Human capital protection

What is Human Capital?

What is your greatest asset? Is it your home? Is it your investment portfolio? If you’re a business owner, is it your business? Although these things are very important, they are probably not the greatest asset you possess. Consider your human capital; that could well be your greatest financial asset.

Human capital is the sum of our knowledge, experience and expertise that contributes to our income earning potential. This can be our greatest asset, after all, we use our incomes to purchase our homes, build our investment portfolios, and create our businesses. Our income earning potential supports everything we do. For this reason, it makes sense to think twice about the risks that might impact our human capital and how we protect our human capital from those risks.

What is Financial Capital?

Human capital is not the full story. As we earn income, we use some of that income to grow our wealth as we accumulate assets. This could be a home, a business, or an investment portfolio, and collectively we refer to these assets as financial capital. Financial capital is the sum total of our accumulated assets and this forms our financial legacy. As we move closer to retirement our financial capital can become a significant store of wealth.  Because financial capital is easy to relate to, it becomes the focus of most financial media, typically through discussions around the assets that store this wealth like stocks, bonds and real estate. 

Growing our financial capital is important, and as we make investment decisions, we carefully choose between risk and reward. The value of financial capital assets are generally easy to determine since a clear market exists to identify the asset values typically used to store financial capital.  The risks associated with these assets tend to be the following:

  1. The market value of these assets decreases.
  2. Taxes erode these asset values in life and at death.

Protecting against these risks typically involves identifying the value of the assets at risk, then reviewing the options available to protect against these risks. There are many effective strategies at protecting financial capital but typically none of these strategies address human capital risk.

How Much Is Human Capital Worth?

In contrast to financial capital, the value of human capital is much more difficult to pin down. How do you assign an overall value on the income you’ll earn for the rest of your life? One simple way to calculate its value is to take a person’s remaining working years and add up all the potential income they expect to earn over those years. This is simplistic since it overstates the current value of future income in today’s dollars.

Alternatively, a more accurate method takes the present value of the expected income over one’s lifetime. This will discount future income at prevailing interest rates and can take into account probabilities around living into the future (see graph below). One thing that becomes surprising when going through the exercise of calculating human capital, is how even moderate levels of income translate into large values of human capital. For younger individuals, human capital is typically by far their greatest and most valuable asset.

As an example, let’s take Sam, a 35 year old earning $70k per year net of taxes. Sam is interested in using some conservative estimates to calculate human capital. Currently Sam projects working until age 65 and uses 40% of after tax income to accumulate assets over that period. These assets include a home, retirement savings (i.e. RRSPs), and TFSA’s. Let’s also assume the growing assets earn 5 % net of fees and taxes. We assume Sam’s income is growing with inflation of 2% over 30 years of projected employment which translates to Sam’s human capital being worth $1.33 million today! How many 35 year olds realize their human capital is worth so much?

Click on the image to enlarge it

line chart of Sam's Capital

Risks to Human Capital Value

What risks might human capital be exposed to? The most obvious risk to human capital is death; after all, once you’re dead your income earning stops. This is a serious problem since there may be multiple people relying on that income like a spouse, children, or business partners. In addition, if income earning stops unexpectedly, financial capital accumulation is jeopardized.

Death is obvious but how might an illness affect future income? The risk that illness poses is not as well defined as death, where death is permanent but illness introduces elements of uncertainty. Illness can put a temporary pause on income earning while recovery takes place, and serious illness can cause disruption to overall family income when members of the family help in the recovery process. The impact to human capital could be one year of income or five years’ of family income, it’s hard to say.

Less well understood is the risk introduced through source of income, where some sources of income are more volatile than others. Take for example employment income from a unionized employer where income tends to be more stable and moderate. This type of income can be relied upon with a high degree of certainty for the working life of the earner. Compare this to volatile income sources like commission income. These sources tend to be volatile with periods of very high income and periods of little or no income. Volatility in income source can have significant impact to both human and financial capital value if the risk is not properly mitigated.

How to Protect Human Capital from Early Death

Death is probably the single biggest risk to human capital because it stops earnings completely. An early death, when one’s human capital is near its peak, can leave legacies to loved ones unfulfilled. We insure our cars against accidents and insure our houses against fires, so why not insure our human capital? To paraphrase Jack Ma, one of the world’s richest individuals, insurance premiums will not bankrupt you, but without insurance your loved ones could become bankrupt.

Human capital protection is typically needed in the working years only. Protecting human capital from the risk of death through temporary or “term” insurance is a natural fit. What most people do not realize is just how affordable term insurance can be – for a very low annual or monthly premium, human capital can be fully protected, safeguarding the lifestyle of loved ones and the realization of legacies.

Below is a table that shows the initial premiums for $1 million of term insurance policies using various term lengths and issue ages for male nonsmokers.

Annual Term Insurance Premium
$1 million death benefit, initial term only
Age Term 10 Term 20 Term 30
30 $485 $705 $1,075
35 $485 $745 $1,415
40 $515 $1,115 $2,245
45 $965 $1,825 $3,815
50 $1,565 $3,145 $6,185

Term insurance protection is an affordable way of protecting human capital and unfortunately many people don’t realize this and choose to take on the risk themselves by remaining uninsured.

How to Protect Human Capital from Health Risk

Although death is the most obvious risk to human capital, Illness is equally risky. Instinctively people appreciate that medical costs can loom large, but we typically fail to appreciate impacts to income over the long term. Not only can health issues jeopardize income, but they can also cause loved ones to miss work themselves in order to care for the ill person, thereby putting additional human capital within the family at risk. How much human capital is at risk during an illness? Is it one year’s income? Two years income? Or can it derail all income? Prolonged illnesses can challenge budgets, so in addition to lost incomes and medical costs, saving for retirement during an illness (or disability) can become outright unaffordable.

Unfortunately, the tools available to protect human capital from illness are not well understood by Canadians. “Stand-alone, fully-guaranteed individual critical illness policies have been available for around 20 years, and yet penetration rate among Canadians is only 3%” 1. Critical illness insurance is the most direct tool available to protect human capital from illness. Critical illness insurance offers the financial help to pay the costs associated with life-altering illnesses. If you become sick with an illness covered by your policy and survive the waiting period, you’ll receive a lump-sum cash payment that you decide how to spend.

Financial Capital and the Role of Diversification

Diversification is sometimes referred to as the only free lunch – it’s an important aspect of sound money management and for this reason it is frequently discussed in the context of financial capital.  In essence, diversification strives to smooth out volatility in a portfolio so that positive performance of some investments counterbalance the negative performance of others. This has the effect of producing portfolios that provide maximum return with minimal volatility.

Properly diversified portfolios include a mix of different asset classes like bonds, equities, and real estate.  In combination, these assets reduce volatility, improve risk-return characteristics, and protect capital.  Financial capital diversification is important, but in today’s fast moving marketplace it makes sense to consider broadening the scope of this risk management technique to include a look at human capital.

Human Capital and the Role of Diversification

Not only is human capital missing from the typical financial planning discussion, but the idea of diversification based on human capital is downright uncommon.  Instead, think about treating human capital like a valuable diversifiable asset with unique risk attributes. This can ensure that human capital works in conjunction with all the other assets in a portfolio. Each sector within the economy has different characteristics with respect to earnings volatility, so it makes sense to take this into account when designing portfolios.  There are two different ways that considering this earnings volatility can affect portfolio design. The first is how aggressive your portfolio might be. Those people that have more volatile human capital (i.e. financial services, sales, small business owners) should think about being more conservative in constructing their portfolios. What that might mean is having more cash in their savings accounts, potentially having six to nine months of income saved away. It might also mean that there is an asset class impact with more weighting to less volatile assets and less exposure to sectors that are the same as the source of income. An example might be someone who is working in financial services, their portfolio would underweight financial services assets as to not be overexposed.

Another way to think of human capital is to say that it exhibits “bond-like” or “equity-like” characteristics.  Bond-like human capital has slow, steady and predictable earnings.  Equity-like human capital has big earnings potential but carries other risks, such as a lack of job stability. Thought of this way, diversification can be achieved by matching bond-like human capital with more aggressive investment portfolios, and conversely equity-like human capital is coupled with the stability of less aggressive products like government bonds.

Putting it all into Perspective

Working through the process of calculating human capital is valuable because of the questions generated – it forces us to think about the future and to consider protecting the future we want to see unfold.  The questions generated when working at protecting human capital can sometimes be uncomfortable, but the upside is more satisfaction and confidence about the future. Rather than planning for risk in isolation, in today’s economy a more holistic view is needed.

Affordable solutions like term insurance and critical illness fit well with the temporary nature of our human capital, but we advise going even further by considering human capital as an extremely valuable, distinctive and diversifiable asset.

Each individual brings a unique set of resources into the marketplace, and simply introducing the idea of human capital into your next financial conversation will be a welcome change over the typical planning discussion.

Mark L. Arruda, BMATH, FCIA, FSA, CERA, Assistant Vice-President, Strategic Business Development & Marketing Actuary, Insurance Distribution, Sun Life Financial. He’s found his niche helping explain often complex elements of product design to advisors in straightforward terms – so they can see opportunities more clearly and help clients reach their financial and retirement goals.