FIN1 FTU - Stage 9

F1 – Project-Stage 9: Insuring your health TCHE322 Lawrence et al (2011). Chapter Chapter 9 CFA Level III, Volume 4 1 Schedule of lectures Project topic covered • Risk management for individual • Health insurance • Benefits and costs Groupwork project activities • Estimating human capital and economic net worth • Illustrating and analyzing health insurance packages • Making decision 2 Human capital, Financial capital and Economic net worth Human capital Financial capital Economic net worth Traditional balance sheet versus Economic (Holistic) balance sheet 3 Human capital • Future wages or earnings can be thought of as analogous (in a rough sense) to future interest or dividend payments that flow from an individual’s work-related skills, knowledge, experience, and other productive attributes that can be converted into wage income—or human capital. • Human capital provides a significant stream of income over decades, its present value is a significant part of most working households’ total wealth portfolio. ⟹human capital is often the dominant asset on a household’s economic balance sheet. ⟹From a risk management perspective, it is critical to understand the approximate total monetary value of an individual’s human capital, the investment characteristics of the individual’s human capital (i.e., whether the capital is more stock-like or bond-like), and how the approximate value of an individual’s human capital relates to the value of the individual’s financial capital. 4 Human capital – Estimating human capital • Human capital is commonly defined as the mortality-weighted net present value of an individual’s future expected labor income. • Estimating human capital: by discounting the expected future cash flows generated from wages or other income sources. Simple model: General model: 5 John Adam is 60 years old and plans on retiring in 5 years. Adam’s annual wage is currently $50,000 and is expected to grow 2% per year. The risk-free rate is 4%. Adam works in a job with a moderate degree of occupational risk; therefore, we assume a risk adjustment based on occupational income volatility of 3%. There is a 99% probability that Adam survives the first year, a 98% probability that he survives the second year, and probabilities of 98%, 97%, and 96% for the following years, respectively. Given this information and using Equation 2, what is the present value of Adam’s human capital? 6 Financial capital • Financial capital includes the tangible and intangible assets (outside of human capital) owned by an individual or household. • For example, a home, a car, stocks, bonds, a vested retirement portfolio, and money in the bank • Personal assets • Investment assets • Publicly traded marketable assets • Non-publicly traded marketable assets • Non-marketable assets • Mixed assets 7 Personal assets • Personal assets are assets an individual consumes (or uses) in some form in the course of his or her life. • For example: automobiles, clothes, furniture, or a personal residence. • In many cases, personal assets are not expected to appreciate in value. • They are often worth more to the individual than their current fair market value. 8