Tuesday, January 23, 2007

Asset Allocation and Insurance Hedging

The question of how to hedge risks to human capital (early in life) and indeterminate life expectancy (later in life) by broadening the asset allocation paradigm to included insurance hedging with life insurance and immediate annuities are examined in the following two papers:

Human Capital, Asset Allocation, and Life Insurance

P. Chen, R. Ibbotson, M. Milevsky and K. Zhu
Version: February 25, 2005

Human capital should be taken into account when building portfolios for individual investors. One unique risk for an investor’s human capital is mortality risk, the loss of human capital in the unfortunate event of premature death. Life insurance hedges against mortality risk. Human capital affects both the optimal asset allocation and the optimal life insurance demand. However, asset allocation and life insurance decisions have consistently been analyzed separately in theory and practice. We develop a unified human capital based framework to help individual investors make both decisions. We investigate the impact of the size of human capital, its volatility, and its correlation with other assets; bequest preference; and subjective survival probability through five case studies. Our analysis validates some intuitive rules of thumb and provides additional results.

Merging Asset Allocation and Longevity Insurance: An Optimal Perspective on Payout Annuities

by Peng Chen, Ph.D., and Moshe A.Milevsky, Ph.D.

Although several recent papers in the Journal of Financial Planning have discussed the mechanics and importance of lifetime, or payout annuities, the industry currently lacks a coherent and formal model of how much wealth should be allocated within and between these products.This paper revisits the importance of longevity insurance—while discussing the concerns with a strategy consisting purely of fixed payout annuities—and then addresses the proper asset allocation between conventional financial assets and payout annuity products. Our focus is on maximizing a suitably defined objective function in an intuitive,comprehensible and practical manner. In addition to the usual risk and return preferences of investors, our modeling framework requires inputs on the relative strength of retirees’bequest motives, their subjective versus objective health status, and their pre-existing longevity insurance (aka pensions).To illustrate the model,we provide some brief case studies.

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