Introduction
Modern portfolio theory has taught how to manage risk of capital but does not address the risk of failing to meet financial goals because of loss of life. The risk tolerance that varies for each investor extends beyond the fear of asset safety and extends to the fear of personal safety.
Using as a premise that each investment portfolio has either an expressed or implied goal that can be defined in time/dollar terms, then, loss of life will either change these goals or materially affect the ability to achieve them.
Mortality risk is defined as the effect of loss of life on portfolio goals.
Managing Mortality Risk
Mortality risk is managed by providing the life insurance that fills the gap at each point in time on the path to achieving the portfolio goal. This gap is measured by assessing two changes:
- Distance from Goal: The difference between the current portfolio and the goal.
- Mortality Effect: The change in goal caused by the loss of life.
These changes are translated into current dollars and added together to determine the value of life insurance needed to offset the mortality risk.
Computing Distance From Goal
The distance from the goal must be calculated in present dollar terms. This requires that a single dollar goal and a time frame to achieve it be determined for the portfolio.
The computation is done by inflation adjusting the goal into today's dollars. The current portfolio value is then subtracted to yield the Distance from Goal:
Distance from Goal = (Goal - Inflation Factor) - Current Portfolio Value
The inflation factor (PV) is computed using the goal (FV), a forecasted inflation rate (I) for the period of time from today to the date of the goal (n), using a calculator or the formula:
PV = FV - ((1-(1-I)^-n)/I)
This computation requires variables that change over time so it must be repeated periodically.
Computing Mortality Effect
The mortality effect may either increase the mortality gap (higher demand than the goal contemplates) or reduce the gap. The gap is increased if the mortality has the net effect of reducing personal earnings and decreased if the net effect is lowered expenses.
The mortality effect is calculated using the same time frame established for the goal (See Computing Distance from Goal). The personal earning and personal expenses are projected for this time frame. The expenses are subtracted from the earnings (if any).
Mortality Effect = Personal Earning - Personal Expenses
The result could be either positive and increase to the mortality gap or negative and reduce the gap.
Computing Coverage
The life insurance coverage required at any point in time is computed as the sum of the Distance from Goal and Mortality Effect:
Mortality Gap = Distance from Goal + Mortality Effect
This coverage will change over time as a result of:
- Market conditions
- Changed goals
- Reduced time frames
- Earning or expense forecasts
These changes should trigger another calculation of the required coverage.
* Article Source: Dalbar, Inc
|
