Individuals Risk Exposures

Typical Individual Risks

• Earnings Risk: Refers to loss of Human Capital. Certain professions are inherently riskier than others. Earnings risk can refer to either a complete loss of earnings or a diminution of earnings.
• Premature Death Risk: Occurs when the untimely death of an individual leaves family members without a main source of income. This risk is higher the early the worker is in their career, as Human Capital is higher in the earlier stages of a career.
• Longevity Risk: This is the economic opposite of premature death risk. Longevity risk involves an individual living longer than planned, which may put an undue burden on a portfolio. Previous withdrawals that may have appeared sustainable given a shorter time horizon may be in retrospect, entirely too high for someone who lives substantially longer than planned. Monte Carlo Simulation and mortality tables are often used to quantify this risk.
• Property Risk: Refers to a loss of value in physical property. Risk events such as fires, adverse weather conditions, and terrorist attacks all fall into the category of property risk.
• Liability Risk: Involves being held legally liable for punitive or civil penalties.
• Health Risk: This is the loss of financial capital as an individual may have unexpected and burdensome medical bills. Such expenses can also contribute directly to earnings risk.

Methods of Insuring Typical Individual Risks

The following table matches the risk type with the method or product designed to hedge that particular risk:

$$ \begin{array}{l|l}
\textbf{Risk Type} & \text{Insurance Method} \\ \hline
\textbf{Earnings} & \text{Disability insurance} \\ \hline
\textbf{Premature Death} & \text{Life insurance} \\ \hline
\textbf{Longevity} & \text{Annuities} \\ \hline
\textbf{Property} & \text{Property insurance} \\ \hline
\textbf{Liability} & \text{Liability insurance} \\ \hline
\textbf{Health} & \text{Health insurance} \\
\end{array} $$

Question

An annuity may be used to manage which of the following risks?

1. Longevity.
2. Premature death.
3. Liability.

Solution

The correct answer is A.

An annuity is the purchase of a guaranteed income stream backed by the creditworthiness of the insurer selling it. In the case that an individual outlives the assets of their portfolio, an annuity could kick in to provide income and sustain the person until their eventual passing.

B and C are incorrect. Premature death risk is insured using life insurance. Liability risk is insured using liability insurance.

Reading 9: Risk Management for Individuals

Los 9 (e) Discuss risks (earnings, premature death, longevity, property, liability, and health risks) in relation to human and financial capital