Characteristics of Human Capital and Financial Capital

Insurance is a risk transfer mechanism. It is said to reduce the total wealth of the insured, which makes sense, as it represents a kind of amortized payment schedule of the present value of a predetermined risk event. Some risks are better handled as they arise, if the cost of paying the damages out of pocket is less than the price of a policy, not insuring certain risks is the way to go. Investment advisers may be able to help clients assess the risks they face and determine the best path forward.

Human and Financial Capital

$$ \text{Total wealth} = \text{Human Capital} + \text{Financial Capital} $$

These topics have been covered in previous readings; however, a refresher is in order as they are cornerstone ideas in this segment. Human capital (“HC”) represents the present value of lifetime income. While financial capital (“FC”) is the sum of assets, excluding human capital. FC may include:

• Stocks.
• Bonds.
• Savings accounts.
• Automobiles.
• Real estate, etc.

One important asset to note is defined benefit pension plan benefits. These benefits are a hybrid, including both components of HC and FC.

Human Capital Valuation

Valuing human capital works much like valuing a bond. All future income is projected, and then discounted and brought back to one lump sum present value. The discount rate is used at the discretion of the valuator. Riskier professions, such as race car drivers, or professional mixed martial artists, should have a higher discount rate than a union employee or government bond trader. This higher discount rate reflects the possibility of an adverse event that could diminish the income stream from employment. No matter how astute the valuation performed, longer periods of projection are always subject to error.

Example:

Ronkye Olayawe, CFA, is a young and ambitious derivatives trader working in London for a prestigious bank. Ronkye enjoys her career but often works long hours. She has already amassed sufficient financial capital to meet her needs and plans to work five more years on the trading desk before retiring to backpack the world. She has begun working with a local wealth manager to determine if life insurance would be prudent in her case, and he has suggested calculating Ronkye's human capital. Ronkye is young and has a high probability of survival from year to year, so this has a minimal effect on human capital. Her income is projected at £254,000 and is projected to grow at 3% annually based on her previous lifetime earnings. The discount rate used in this case is 5%, as Ronkye is in an industry with high turnover but also is well established and well respected at her firm. The resulting present value of her human capital is as follows:

$$ \begin{array}{c|c|c|c|c}
\textbf{Year} & \textbf{Prob. of} & \textbf{Projected} & \textbf{Prob. Weighted} & \textbf{PV} \\
& \textbf{Survival} & \textbf{Income} & \textbf{Income} & \\ \hline
1 & 99.98\% & 254,000 & 253,949 & 241,856 \\ \hline
2 & 99.5\% & 261,620 & 260,266 & 236,069 \\ \hline
3 & 99.0\% & 269,469 & 266,741 & 230,421 \\ \hline
4 & 98.5\% & 277,553 & 273,376 & 224,907 \\ \hline
5 & 98.0\% & 285,879 & 280,176 & \underline{219,526} \\
& & & \textbf{Human Capital} & £1,152,779
\end{array} $$

Financial Capital

Financial capital represents the totality of an individual's wealth ex-human capital. Some components of FC are for consumption, such as an automobile or furniture, while others are investments with the potential to appreciate in the future. Publicly traded assets will be relatively easy to value, while non-publicly traded assets do not have ready-made markets or publicly listed prices. Non-publicly traded assets may include:

• Real estate such as private residences (not including publicly traded REITS).
• Annuities that are equivalent to private defined pension benefits.
• Cash-value life insurance is life insurance with an option to borrow.
• Business assets can be a prominent component of total wealth for entrepreneurs.
• Collectables have an element of both consumption and investment value as well.
• Pensions is a stream of cash flow payable to an employee upon retirement. The vested portion belongs to the employee and can be valued according to the pension formula given by the employer.

Question

Total value of human capital and riskiness of a profession are?

1. Inversely related.
2. Positively related.
3. Not enough information.

Solution

The correct answer is A.

Riskier professions require a higher discount rate for future income, per the equation below:

$$
\sum {\frac {CF_i }{ (1 + R)}} $$

Where:

\(CF_i\) = ith cash flow.

\(R\) = discount rate.

Risky professions are those in which income may be lost altogether or may be negatively impacted by unforeseen events.

B is incorrect. This would mean that as the total value of human capital increases, the riskiness of the profession also increases. This is not a common relationship. Generally, professions requiring higher human capital tend to be less risky due to the stability and security that comes with specialized skills and education.

C is incorrect. It suggests that we don't have enough information to determine the relationship between the total value of human capital and the riskiness of a profession. While individual cases may vary, the general trend is that they are inversely related

Reading 9: Risk Management for Individuals

Los 9 (a) Compare the characteristics of human capital and financial capital as components of an individual's total wealth