Human Capital, Asset Allocation, and Life Insurance
Life insurance is something everyone needs for multiple reasons. These reasons include, but are not limited to: protection, financial aid, peace of mind, etc. Life insurance is great benefit especially when people want to protect the family and/or the people they love the most. However, it is important to assess what this guarantee offers, and what you can expect with your ideas in the future. The main objective of this article is to argue about what is really human capital, and how it affects more than asset allocation. Human capital also affects life insurance, which, as already mentioned, plays an important role for an individual investor. Both of these financial decisions serve as substitutes for the risk when it comes to the portfolio of an individual investor, and according to the point of view of the authors, they must be determined jointly.
Human Capital and Financial Capital
Although there are several types of capitals for an investor, only two of them make up total wealth. Human capital and financial capital accurately represents the value of total wealth. In spite of this the economic theory predicts that investors make life insurance and asset allocation decisions to maximize their lifetime utilities of wealth and consumption. This makes the human capital more prominent, and is frequently the largest asset an investor has.
Investment in human capital has the potential to increase the possibilities of production in the future. This is why young investors have more human than financial capital, especially since they have had few years to save and accumulate financial wealth. On the other hand, older investors have more financial capital; those who have had more time to save and have enough to invest.
Both capitals have changing mix throughout the life cycle of an individual/investor, and therefore affects their financial assets. Human capital has a tendency to move more than financial capital, particularly in global economies. Human capital theory holds that there is a direct relationship between education, experience, and income. To determine which are the variables that influence the labor income, it is not enough to include variables related to the stock of human capital. This would allow us to find out if there are differences between individuals. The key theoretical implications are: “1) young investors will invest more in stocks than older investors; 2) investors with safe labor income (thus safe human capital) will invest more of their financial portfolio into stocks; 3) investors with labor income highly correlated with stock markets will invest their financial assets into less risky assets; and, 4) the ability to adjust labor supply (i.e., higher flexibility) also increases an investor’s allocation toward stocks.” (2006)
For all the above, the objectives of this theory are to determine the influence of human capital accumulation on individual incomes and wage dispersion. Also, to arbitrate if belonging to a specific sector (modern or traditional) influences the relationship between the accumulation of human capital and income. Likewise, analyze the evolution of returns to education and experience in each of the sectors throughout this decade. According to theoretical studies, there is a clear link between the demand for life insurances and the uncertainty of human capital. Campbell (1980) believes that for most household, labor income uncertainty dictates the uncertainty of financial capital income.
Description of The Model
Consider a portfolio of risks, in a time interval that is usually considered a year. Although there are several types of variations in the products offered by life insurance, we will focus on the main one: Annual renewable term; insurance that provides coverage for one year with the option to renew it each year for a specific time, such as 20 years. With this policy, your rates increase each year that you renew it, and are calculated based on the probability that you will die within the next year.
where:
P, is premium
, is desired value
q, is the probability of death
1+r, is interest rate factor.
For an investor, choosing the correct policy is based on deciding which term to acquire (usually 10, 20 or 30 years) requires a review of debts, financial needs, needs of their dependents. Therefore, assets are distributed in two types of classes; risk free asset (bonds), and risky asset (shares/stocks).
The principal objective of the investor is to maximize the overall utility, which includes the utility from the investor’s alive state/dead state. Here an equation that explains in more detail what mentioned above.
This model is inspired by Campbell, Smith and Buser.
The relationship between the financial and labor world go beyond being simple relations of interdependence, and in this sense, they have an organic character. These relations are difficult to define during the development periods, they are more visible in periods of crisis, and, manifest themselves in different ways, whether the financial crisis is caused by insufficient valuation of the capital committed or that is directly financial, as a result of a lack of confidence in international financial markets caused, for example, by a deep and growing imbalance in the balance of current accounts.
According to the analyzed cases on the article, this document is based on the Mertonian idea, as mentioned above; follows the theory that human capital is worth more than financial capital according to the individual’s daily life, and even more for an investor’s life. It is important to try to constantly expand your human capital, think of it as a form of investment. Human capital is the asset that you personally contribute every day. It is the realization of your potential to earn income. Why is human capital important?
When an investor has an idea of the value of their personal effort and their life's work, they can plan smarter and take action to avoid or reduce the big risks in the way they invest or spend their money. Like any asset, human capital must first be examined independently and then in relation to its finances in general.
Bequests should also encourage an investor to consider the use of insurance to replace assets. It is necessary that you grant a will to make a bequest. This is a reference tool with which you make sure that, when the time comes, your gesture will be respected.
Human Capital
This is the basic life insurance pricing mechanism and, more importantly, the detailed model that underlies the numerical results and the examples we provide.
where:
ht, denotes the random (real, after-tax) wage or salary
n, is the number of periods over which we are discounting
r, is the relevant risk-free discount rate
v, is the parameter that captures illiquidity
This formula is based on the education and profession of the investor. You would expect them to earn the same amount in each period. There are different characteristics regarding the portfolio of the market, thus inducing risk premiums. Therefore, it is important to determine in which class an investor/individual can belong to, in order to receive a correct amount for life insurance.
In conclusion to this article, investors must take serious decisions about the allocation of assets, like life insurance decisions. The magnitude of human capital, its volatility and its correlation with other assets significantly affect the two decisions throughout the life cycle. One of the significant effects in insurance demand is; the legacy preference and/or the subjective survival probability of one individual. Finally, investors who are conservative should invest more in risk-free assets and acquire more life insurance.
Asset Allocation in a Crisis
During 2007 and 2008 there was a market crisis, which destroyed the knowledge of many investors; about efficiency and stability in their markets. Jacobsen makes reference to three main culprits. (1) confusing static for the strategic allocation of assets, (2) use of historical estimates instead of prospective estimates as inputs in an optimization of asset allocation, and (3) acceptance of risk management has to do with size and style, while ignoring sectors, countries, liquidity and other factors.
Static for the Strategic Allocation of Assets
This was confusing, because this allocation needs to be dynamic, and not static.
The attractiveness of real assets is multifactorial; they allow us to avoid the current context of low interest rates, they are a protection against inflation, they allow us to take advantage of interesting correlations, capture liquidity premiums, etc. Also shows the importance of integrating real assets (real estate assets, private capital and private debt) into a diversified portfolio: diversified portfolios that incorporate real assets do a better performance in times of crisis.
Human Capital and Financial Capital
A common rule is that, as a person grows older, the more assets should be assigned to the bonds. But, why? Well, because at the beginning, investors carry a lot of wealth to human capital or potential future income, and
as they approach their retirement their human capital begins to mature, and they must lean towards financial capital.
The Pool and the Stream
About 78 million baby boomers are reaching retirement here in the United States, and most of them are just not ready for their retirement. Researchers use “decumulation” as a new frontier in retirement planning. The intention of these researchers is to help the baby boomers make a good decision, and thoroughly explain the so-called “annuity puzzle” and determine how the annuity products should be structured and marketed.
The Annuity Puzzle
Just as people do not insure their future or their life, with life insurance, although the reasons for doing so are too many. The same is an annuity puzzle; Few investors choose to benefit even on a part of their accumulated savings. But, what about the rest of the investors? Even if they have many good and justifiable reasons to do it, they just do not do it. Likewise, we can understand, that is the disconnection between economic arguments of annuity and the aversion of the investment towards the annuity.
The aging of the population makes longevity a significant risk for pension and annuity fund payments. Public budgets should finance increasingly longer pensions. But, what alternatives do we have to cover this economic risk of a long life? The risk of longevity begins at retirement age and increases progressively as we become more dependent and need more medical attention. Insurers will have an important role in this process with the possibility of offering longevity insurance.
The idea is that these insurances are contracted at an early age and begin to receive from 70-80 years as a life annuity. Other alternatives have also been proposed, such as longevity risk coverage contracts, longevity bonds or reinsurance agreements. The most important thing about reaching a long-term age is having lived with a quality standard of living.
There is no magic formula for longevity, but our lifestyle along with a healthy diet will mark our life expectancy. Also, if we have a life insurance that protects us when we need it most, we can enjoy a long and carefree life.
Framing Effect
The decisions an individual can make with respect to a certain situation. Professor Sweet refers to this, as an example of cognitive bias, in which people react to a particular choice in different ways depending on how it is presented; e.g. as loss or as gain.
An example to this could be that, imagine that a certain action must be performed out in a stipulated time, in case this action is performed out completely in the period of time required, the person will be gratified in the amount of $ 50.00, but in case, the person takes longer than required, will be sanctioned for the same amount of money $ 50.00. Studies analyzed that the second option was more favorable and effective, because people complied with the norm thinking about the possibility they had of losing. That is why we can make bad decisions when choosing annuities.
New Products
This could be a solution by increasing number of variations on the life annuity product are emerging to address considerations that savers have but often don’t or can’t articulate…Investing your Lump Sum at Retirement
Most retirement savings have in common that they incorporate tax advantages -which differentiate them from other investment alternatives-. Hence, as a counterpart, also require a minimum investment period or the occurrence of any event that allows the rescue such as retirement.
Perfect Storm
Also known as "Tsunami Wave". The organization of our own finances is the best solution, for this storm that cannot be hindered. Five forces flow in this "storm". (1) The decreasing levels and importance of Social Security benefits; Social Security helps people of legal age, workers who become disabled, and families who suffer the death of a provider. The adverse effect of this lower rate of return affects especially the highest taxpayers, as shown below. The table below shows that people with the lowest income levels are projected to receive a rate of return on their contributions of 2.8%, seven times more than the 0.4% returns projected for those whose income was taxed at the maximum levels.
(2) The demise of defined benefit (DB) pensions; The fact is that the retirement crisis is real, and that it is coming at full speed. Pensions are disappearing. The attack on Social Security would result in millions of retired Americans staying with practically nothing. (3) The aging of the baby boom generation; experts remember that such a large increase in the population with older age poses other important challenges for which the country must prepare and also the society itself. (4) The emergence of post boomers (5) The increasing longevity of the American population; the retirement system has had to deal with longevity because when the Social Security was instituted, the average person did not live until he was 65 years old.
Annuitization
people put many pretexts about this, such as; is very expensive, what if I get sick? and if inflation returns? but the reality is that when you consider the benefits associated with annuities, and guaranteed payments, all these excuses have no argument.