As discussed in my December 2005 column ("The Human Capital Equation"), the risk and return characteristics of human capital should be taken into account when building portfolios for individual investors over their lifecycle. In this column, I want to extend the discussion from the classical asset allocation framework to include the demand for life insurance. These two decisions (asset allocation and life insurance needs) should be determined jointly since financial assets and human capital serve as risk substitutes for each other. I'll begin with a brief review of the financial and statistical interaction between human capital, asset allocation and life insurance. Then I'll delve into a detailed description of the integrated framework and the model which are based on the recent paper of Chen, Ibbotson, Milevsky and Zhu (2005).

HUMAN CAPITAL AND FINANCIAL ASSET ALLOCATION
From a personal balance sheet perspective, an investor's total wealth consists of two parts--financial assets and human capital. The latter--human capital--is defined as the present value of an investor's future labor income. Although human capital is not readily tradable like financial assets, it is often the single largest asset of value when an individual is young.

Typically, younger investors have far more human capital than financial capital. This is because younger investors have more years left to work but so far have had fewer years to save and accumulate financial wealth. Conversely, older investors tend to have more financial capital than human capital, since they have fewer years ahead to work but have accumulated financial capital over a long career. The chart here provides a stylized example of financial capital and human capital over an investor's working years (pre-retirement) from age 25 to age 65. When the investor is young, his human capital far outweighs his financial capital. As the investor ages and converts human capital into financial capital that is saved and invested, the amount of financial capital will increase.

We believe that the changing mix of financial capital and human capital over the lifecycle affects optimal financial asset allocation. When labor income is included in the portfolio choice model, individuals will optimally change their allocation of financial assets in a pattern related to the lifecycle. In other words, the optimal asset allocation of financial capital depends not only on its risk-return characteristics but also on the characteristics of human capital. The investor needs to adjust the financial portfolio to compensate for the non-tradable human capital risk exposures. This line of thinking has been popularized in a recent book by John Campbell and Luis Viceira (2002), who also provide a detailed discussion on human capital and asset allocation. However, the role of life insurance in the optimal portfolio has not received as much attention.

HUMAN CAPITAL AND LIFE INSURANCE
One unique aspect of human capital is mortality risk--the loss of that capital in the event of death. Life insurance has long been used to hedge against mortality risk. The greater the value of human capital, the more life insurance the family should have.

The demand for life insurance depends on the characteristics of human capital as well. For instance, a person whose income relies heavily on stock commissions (for example a broker or financial planner) should consider his human capital closer to a stock since the income is highly correlated with the stock market. This also results in greater uncertainty in his human capital. Consequently, he should purchase less insurance and invest more financial wealth in bonds because the economic value of his human capital is lower.

There are two important factors in addition to human capital that investors need to take into account when they make life insurance decisions. The first is the investor's preference for the well-being of his family--called his "bequest preference" or "bequest motive." For example, the investor with a low bequest preference cares more about providing money for himself than leaving money for his family, so he would buy less life insurance. Investors who put more weight in their bequest preference are likely to purchase more life insurance.

The second factor is the amount of wealth an investor possesses. Typically, the life insurance demand decreases with the increase of financial wealth. This can be explained intuitively through the substitution effects between financial wealth and life insurance. With a large amount of wealth in hand, the investor has less demand for life insurance, since the loss of human capital has a much lower impact on the well-being of his family.

ASSET ALLOCATION, HUMAN CAPITAL AND LIFE INSURANCE
Clearly, human capital is linked not only to asset allocation, but also to life insurance demand. However, these two important financial decisions have consistently been analyzed separately in practice. In other words, popular investment and financial planning advice regarding how much life insurance one should acquire is seldom framed in terms of the riskiness of one's human capital. Conversely, the optimal asset allocation decision is only lately being framed in terms of risk characteristics of human capital, and rarely is integrated with life insurance decisions.