thus the risk premium would also be low resulting in a lower overall

discount rate and higher human capital

(Study Session 6, Module 14.5, LOS 14.l)

Given the Arlt's personal information gathered from the questionnaire, which of the following

statements regarding the correct asset allocation of their portfolio is most accurate?

A) Their portfolio should be allocated more towards less risky assets because they

have a below average willingness to accept risk thus their overall risk level is below

B) Their portfolio should be allocated more towards risky assets since their human

capital is bond-like

C) Since they are in the early part of the accumulation phase of their careers they can

tolerate more risk in their portfolio and thus should be invested more heavily in

i i

Explanation

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Even though the Arlt's human capital is bond-like indicating they should invest their portfolio

more towards equities, Karen's statement about the mortgage crisis indicates a below

average willingness to take risk, thus their overall level of risk tolerance is below average

Knowing the size of their portfolio is relatively small the advisor should defer to the client's

willingness to take risk if willingness is below ability and the portfolio is not appreciably large

The statements made by the nancial consultant regarding the demand for life insurance and

the asset allocation of the policy premiums are:

A) correct for only one of the statements.

B) incorrect for both statements.

C) correct for both statements.

Explanation

The statements made by the nancial consultant are correct for both statements Since the

incomes of both Karen and Karl are stable their human capital is bond-like thus to replace

this income their demand for life insurance is high and their assets should be allocated more

aggressively in equity type investments

A disadvantage of the Arlt's choice of the annuity is:

A) if they both die before their predicted life expectancy the remainder of their assets

will go to the insurance company instead of their heirs

B) the annuity is less tax e cient than utilizing a de ned contribution plan.

C) the annuity will lose real earning power in periods of high in ation.

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One disadvantage of an annuity is that a person may die sooner than their predicted life

expectancy in which case if they also choose the largest payout this means they aren't leaving

anything to bene ciaries In that case the rest of their assets in the annuity would go to the

insurance company instead of being passed on as a bequest to their heirs Real earning

power is only lost in a xed annuity in which the income stream is xed and thus would not

keep pace with in ation The Arlts purchased a variable annuity which should keep pace with

in ation assuming the investment returns are at least as high as the rate of in ation A

deferred annuity is not necessarily less tax e cient than a de ned contribution plan because

in all these accounts income and capital gains are tax deferred so they are equivalent from

that tax standpoint One tax di erence between the de ned contribution accounts and

annuities is the de ned contribution accounts are funded with pretax dollars which lowers

the investor's taxable income by the amount contributed In contrast the annuity is funded

with after tax dollars thus the investor's taxable income is not lowered at the time of the

contribution as occurs with the de ned contribution plan but they owe less income taxes

when they withdraw the money during retirement The goal of the Arlts was to mitigate

longevity risk which can only be done with an annuity which o ers lifetime payments which is

not an option with a de ned contribution Although taxes should always be considered they

are not speci cally mentioned as an issue in this case

The deferred variable annuity will mitigate against longevity risk which is the risk of living too

long by paying out an income stream for the remaining life of the purchaser of the annuity

Liability risk refers to legal responsibilities for damages imposed by lawsuits or other claims

Financial market risk is the risk of a person's wealth decreasing due to a downturn in the

nancial markets A remedy for nancial risk is to diversify your assets A variable annuity can

hedge against nancial risk because they o er the ability to diversify among many di erent

types of equity and xed income investments Thus, even though a deferred variable annuity

can help to reduce nancial market risk through diversi cation options, the main purpose of

an annuity is to provide an income stream for life which reduces longevity risk

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A) Net wealth cannot be negative or else an individual would be bankrupt.

B) A de ned contribution plan balance is not included in a traditional balance sheet

but is in an economic balance sheet

C) Planned bequests are a liability.

Explanation

Planned bequests are considered a liability on an economic balance sheet but not on a

traditional balance sheet A de ned contribution plan balance is likely to be included in a

traditional balance sheet The statement would have been true for the individual's de ned

bene t plan value Negative net wealth is possible and it does not necessarily mean than an

individual is bankrupt From the perspective of an economic balance sheet, it more likely

suggests that the individual's consumption and bequest plans are unrealistic Or negative net

wealth could be an estimation error due to the di culty of valuing the additional items on

the economic balance sheet such as future labor income and pensions

(Study Session 6, Module 14.1, LOS 14.d)

A) A single male with no dependents.

B) A married male su ering from a rare congenital heart condition.

C) A married female with low tolerance for investment risk.

Explanation

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Annuities are more appropriate for individuals at risk of outliving their savings (longevity

risk) An individual with a rare heart condition would likely have a shorter life expectancy,

making the economics of the annuity purchase less appealing (If they can nd reasonably

priced health insurance that is a more pressing need) Depending on the size of their

nancial capital versus needs, the other individuals are more likely to need insurance

(annuities) for longevity risk

(Study Session 6, Module 14.4, LOS 14.i)

Whole life typically has a xed annual premium payment Because the policy cannot be

cancelled by the insurance company as long as the premiums are paid, purchase at a young

age may be more desirable as new insurance may be unavailable or much more expensive if

the insured person's health deteriorates Universal life is similar to whole life but the

premium payment can be increased or decreased to change the amount of insurance

coverage and/or the rate at which the cash value grows Term life covers only a designated

period and the premiums can be xed or increasing but only over the designated period

(Study Session 6, Module 14.3, LOS 14.f)

A) Net wealth is the sum of nancial capital and human capital.

B) Human capital and nancial capital tend to move together over time.

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C) Financial capital tends to increase with age.

Explanation

Financial capital tends to increase with age up to retirement as individuals save and invest,

but then declines during retirement Net wealth is the sum of nancial capital and human

capital less any liabilities owed Human capital generally decreases until retirement as the

remaining work career decreases with age while nancial capital increases

(Study Session 6, Module 14.2, LOS 14.b)

A) Sale of the asset.

B) Forward conversion with options.

C) Total return equity swap.

Explanation

Sale of the asset typically generates cash and there is no need for a loan The other strategies

hedge away much of the risk in the position and should allow a higher LTV loan to be

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C) Premature death risk.

Explanation

Longevity risk primarily relates to the 'retirement' phase of an individual's life, whereas,

premature death risk is greater at a younger stage in life, especially when human capital is

high and nancial capital is low Career risk can be high at later stages of the working life

(peak accumulation) as it can be di cult to nd new employment in the event of an

unforeseen loss of job

(Study Session 6, Module 14.3, LOS 14.c)

A) A married 49 year old stockbroker.

B) A single 25 year old consistently highly paid individual with no dependents.

C) A married 31 year old systems analyst who supports his aged parents and has a

large mortgage

Explanation

Without dependents such as parents or a spouse, there are unlikely to be needs that

continue beyond premature death Without such needs there is no reason for life insurance

A younger age implies a longer time horizon High and consistent wage income implies the

ability to save and replace investment losses Both of these factors increase ability to take

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A) a tax e cient exit strategy.

B) provide funds to meet portfolio objectives.

C) increase portfolio systematic risk.

Explanation

Increasing systematic (market) risk is least likely The client may need to increase, decrease,

or leave systematic (market) risk unchanged Decreasing non-systematic (or asset speci c)

risk, providing funds for portfolio objectives, and tax e ciency are common objectives in

Which of the following statements regarding human capital volatility is most accurate? When

human-capital is bond-like, an investor's nancial assets should be:

A) allocated towards low risk assets and their demand for life insurance will increase.

B) more aggressively allocated and their demand for life insurance will decrease.

C) more aggressively allocated and their demand for life insurance will increase.

Explanation

When human-capital is bond-like, an investor's nancial assets can be more aggressively

allocated and the demand for life insurance will increase On the other hand, when

human-capital is equity-like, an investor's nancial assets should be allocated towards low risk assets

and their demand for life insurance will decrease

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A) a private company acquired at the bottom of a past economic cycle.

B) publicly traded shares of stock recently awarded to a company executive.

C) a real estate asset held a couple of years.

Explanation

A past economic cycle implies quite a few years ago and the bottom of the cycle suggests a

low acquisition price and subsequent price appreciation With nothing else to go on the

largest unrealized gain and tax liability would be with the privately held company

(Study Session 6, Module 13.1, LOS 13.c)

Which of the following has a positive relationship with the demand for life insurance?

A) The level of nancial wealth.

B) An investor’s aversion to risk.

C) The volatility of the investor’s human capital.

Explanation

An investor's aversion to risk and the demand for life insurance have a positive relationship –

the greater their level of risk aversion the more life insurance they demand The level of

nancial wealth and demand for life insurance have a negative relationship as does the

volatility of the investor's human capital and demand for life insurance

Which of the following statements is most correct?

A) Prior to retirement, an individual’s nancial capital is expected to increase while

human capital is likely to decrease

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B) An individual’s net wealth is equal to the value of their nancial assets less the value

of the nancial liabilities

C) An individual’s human capital will always be lower than their nancial capital.

Explanation

Generally speaking, nancial capital will be low when an individual enters the workforce and

will increase during their working life Human capital will decrease as retirement approaches

Net worth takes into account an individual's traditional assets and liabilities, whereas their

net wealth also takes into account their human capital, pensions and the present value of

their future lifestyle costs

(Study Session 6, Module 14.2, LOS 14.b)

An advantage of a variable annuity over a xed annuity is the:

A) variable annuity o ers the opportunity to stay even with the rate of in ation.

B) variable annuity o ers stable income over the life of the purchaser of the annuity.

C) purchaser of the variable annuity will never out live the income stream from the

annuity

Explanation

Since variable annuities are invested in mutual fund like sub-accounts that can be directly

invested in equities they o er a return that can meet or exceed the in ation rate For

example if the return in the equity-like subaccounts is high enough the annuity payments will

increase instead of stay the same as would be the case with a xed annuity Both xed and

variable annuities o er income streams for the remaining life of the annuitant The variable

annuity's cash ows are not stable and will uctuate according the investment returns in the

sub-accounts and will not keep pace with in ation if the returns are less than the in ation

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