Life Insurance and Life Settlements: The Case for Health‐Contingent Cash Surrender Values

• Author: Edward Kung,Hanming Fang
• DOI: http://doi.org/10.1111/jori.12265
• Published date: 01 March 2020
• Date: 01 March 2020

©2018 The Journal of Risk and Insurance (2018).

DOI: 10.1111/jori.12265

Life Insurance and Life Settlements: The Case for

Health-Contingent Cash Surrender Values

Hanming Fang

Edward Kung

Abstract

We investigate why life insurance policies in practice either do not have a

cash surrender value (CSV), or have CSVs that are small and arenot adjusted

for health status. We show that including health-contingent CSVs in a life

insurance contract causes a dynamic commitment problem, which makes

it more costly up front for policyholders to purchase long-term contracts

(because some poor risks who would otherwise have lapsed can and will

now capture the CSV instead). Tothe extent that life insurance policyholders’

incomes tend to increase over the course of the policy,policyholders are not

willing to accept higher ex ante premium costs in return for the extra liquidity

provided by the CSV. Because health-contingent CSVs act in a similar way to

a life settlement market, we also study the life insurers’ equilibrium choice

of CSVs in the presence of a life settlement market. We find that optimally

chosen CSVs can partially mitigate the consumer welfare loss caused by the

settlement market (as in Daily, Hendel, and Lizzeri, 2008), but only if the

CSVs are allowed to be contingent on health status.

Introduction

Life insurance policies are typically long-term contracts in which policyholders pay an

annual premium in return for a guarantee that his/her beneficiaries will receive a sum

of cash, called the death benefit, if the policyholder dies within the coverage period.

Premiums are almost universally front-loaded, meaning that policyholders pay more

than the actuarially fair cost of insurance in the early stage of the contract (when they

are young), and less than the actuarially fair cost of insurance in later stages of the

Hanming Fang is at the Department of Economics, University of Pennsylvania, 3718 Locust

Walk,Philadelphia, PA 19104; ShanghaiTech University, Shanghai, China; and the NBER. Fang

can be contacted via e-mail: hanming.fang@econ.upenn.edu. EdwardKung is at the Department

of Economics, UCLA, 8343 Bunche Hall, Los Angeles, CA 90095. Kung can be contacted via

e-mail: ekung@econ.ucla.edu. This article supersedes our earlier NBER Working Paper (Fang

and Kung, 2010a). Wewould like to thank the editor, three anonymous referees,Jacques Crémer,

Alessandro Lizzeri, George Mailath, AndrewPostlewaite, Wing Suen, and seminar participants

at Duke University,Hong Kong University, Peking University,University of Pennsylvania, and

the 2009 Econometric Society Summer Meeting in Boston for useful comments. Fang would

also like to gratefully acknowledge the generous financial support from the National Science

Foundation through Grant SES-0844845. All remaining errors are our own.

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2The Journal of Risk and Insurance

contract (when they are old and when their mortality risk has likely increased).Hendel

and Lizzeri (2003) (henceforth HL) show that long-term, front-loaded contracts serve

a useful purpose by protecting policyholders against reclassification risk—that is, the

risk of negative health shocks driving up the contemporaneous price of insurance,

thus making insurance unaffordable in bad health states.

An interesting feature of most life insurance contracts is that if the policyholder lapses

before the coverage period is over, the cash they receivefor surrendering their policy

(called the cash surrender value [CSV]) is usually zero or else very small.1Moreover,

CSVs are typically not adjusted for the health status of the policyholder. To see why

these features are puzzling, consider that most contracts are front-loaded. This im-

plies that later in the life of a policy, the expected payout of benefits exceeds the net

present value of premiums. Lapsation with no CSV therefore representsa pure profit

to the insurer, and even more so if the policyholder has impaired health status. In a

competitive marketplace, one might expect the policyholder to be able to extract some

value from the contract, rather than lapsing it for zero private returns.

It has been suggested by Doherty and Singer (2003) and Deloitte (2005) that health-

contingent CSVs may face regulatory difficulties. While this may indeed be the case,

we have not been able to find any specific regulations that explicitly prohibit the writ-

ing of health-contingent CSVs in life insurance contracts. In response to the inquiries

we sent to the North Carolina Department of Insurance, regulators said that they were

not aware of any such regulations, either in North Carolina or in other states. Another

possibility, also suggested by Doherty and Singer, is that there may be large admin-

istrative costs to implementing health-contingent surrender values. This is certainly

a possibility, but it begs the question of why a life settlement market has emerged

precisely to take advantage of the gap between the actuarial value of a life insurance

policy and its CSV.2A third possibility is that if surrender values are health contin-

gent, then policyholders can game the system by pretending to be of poor health. As

it is likely easier for a healthy person to pretend to be sick, than for a sick person to

pretend to be healthy, verification costs may be high.3

In this article, we study the role of surrender values in life insurance contract design.

We find that when there is no life settlement market, the life insurance contracts that

would emerge in equilibrium will not contain CSVs. This result holds regardless of

1The Life Insurance Settlement Association (LISA) estimates that the average surrender value

is only 3–5 percent of the policy’s face value. See http://www.lisa.org/content/13/What-is-

a-Life-Settlement.aspx/.

2A life settlement is a financial transaction in which a policyholder sells his/her policy to a

third party for more cash than the surrender value offered by the policy itself. The thirdparty

subsequently assumes responsibility for all future premium payments, and is entitled to the

death benefits if the original policyholder dies within the coverage period. The industry is

young but growing rapidly,with purchases of about $2.57 billion in face value in 2013 (LISA).

3Tobe sure, the life settlement market faces the same issue, and verification costs could explain

why the settlement market tends to target people who are already aged, and why the initial

development of the settlement market started with viatical transactions that focused entirely

on policyholders who were terminally ill.

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Health-Contingent Cash Surrender Values 3

the presence of any regulatory, administrative, or verification costs in implement-

ing health-contingent CSVs. Thus, the observed lack of health-contingent surrender

values is an equilibrium outcome of consumers’ optimizing behavior.

Our analysis follows closely the HL model of life insurance contracts. HL study a

model in which consumers’ mortality risks change over time, and these changes are

symmetrically observed by both the consumer and the life insurance companies. Be-

cause the consumers’ mortality risks change over time, they face reclassification risk,

which is the risk that a deterioration in health makes it more costly for them to obtain

life insurance on the spot market. HL show that, in equilibrium, a competitive life

insurance market will offer dynamic contracts that insure against reclassification risk

by charging a higher premium up front, in exchange for fixed premiums that do not

depend on mortality risk later. Thus, the front-loaded contracts that are so widely

prevalent in the life insurance industry emerge in the equilibrium of the HL model.

However, the HL model does not allow for the possibility that life insurance may no

longer be needed in the future, nor for the possibility of a CSV to be specified as part

of the contract. In this article, we expand on the HL model by allowing for possible

bequest-motive loss and surrender values that are endogenously chosen. We find

that having a positive surrender value introduces a dynamic commitment problem in

which some ex post poor risks who would have otherwise dropped out of the pool for

exogenous reasons, instead capture the surrender value. This makes it more costly

for life insurers, who operate competitively, to provide reclassification risk insurance

via front-loading. Specifically, for any level of premiums guaranteed in the second

stage of the contract, a higher up-front premium must be charged in the first stage of

the contract if the contract contains a positive surrender value. If the policyholder’s

income is rising over the term of the contract—which is likely to be the case for most

life insurance purchasers—this represents a transfer of wealth from a low-income

state to a high-income state. Because of this, the policyholder is not willing to accept

a higher up-front premium cost in return for the extra liquidity provided by the CSV.

Our results thus help explain why CSVs are not typically observed in the life insurance

industry.

The logic underpinning our analysis relies on the assumption that life insurance com-

panies can perfectly commit to “not” buy back policies from individuals whose health

has deteriorated. It also assumes the absence of a life settlement market that would

purchase policies for which there is a gap between the actuarial value and the CSV

(and thus keep these policies in the pool). In reality, a life settlements market has

emerged precisely to take advantage of that gap. We therefore also analyze the effects

that a life settlement market would have on the equilibrium of our model. We find

that if surrender values are zero, then the presence of a life settlement market distorts

the form of the optimal contract. In particular, the life settlement market reduces the

amount of reclassification risk through front-loading, reducing ex ante consumer wel-

fare. Intuitively, this happens because even though life insurers can commit to zero

CSVs, policyholders who no longer need their policies ex post cannot commit not to

sell their policies on the settlement market. The original insurer is thus required to

honor some policies that otherwise would have been lapsed or surrendered for less

than the actuarial value. In a competitive setting, this increased cost will have to be

Health-Contingent Cash Surrender Values 39