Life insurance demand - FC

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FrankCFA

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Life insurance demand is inversely related to FC.
Is it because less need for life insurance to meet obligations or less HC to insure?
If HC and FC have highly correlation, employee stock option, high or less insurance demand?
Thanks.
 
I would tell you my understanding:
The reason for life insurance is to “hedge”mortality risk, that is in case of people die prematurely. Effectively it hedges for HC, not FC.
If you recall the chart, FC and HC have inverse relationship and sum of HC and FC is wealth. Hence FC and HC cannot be corellated .
When FC increases, HC decreases, thus higher need for insurance -> FC and insurance have inverse relationship.
In a nutshell, mean less HC to insure
Does this help?
 
Life insurance is to hedge lost Human Capital..i.e. replaces lost future earnings. As HC decreases there is less need for HC. As FC increases there is less need for HC.
 
Thanks both. How if HC and FC are highly correlated?
 
FrankCFA wrote:
Thanks both. How if HC and FC are highly correlated?
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Depends on horizon, accumulated wealth,
eg, if you’re a young broker, and all of your investment is in equity, sell some equity and buy bonds.
 
If we do not have any other info and his FC is built from HC and mainly ESOP, it’ll be future wealth so high HC% –> higher demand for LI.
Now, tell us the answer, Frank :)
 
maxmeomeo wrote:
If you recall the chart, FC and HC have inverse relationship and sum of HC and FC is wealth. Hence FC and HC cannot be corellated .
Click to expand...
HC and FC are correlated. The strength and direction depends on what FC is invested in compared to the composition of HC. For example, a stock broker has her FC invested in equities. Her income (HC) is highly correlated with equities and she’s invested (FC) in equities. Positive correlation exists. Conversely, the professor who’s income (HC) is predictable (behaves like fixed income security) and is invested (FC) in equities shows a negative correlation between FC and HC.
To clarify. My understanding is that the inverse relationship over time simply which you describe illustrates that as time passes and a person ages, they theoretically accumulate FC and FC grows (positive slope). HC’s negative slope illustrates that as you get closer to death, there is less time available to earn, PV of future earnings decrease over time, and HC shrinks.
 
A strong positive correlation of HC and FC reduces the need for life insurance.
The reasoning is that higher correlation means less diversification and higher overall risk. Higher risk requires a higher discount rate be used to find the PV of future income (i.e., less HC). Less HC today means less need for life insurance to insure against the loss of HC. (Kaplan)
 
Below from Schweser. I found it’s useful, fyi.
Life Insurance Demand
• Financial Wealth – High accumulated wealth → less demand for life insurance.
• Human Capital Volatility – High volatility of human capital → less demand for life insurance.
• Risk Aversion – High risk aversion → greater demand for life insurance.
• Probability of Death – High probability of death greater demand for life insurance.
• High Bequest Desire – Increased demand for life insurance.
 
Starting this thread back up again, just could’t resist the urge…
High FC, generally implying lower relative HC (as one rises, the other declines) would mean lower demand for life insurance, true. So HC and life insurance are positively correlated, and FC and life insurance are negatively correlated.
Just getting the concepts straight here.
 
mellex wrote:
Starting this thread back up again, just could’t resist the urge…
High FC, generally implying lower relative HC (as one rises, the other declines) would mean lower demand for life insurance, true. So HC and life insurance are positively correlated, and FC and life insurance are negatively correlated.
Just getting the concepts straight here.
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Kind of.
The question that’s getting lost in the confusion earlier is a special case where HC is correlated with FC. An example would be a tech employee owning all tech stocks. The risk implied = a higher discount rate = reduces the amount of life insurance need. Straight from CFA text.
 
In that case, a higher discount rate reduces the PV of future labor income, which translates into lower HC. Lower HC (which generally implies higher FC if you take your average person) means less demand for life insurance. FC (think your SAA) should be adjusted so that it is uncorrelated with your HC.
 
Cubemonkey wrote:
Kind of.
The question that’s getting lost in the confusion earlier is a special case where HC is correlated with FC. An example would be a tech employee owning all tech stocks. The risk implied = a higher discount rate = reduces the amount of life insurance need. Straight from CFA text.
Click to expand...
I think the reason people struggle with this is it’s not that intuitive in real world terms.
Imagine a 30 year old broker, who is supporting a family. His HC is highly correlated to FC (although argument would be he should then invest more in fixed income, but let’s just say he has overconfidence bias and wants to invest in his area of expertise). So because his HC and total wealth are riskier and have a higher r, he has less need of life insurance per CFA. Tell that to his young family when he dies prematurely - oh he didn’t buy life insurance because his human capital was risky..
 
Lea124 wrote:
Cubemonkey wrote:
Kind of.
The question that’s getting lost in the confusion earlier is a special case where HC is correlated with FC. An example would be a tech employee owning all tech stocks. The risk implied = a higher discount rate = reduces the amount of life insurance need. Straight from CFA text.
Click to expand...
I think the reason people struggle with this is it’s not that intuitive in real world terms.
Imagine a 30 year old broker, who is supporting a family. His HC is highly correlated to FC (although argument would be he should then invest more in fixed income, but let’s just say he has overconfidence bias and wants to invest in his area of expertise). So because his HC and total wealth are riskier and have a higher r, he has less need of life insurance per CFA. Tell that to his young family when he dies prematurely - oh he didn’t buy life insurance because his human capital was risky..
Click to expand...
Right. In my opinion, this specific odd case is just CFA trying to be consistent with their methodology even though in the real world it wouldn’t apply.
“Well you see, the deceased’s discount rate was actually quite high because…”
 
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