Human Capital
discounted PV of expected future labor income; decreases over time
discount rate pos correlated to riskiness of cash flows
inc HC volatility = dec PV HC = dec demand for life insurance
Financial Capital
sum of all other assets; increases over time
defined benefit plan
Net Wealth
financial capital + human capital - liabilities
Financial Stages of Life
- education
- early career
- career development
- peak accumulation
- preretirement
- early retirement
- late retirement
Risks for Individuals
- earnings risk - disability insurance
- premature death risk
- longevity risk - annuities
- property risk
- liability risk
- health risk
Types of Life Insurance
- Temporary: set time frame, cheaper
- Permanent: lasts for life
- Whole Life: fixed annual premium payment
- Universal Life: variable payments
Gross Premium
net premium + load
- net premium: PV benefit payments
- load: operating exp + cost to write plan
Net Payment Cost Index
NPCI
assumes dealth at the end of the eval period, cash value is not considered
Net Surrender Cost Index
NSCI
assumes policy is terminated at end of period and cash value is received
Why Choose an Annuity
- expect to live longer
- lifetime income
- leave an estate
- less risky
- don’t have other guarenteed income sources (pension)
Asset Allocation of Total Wealth
higher risk HC (similar to equity), diversify with bond-like FC
lower risk HC (similar to FI), diversify with equity-like FC
- HC similar to FI = higher need for life insurance
Risk Management
- risk aoidance
- risk reduction
- risk transfer (buying insurance)
- risk retention (self-insure)
Systematic Risk
Cannot be diversified away; beta
Company [Property] Specific Risk
Nonsystematic risk; can be diversified away
Objectives When Managing Concentrated Positions
- Reduce risk
- Generate liquidity
- Optimize tax efficiency
Considerations When Managing a Concentrated Position
- Restrictions on sale
- Desire for control
- Wealth creation
- Other uses for asset
Institutional and Capital Market Constraints
- Margin lending rules
- Securities laws and regulations
- Contractual restrictions
- Capital market limitations
Goal-Based Investing
primary capital
- personal risk bucket
- market risk bucket
surplus capital
- aspirational risk bucket
Estate Tax Freeze
split company and retain voting preferred stock and gift non-voting common stock; growth increases value of common stock, freeze taxes on future gain (shift taxes)
retain control, decrease taxes
Limited Partnership
serve as general partner and gift limited partnership; retain control, lower limited partnership taxes because lacking control and liquidity
Monetization of Stock
- Forward sale: sell stock for delayed delivery
- Forward conversion w/ options: collar (long put, short call)
- Total return equity swap: pay equity return, get another asset’s return
- Short sale against the box: borrow shares, short stock (best for public firms)
Modified Hedging
dec downside risk, retain upside on underlying - avoid being treated as sale for tax purposes
- Protective put: long stock, long put
- No-cost/ zero-prem collar: long put, short call (diff strike prices, same premium)
- Prepaid variable forward: $/ share upfront, variation in future shares paid b/c change in stock price
Cross Hedge
- short another highly correlated stock
- short a highly correlated index
- long puts
Liquidating Private Business Options
- strategic buyout
- financial buyer/ sponsor
- recapitalization
- sell to management/ key employees
- divest non-core business assets
- sell/ gift to family
- personal line of credit secured by firm
- IPO
- employee stock ownership plan (ESOP)
Accumulated Benefit Obligation
ABO
total PV of pension liabilities to date, assuming no further accumulation of benefits
Projected Benefit Obligation
PBO
ABO + PV of additional liability from future employee compensation increases
used to calc funded status
Total Future Libability
PBO + PV of expected inc in benefits due to employees based on future service
Defined Benefit Plan
DB
company agrees to make payments to employees after retirement base on criteria; employer bears investment risk
Defined Contribution Plan
DC
company agrees to make contributions of a certain amount as they are earned by an employee; employee bears risk, portable
- participant directed: employee chooses investments
- sponsor directed: firm chooses investments
DB Plan Risk Considerations
- manage standard deviation of surplus or assets
- achieve 100% funded status
DB Plans Return Objectives
- generate return to meet liabilities
- minimum return = actuarial discount rate
- absolute return objective
DB Plan Risk Objectives
use asset/ liability management (ALM)
- funded status
- financial status and profitability
- correlation between profitability and plan assets
- plan fatures (impact on liquidity needs)
- workforce characteristics (age)
Cash Balance Plan
DB plan
defines benefit in terms of an account balance; firm must pay promised benefit payments
balance belongs to employee, portable, pay credit based on individ characteristics, interest credit based on benchmark
Foundation
grant making entity funded by gift
Endowment
long-term funds owned by a non-profit institution
Smoothing Rate
average out distributions or factor in inflation; less volatile
Simple Spending Rule
spendingt = S*( MVt-1 )
Rolling 3-yr Average Spending Rule
spendingt = ( spending rate ) * ( 3 year avg MV )
Geometric Spending Rule
spendingt = ( R )*( spendingt-1 ) + ( 1 - R )*( S )*( MVt-1 )
R = smoothing rate to reduce volatility
Foundation and Endowment Objectives and Constraints
- return: maintain value (compounded return)
- risk: more risk, no defined liability reqs
- tax: exempt, outside income taxed
- time: legally perpetual
- liquidity: minimum spending rate
- legal/ unique: depends
Life Insurance Return Objectives
- credit rate: required rate of return to pay off policy
- net interest spread: more money - charge lower premiums, invest more aggressively
- portfolio segmented by line of business
- total return: difficult b/c highly regulated
- WANNA MAKE A PROFIT AND BE COMPETITIVE
Life Insurance Risk Tolerance
- ALM: durationliabilities = durationassets to minimize volatility
- valuation risk
- reinvestment risk
- heavily regulated: reserves, capital requirements
- cash flow volatility
- credit risk
Life Insurance Liquidity Constraints
- aggregate liquidity needs
- asset marketability risk: issues selling assets to liquidate portfolio
- disintermediation risk: policyholders can borrow against plan at predetermined fixed interest rate; inc interest rate, policyholders will invest directly
Life Insurance Constraints
(excluding liquidity)
- time: long term, duration of liability
- tax: frim tax, policyholder usually not taxed
- legal: heavily regulated > eligible inv, valuation methods
- unique: depends on product offerings, firm size, level of surplus
Non-Life Insurance Objectives
- risk: uncertain payouts, shorter duration, geographical correlation
- return: depends on pricing, profitability, surplus size, taxes > total return approach
Underwriting Cycle
usually tied to business cycle
low profits (t = 0) > inv in taxable bonds (higher yield) > dec duration > raise premiums > begin profiting (t > 0) > inv in tax exempt bonds > inc duration > lower premiums > low profits (t = 0)
Non-Life Insurance Constraints
- time: shorter than life insurance, long tail (long time to actual payout)
- liquidity: higher, less predictable
- legal: regulatory constraints
- unique: depends
Bank Constraints
- time: short, duration of liabilities
- liquidity: generally short an liquid, dependent on deposits and regulations
- taxes: taxable
- legal: regulations to prevent mismatch of asset-liability duration
- unique: depends
Bank Objectives
- risk: usually below average, based on ALM framework (DA vs DL)
- return: postive interest rate spread, meet liquidity needs
- capital risk position = capital needed to support risk weighted assets (investment activities)
Investment Companies, Commodity Pools, Hedge Funds
intermediaries that pool and invest money based on stated objective of portfolio, returns are passed to investors