human capital volitility discount, insurance, gap, capital, positive

ASSet_MANagemen

The volatility of human capital and the demand for life insurance are correlated how:
positive
negative
unrelated

If vol is high, the PV of human capital is low (higher discount rate), so in my mind, the demand for life insurance would be high because you can't depend on that human capital and need life insurance to "fill the gap".

Thoughts??

Valores

Thanks CP...

still a bit cloudy to me, but I know the explanations are correct and will just have to take it at face value. human cap vol is NEGATIVELY correlated with demand for life insurance.

I would argue that if Bob was making 250k with a 5% raise each year and very low volitility, then he has visibility to plan for retirement w/o the use of life insurance. If the portfolio takes a hit this year, its not that big a deal because he can bank on 250k coming next year.

And if Joe was making $250k average but volitility in those earnings was high, he doesn't have great visibility and would rely more heavily on life insurance. financial assets go into low risk assets because if the portfolio takes a hit, he can't rely on $250k next year. Maybe its only 100k next year...its that greater uncertainty that would make the life insurance a good idea.

I'll just remember to do the opposite of that. Right way, wrong way, CFA way.

thommo77

"volatility" of human capital...

if human capital is more volatile I say its "less" certain. If you have uncertain capital what can you do to offset that uncertain capital? You obtain more guaranteed capital via insurance.

bpdulog

I am not sure that the above is essentially correct = not according to CFA at least.

the earlier statement - this is how CFA wants you to think

1. human capital is more volatile, so riskier - need to have a higher discount rate.
life insurance is a substitute for hc -> so based on the higher discount rate - you would need to have lower of it.

2. your financial capital is less volatile, so need to have it invested in low volatile securities (bond).

CP

liangfeng

Skip - I agree w/ you. You are saying volitility of human capital and insurance demand are positively correlated.

However that is wrong. human capital volitility is NEGATIVELY correlated with demand for life insurance.

My new thinking is:
1) assume everyone gets life insurance. life insurance substitutes for human capital.
2) High volitility human capital is discounted at higher rates. high rates make PV lower.
3) Low volitility human capital is discounted at lower rates. low rates make PV higher.
4) then just compare the PVs. If PV is lower, i need less of a substitute (insurance), and vice versa.

That's how they look at it to arrive at the negative correlation.



Edited 1 time(s). Last edit at Wednesday, January 12, 2011 at 05:10PM by june2009.

IAmNeil

nice lil lesson there fellas. what has two thumbs and a better understanding of this concept now???? this guy

justin88

That is so wrong, but CFA says:

It has negative correlation – more bond-like capital = more aggressive in financial capital = more insurance.

Windjam

so CFA is basically saying that since the income is volatile and uncertain, it should be worth less today. volatility = a higher discount rate = less PV of human capital to protect= lower life insurance need....

sounds like a quant developed this who has never dealt with life insurance concerns of real people and families...whatever...I will hold it in until the exam and then let it out

bodhisattva

I still dont get it bros.

Chuckrox

Mechanics are:
human cap = PV of all your future earnings discounted back to today.
insurance is a substitute for human cap
if earnings are volitile you discount at a higher rate, making PV (human capital) lower
if the PV (human capital) is lower, one would need less of a substitute to replace it - relative to someone with a higher PV.

I hate it...but I accept it.