Gostudymock3

Factors Affecting the Demand For Life Insurance



As previously discussed, an individual’s balance sheet gives us a complete overview of all of an individual’s assets including both human capital and financial capital. 

Human and Financial Capital - CFA Exam

Within this portfolio each specific component is subject to a risk of random loss: that is exogenous risk not captured in a given financial model. This type of risk is especially relevant for human capital.

Life Insurance Hedges Mortality Risk

Mortality risk is the risk of premature death and the subsequent loss of a family’s human capital that occurs as a result. In other words, if you die there is a huge impact on your family’s current and future earnings. Mitigating mortality risk is generally accomplished through buying life insurance.

In fact, life insurance and HC are 100% negatively correlated.

This should make intuitive sense. If you are alive then life insurance is not worth anything but your human capital is intact. If you die, however, your HC immediately falls to zero but life insurance kicks in. Thus the greater the value of your HC the more you need life insurance to protect from the loss of that HC (all else equal).

But how much life insurance do you buy?

The greater the potential loss of human capital the higher the demand for life insurance. Think about it this way: if you die your HC=0. Whatever the gap between your financial capital and the amount needed for post-death objectives equals the optimal amount of life insurance to purchase. In fact, if you perfectly match the loss of your human capital with an equal amount of life insurance it can be a perfect hedge for mortality risk.

Life Insurance - CFA Exam

The purpose of this section is to explore two of the main ways we can hedge against this type of risk, namely through the use of life insurance and annuity products respectively. Both tools can mitigate the possibility and magnitude of any potential loss.

Factors Affecting the Demand for Life Insurance

The specific checklist here remains highly testable for the CFA Level 3 exam. Pay attention.

There are two approaches to determining the exact amount of life insurance required: one that centers on the needs of the family and the other that seeks to perfectly replace the lost earnings.

One’s demand for life insurance also depends on other factors including the strength of your desire to leave an estate, how much financial capital you have, and of course, how likely you are to die.

Let’s break down each of these additional factors and how they impact the demand for life insurance.[1]

Key Factors Impacting Demand for Life Insurance

  1. AGE: The younger you are, the more HC you have, the greater your expected demand for life insurance will be
  2. DESIRE TO LEAVE BEQUEST: If you have a strong desire or need for post-death objectives, your demand for life insurance will be higher than if you don’t care about leaving anything to heirs
  3. RISK TOLERANCE: Lower risk-tolerance leads to bond-like investments (more conservative allocation) and greater demand for life insurance. The opposite is also true. You can also think about it this way—if you have a high risk tolerance you don’t want to “waste” your money buying life insurance when you could invest it instead
  4. AMOUNT OF FINANCIAL CAPITAL: More FC means less demand for life insurance. This can be because the more FC you have the less you may need a substitute in case of loss of HC. Alternatively, the more FC you have, the lower the % of HC in your total wealth and the less demand you have for life insurance in general
  5. SUBJECTIVE PROBABILITY OF SURVIVAL: The more likely you think you are to die, the higher your demand for life insurance.

To summarize:

Life Insurance - CFA Exam

 

[1] In the CFA Institute reading these factors are modelled in an optimization problem between life insurance, and other assets. You are safe to ignore the specifics of that equation as long as you have a general understanding of the factors above and their influence on the demand for life insurance.