Health vs. Wealth: Non-financial life-cycle decisions and their impact on consumption-portfolio choice with unspanned labor income

• Applicant: Professor Dr. Holger Kraft
• Subject Area: Accounting and Finance
• Term: from 2015 to 2018
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 269126390

Studying life-cycle consumption-portfolio problems of individuals is a central field of research in finance. This project makes an important contribution by explicitly taking unspanned labor income risk and biometric risks (mortality, morbidity) into account. Although these two sources of risk are of major importance for all households, they are either disregarded or at least not analyzed simultaneously. In particular, the existing literature usually makes the unrealistic assumption that labor income is hedgeable, since problems with unspanned labor income are notoriously hard to solve. However, it is well known that the presence of unspanned income can significantly influence consumption-portfolio decisions. Our project closes this gap and thus several relevant research questions can be addressed. First, we assume that complete insurance markets for biometric risks exist and analyze how unspanned labor income risk affects insurance demands. We also study whether mispricing of insurance contracts (e.g. due to moral hazard or adverse selection problems) can crowd out insurance demands and might explain potential non-participation puzzles. Therefore, our project leads to a deeper understanding of an individual's consumption-portfolio decision if two of the most relevant risk sources (labor income and biometric) are taken into account. Second, we consider a model with unspanned biometric risks, which for instance might arise from significant copayments, and calculate indifference prices that an individual would be willing to pay if these unspanned biometric risks were insurable. This might lead to relevant policy implications. For instance, we can address the question of which size of copayments an agent with average health status is willing to tolerate without suffering significant welfare losses. In an aging society with exploding health care costs, this issue is very relevant, since copayments can be used to curtail the cost explosion in the health sector. Besides, they mitigate moral hazard issues arising from the fact that especially high-risk agents might seek insurance coverage. Third, we also enrich our model by adding owner-occupied real estate. This is a relevant extension because, among other things, a house can serve as collateral to cover health expenses. Alternatively, it can be sold so that the proceeds can be used to pay for services such as nursing home care. Therefore, owning a house also provides a hedge against uninsurable biometric risks. Understanding the link between owner-occupied real estate and health decisions is another important issue that we address. Finally, our project also makes a significant theoretical contribution since we develop a numerical approach that provides explicit near-optimal solutions to consumption-portfolio problems in the presence of unspanned event risks (e.g. health shocks).

• DFG Programme: Research Grants