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??

NakedPuts2011

I think of it this way:

If my human capital volatility is high (i.e - I work in a very risky environment where I could either make a lot or go home), then I'm most likely to be the guy who is risky by nature and confident that even if my career is volatile, I'll still bounce on my feet and hit it big.

Having this attitude dismisses the thought of paying for life insurance because hey, I'm the guy that's going to hit it big anyway, and the insurance money is pocket change for the lifestyle I'll be living.

Now, if I'm a professor who makes a stable salary and benefits, my human capital volatility is low, but I'm still nervous something might happen because I'm the guy that enjoys being risk-averse, so I might as well buy some life insurance should something happen.

Hopefully that explains it a bit.

lcai

Maybe just remove the volatility part of it for sake of understanding. Now lets consider 2 cases below:

Case 1: I earn $18,000 a year (mening PV of my Human Capital is very low). Me and my family live in dire conditions. If I die tomorrow, my family's condition will not be so much worse off as it is when I am alive today.

Case 2: I earn $500,000 a year (meaning, PV of my Human Capital is relatively very high). Me and my family is used to living a lavish life style. If I die tomorrow, the stop on $500,000 every year will make a LOT of difference in the way my family has lived so far.

So, higher the PV of human capital, higher is the need for life insurance (to substitute it). Now, PV can be high because you are actually earning high or it could be high because though you are earning relatively lower, but your earning volatility is lower.

Hope this makes sense.

susana

The reading is basically a theoretical framework, and as such, you can take a few liberties with understanding it. Here's my take:

1. Start from a total wealth perspective. Total wealth = financial wealth + human capital (PV of future earnings)
2. Think of your career as a continuum, whereby your goal is to convert human capital (or latent earnings potential) into financial capital. Over time your total wealth picture is less dependent on human (potential capital) and more on tangible/real/financial capital.
3. Human capital, and the income derived from it functions GENERALLY like a fixed income instrument, you receive regular distributions that IN GENERAL have low volatility. Year-over-year, human capital will perhaps increase in line with inflation and maybe bumps in pay based on promotions or larger bonuses. For most people, career income is more predictable than equity market returns...it functions more like a fixed income instrument than an equity instrument.
4. Think of the discount rate that you use to derive the PV of human capital as similar to a WACC calculation. The weighted average would be based on the percentage of your total wealth derived from human capital and financial capital. For the purposes of discounting, human capital should have a smaller required return than risky capital (or equity-like) capital. Early on in your career, you probably haven't converted a lot of your latent potential into financial (riskier) capital, so your discount rate (WACC) would be dominated by the human capital impact to your total wealth. Intuitively, this makes sense - since in general human capital is less volatile, and the required rate of return is lower, your discount rate is lower. A lower discount rate generates a higher present value -- insurance is a safety-net against that PV
5. Insurance is perfectly negatively correlated with human capital. If you die, you lose 100% of your future earnings - the PV of your future earnings potential. An appropriately purchased insurance policy would yield a distribution equal to exactly the same value of the PV lost ... perfectly negatively correlated.

CONCEPTUALLY, one wrinkle has to do with the nature of your work. Perhaps you manage a hedge fund. Your income (human capital) has a distinct equity-like component to it. In this case, as you convert human capital into financial capital, you need to be mindful that you have an implicit risky asset allocation based on the nature of your work; therefore, you should try to diversify your financial asset allocation into less risky assets.

If I wanted to over think this, I could poke holes in what I've written above (i.e. the WACC argument), but directionally I think it encapsulates the intention of the reading.

ohai

My understanding of the logic is the following:

if your income volatility is high, it limits your future spending planing, the present value of your future expenditures is lower and thus you need less insurance to cover it

when you buy an insurance you insure your life or the stream of future income per se, not its volatility... thus, the level of volatility impacts the amount to hedge



Edited 1 time(s). Last edit at Monday, January 17, 2011 at 11:09AM by diehard.

canadiananalyst

revisor Wrote:
-------------------------------------------------------
> I think what matters regarding this issue is how
> you interpret the "spirit" of insurance....
> Insurance should definetely not regarded as a
> means to "get rich", it must be thought that it is
> there only to cover against what is at risk.
>
> So, what is at risk?-> your smaller human capital
> (due to high volatility, high discount rate etc.)
> -> you should look for less insurance in that
> case. In other words, it helps you to maintain
> what you already had prior to the decease, not to
> generate a gain on it.


+1 breh

Valores

I think what matters regarding this issue is how you interpret the "spirit" of insurance.... Insurance should definetely not regarded as a means to "get rich", it must be thought that it is there only to cover against what is at risk.

So, what is at risk?-> your smaller human capital (due to high volatility, high discount rate etc.) -> you should look for less insurance in that case. In other words, it helps you to maintain what you already had prior to the decease, not to generate a gain on it.

bboo

pimpin - the mechanics make sense. Yes.

the logic is confusing. if earnings are volitile (equity-like), uncertainty is high, hedge uncertainty with insurance guarentee, avoid high risk assets for financial capital. If earnings are steady (bond-like), uncertainty is low, less of a need for the insurance guarentee, take on higher risk assets for financial capital.

dyga

insurance only pays off to surviving fam memebers as a means to replace your lost earnings stream ( it is not a lotto ticket at least it is not modeled that way which is a fair trade off since you also have to pay higher premiums which by def you cannot include in your investable portfolio leading to lost opportunity

mp3bu

its subjective... an assumption is made that higher volatility decreases PV of future earnings. would if it is a volatile industry with an overall upward trend??? or an industry with an overall downward trend? why even consider earnings volatility in 2011?? will anyone in this economy listen to you tell them they need less insurance because they have volatile earnings? show them your little math formula and explain the discount rate to them? i scoff at this....SCOFF SCOFF....that being said... there is a negative correlation. it doesnt matter why. it just is.



Edited 1 time(s). Last edit at Thursday, January 13, 2011 at 02:23PM by SkipE99.