Value Investing.
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The risk management process consists of four steps for individuals:
An economic balance sheet and basic budget are needed at this point to get a high-level view of the individual(s) circumstances and begin the planning process.
Determine what you want to achieve through your financial planning, such as buying a home or securing your family's financial future.
Recognize the potential risks you may face, especially if you're in the early stages of your career. These risks can include job loss, health issues, premature death, car accidents, and liability concerns.
Evaluate the identified risks and decide how to manage them effectively. This might involve insurance, savings, or other financial strategies.
Continuously track your financial situation and risk exposures. Make necessary adjustments to your risk management methods as your circumstances change.
To start this process, it's essential to create an economic balance sheet and a basic budget. These tools provide an overview of your financial situation and kickstart your planning efforts.
Economic Balance Sheet – Early Career
$$ \textbf{Economic Balance Sheet} $$
$$ \begin{array}{l|r|l|c}
\textbf{Assets} & & \textbf{Liabilities} & \\ \hline
\text{Savings account} & 20,000 & \text{Debt} & 100 \\ \\
\text{Accrued DB government} & 21,000 & & \\
\text{retirement plan (Husband)} & & & \\ \\
\text{Accrued DB government} & & & \\
\text{retirement plan (Wife)} & 11,800 & &\\ \\
\text{Husband’s human capital} & 1,800,000 & {\text{PV of lifetime} \\ \text{consumption needs}} & 2,500,000 \\ \\
\text{Wife’s human capital} & 700,000 & & \\
\textbf{Total assets} & \bf{2,552,800} & \textbf{Total liabilities} & \underline{\bf{2,500,100}} \\
& & \textbf{Net wealth} & \underline{\bf{52,700}}
\end{array} $$
Creating an economic balance sheet is a crucial step in financial planning. It serves as a visual representation of the client's financial health.
When net wealth is positive, it indicates that the client's income and savings plan align with their long-term financial goals.
However, if net wealth is negative, it signifies that adjustments are needed to ensure the client's plan can adequately support their family's financial needs.
Earnings risk from loss of employment is not easy to insure. At this stage of the process, advisors will want to look at the circumstances at hand. Are the client's individuals or a couple? Do they have dependents? Which half of the couple has a higher risk of loss? Oftentimes, a savings buffer can help protect against a sudden loss of income. This risk is generally self-insured via an adequate savings buffer.
When health or disability affects a person's income, there are potential safety nets to consider. For instance, state benefits might provide some support.
To bridge any income gap, managers should calculate human income, assess the budget, and consider lifestyle needs. This helps determine the necessary disability insurance coverage.
Finding the right balance is crucial; over-insurance can be costly, while underinsurance leaves individuals vulnerable. Some might opt for self-insurance or retain the risk as an alternative.
$$ \begin{array}{l|r|r}
& \textbf{Husband} & \textbf{Wife} \\ \hline
\text{Annual salary income (net) to be replaced} & 25,300 & 134,500 \\ \hline
{\text{Amount of annual disability coverage} \\ \text{provided by the social security system}} & 18,000 & 18,000 \\ \hline
\text{Shortfall} & 7,300 & 116,500 \\ \hline
\text{Benefit period (years until retirement age)} & 37 & 37 \\ \hline
\text{Assumed annual benefit adjustment (nominal)} & 2\% & 2\% \\ \hline
\text{Discount rate} & 3.8\% & 3.8\% \\ \hline
{\textbf{PV of future earnings replacement} \\ \textbf{required (calculated as PV of annuity} \\ \textbf{due)}} & \bf{(198,744)} & \bf{(3,171,736)}
\end{array} $$
The table above calculates the required present value of disability insurance for the couple to meet their financial goals. This involves complex time value of money calculations, a crucial skill for financial advisors to guide clients effectively.
Couples or individuals with dependents face the risk of premature death, necessitating life insurance. Two methods estimate life insurance: the human capital value method, which calculates future earnings replacement, and the needs analysis method, which considers expenses like lost income, funeral costs, and debts.
Car accidents can be expensive and emotionally challenging. Insurance may cover liability or both liability and self-coverage for repair costs. Assessing the need for coverage involves evaluating driving habits, past records, and local driving conditions.
Buying a home is a significant event with potential added expenses. Advisors should determine an affordable home based on net income and savings without depleting buffers. Residential homes are unique assets with elements of both consumer goods and financial investments.
As life events come and go, advisors need to recalculate their economic balance sheets, budgets, and life insurance needs analysis. Major life events at this stage typically include the possibility of raises or loss of income, the birth of young children, and the purchase of cars and homes. Major changes in financial markets can also be a reason to update analyses. Advisors need to continually update and revise assumptions rather than relying on outdated information. 
Question
Which of the following is not a method for calculating the amount of life insurance needed?
- Human life value.
- Insurance build-up.
- Needs analysis.
Solution
The correct answer is B.
Insurance build-up is not a method for calculating the amount of life insurance needed. This term typically refers to the cash value that accumulates in certain types of permanent life insurance policies, such as whole life insurance. It is not a method for determining how much life insurance is necessary.
A is incorrect. Human life value is a legitimate method for calculating the amount of life insurance needed. Human life value is a method that calculates the amount of insurance coverage based on a person's future earnings potential and the financial support they provide to their dependents.
C is incorrect. Need analysis is another legitimate method for calculating the amount of life insurance needed. Needs analysis involves assessing a person's financial obligations, including debts, future expenses, and the needs of dependents, to determine the appropriate amount of insurance coverage required to meet those needs.
Reading 15: Case Study in Risk Management – Private Wealth
Los 15 (a) Identify and analyze a family's risk exposures during the early career stage
Los 15 (b) Recommend and justify methods to manage a family’s risk exposures during the early career stage