Risk Management for Individuals

The risk management process for individuals is complex given the variety of potential risks that may be experienced over the life cycle and the differences that exist across households. In this reading, key concepts related to risk management and individuals include the following:

• The two primary asset types for most individuals can be described broadly as human capital and financial capital. Human capital is the net present value of the individual’s future expected labor income, whereas financial capital consists of assets currently owned by the individual and can include such items as a bank account, individual securities, pooled funds, a retirement account, and a home.

• Economic net worth is an extension of traditional balance sheet net worth that includes claims to future assets that can be used for consumption, such as human capital, as well as the present value of pension benefits.

• There are typically four key steps in the risk management process for individuals: Specify the objective, identify risks, evaluate risks and select appropriate methods to manage the risks, and monitor outcomes and risk exposures and make appropriate adjustments in methods.

• The financial stages of life for adults can be categorized in the following seven periods: education phase, early career, career development, peak accumulation, pre-retirement, early retirement, and late retirement.

• The primary goal of an economic (holistic) balance sheet is to arrive at an accurate depiction of an individual’s overall financial health by accounting for the present value of all available marketable and non-marketable assets, as well as all liabilities. An economic (holistic) balance sheet includes traditional assets and liabilities, as well as human capital and pension value, as assets and includes consumption and bequests as liabilities.

• The total economic wealth of an individual changes throughout his or her lifetime, as do the underlying assets that make up that wealth. The total economic wealth of younger individuals is typically dominated by the value of their human capital. As individuals age, earnings will accumulate, increasing financial capital.

• Earnings risk refers to the risks associated with the earnings potential of an individual—that is, events that could negatively affect someone’s human and financial capital.

• Premature death risk relates to the death of an individual, such as a family member, whose future earnings (human capital) were expected to help pay for the financial needs and aspirations of the family.

• Longevity risk is the risk of reaching an age at which one’s income and financial assets are insufficient to provide adequate support.

• Property risk relates to the possibility that one’s property may be damaged, destroyed, stolen, or lost. There are different types of property insurance, depending on the asset, such as automobile insurance and homeowner’s insurance.

• Liability risk refers to the possibility that an individual or other entity may be held legally liable for the financial costs of property damage or physical injury.

• Health risk refers to the risks and implications associated with illness or injury. Health risks manifest themselves in different ways over the life cycle and can have significant implications for human capital.

• The primary purpose of life insurance is to help replace the economic value of an individual to a family or a business in the event of that individual’s death. The family’s need for life insurance is related to the potential loss associated with the future earnings power of that individual.

• The two main types of life insurance are temporary and permanent. Temporary life insurance, or term life insurance, provides insurance for a certain period of time specified at purchase, whereas permanent insurance, or whole life insurance, is used to provide lifetime coverage, assuming the premiums are paid over the entire period.

• Fixed annuities provide a benefit that is fixed (or known) for life, whereas variable annuities have a benefit that can change over time and that is generally based on the performance of some underlying portfolio or investment. When selecting between fixed and variable annuities, there are a number of important considerations, such as the volatility of the benefit, flexibility, future market expectations, fees, and inflation concerns.

• Among the factors that would likely increase demand for an annuity are the following: longer-than-average life expectancy, greater preference for lifetime income, less concern for leaving money to heirs, more conservative investing preferences, and lower guaranteed income from other sources (such as pensions).

• Techniques for managing a risk include risk avoidance, risk reduction, risk transfer, and risk retention. The most appropriate choice among these techniques often is related to consideration of the frequency and severity of losses associated with the risk.

• The decision to retain risk or buy insurance is determined by a household’s risk tolerance. At the same level of wealth, a more risk-tolerant household will prefer to retain more risk, either through higher insurance deductibles or by simply not buying insurance, than will a less risk-tolerant household. Insurance products that have a higher load will encourage a household to retain more risk.

• An individual’s total economic wealth affects portfolio construction through asset allocation, which includes the overall allocation to risky assets, as well as the underlying asset classes, such as stocks and bonds, selected by the individual.

• Investment risk, property risk, and human capital risk can be either idiosyncratic or systematic. Examples of idiosyncratic risks include the risks of a specific occupation, the risk of living a very long life or experiencing a long-term illness, and the risk of premature death or loss of property. Systematic risks affect all households.