On the Propensity to Surrender a Variable Annuity Contract: An Empirical Analysis of Dynamic Policyholder Behavior

• Date: 01 December 2016
• Published date: 01 December 2016
• DOI: http://doi.org/10.1111/jori.12076

©2015 The Journal of Risk and Insurance. Vol.83, No. 4, 979–1006 (2016).

DOI: 10.1111/jori.12076

On the Propensity to Surrender a Variable

Annuity Contract: An Empirical Analysis of

Dynamic Policyholder Behavior

Christian Knoller

Gunther Kraut

Pascal Schoenmaekers

Abstract

Weempirically analyze surrender behavior for variable annuity contracts us-

ing Japanese individual policy data. For traditional life insurance products,

surrender behavior is typically explained by the interest rate and the emer-

gency fund hypotheses. For variable annuities, the interest rate hypothesis is

not directly applicable. For these products, we expect the value of the finan-

cial options and guarantees provided to the policyholder to drive surrender

behavior. We define this expectation as the “moneyness hypothesis.” The

statistical analysis confirms our moneyness hypothesis: the value of the em-

bedded financial options and guarantees has the largest explanatory power

for the surrender rate. The extent to which this finding holds depends on the

single premium paid, which we consider a proxy for the policyholder’s fi-

nancial literacy.Moreover, our data set weakly supports the emergency fund

hypothesis for the case of variable annuities.

Introduction

The policyholders’ option to surrender their policy is an important risk factor for

life insurance companies. This importance is reflected by the increasing amount of

The authors are members of the Munich Risk and Insurance Center, Ludwig-Maximilians-

Universität Munich, Schackstraße 4/III, 80539 Munich, Germany. In addition to his academic

work, Christian Knoller works for Allianz SE. Christian Knoller can be contacted via e-mail:

knoller@bwl.lmu.de. In addition to his academic work, Gunther Kraut works for Munich Re. A

travel grant by VersicherungsforenLeipzig is gratefully acknowledged. Gunther Kraut can be

contacted via e-mail: kraut@bwl.lmu.de. Pascal Schoenmaekers works for Munich Re. Pascal

Schoenmaekers can be contacted via e-mail: pschoenmaekers@munichre.com. The conclusions

are those of the authors and do not necessarily reflectthe opinions of any of the institutions men-

tioned above. The authors are indebted to Stefan Jaschke, Andreas Richter, Stephan Reulein,

and Hugo Choi for valuable input and are thankful for the helpful comments from two anony-

mous reviewers as well as from the participants at the Hamburg-München-Hohenheim Insur-

ance Economics Colloquium, the 2011 APRIA meeting, the 2011 ARIA meeting, the CEQURA

Conference on Advances in Financial and Insurance Risk Management in Munich, the 12th

Symposium on Finance, Banking, and Insurance in Karlsruhe, and the 2012 annual meeting of

the Deutscher Vereinf ¨

ur Versicherungswissenschaft.All remaining errors are the authors’.

979

980 The Journal of Risk and Insurance

literature addressing this topic over the last decade, further intensified by the devel-

opment of new regulatory regimes such as Solvency II (see Eling and Kiesenbauer,

2014). For companies that offer variable annuities, understanding surrender behavior

is of particular importance because the value of the policyholder’s surrender option

heavily depends on the development of the underlying fund and thus on the devel-

opment of financial markets.

Variable annuities are essentially unit-linked products with guarantees. In contrast

to other products, the guarantees are provided by the insurance company that man-

ages the product, and they are separate from the underlying fund and not within

it. For variable annuities, surrender assumptions are a substantial pricing factor that

can have an impact on the rider fees. Previous studies found evidence that many

insurance companies assume irrational surrender behavior for at least some of their

policyholders (see, e.g., Milevsky and Salisbury, 2006; Bauer, Kling, and Russ, 2008;

Chen, Vetzal, and Forsyth, 2008). Where surrender assumptions are used to reduce

the rider fee (or the premium, for the traditional life insurance business), the business

is called “lapse supported” (see Dickson, Hardy, and Waters, 2009, p. 259, for more

details). If the actual surrender rates deviate from the surrender rates assumed for the

valuation, the insurer may face significant economic losses. If the surrender value of

a contract is less than the fair value of the contract, lower surrender rates than antic-

ipated lead to insufficient reserves. If the surrender value of a contract exceeds the

fair value of the contract, higher surrender rates than anticipated lead to insufficient

reserves. During the lifetime of a policy, both situations may occur, so it is important

to analyze the surrender behavior in this respect.

According to ING (2011), ING Groep N.V. incurred expenditures of EUR 0.9 billion

to EUR 1.1 billion in 2011 for its closed block variable annuity business in the United

States due to updated assumptions regarding policyholder behavior and mortality;

“the most significant revision was from the adjustments of lapse assumptions.” Also,

in third-quarter 2011, Manulife Financial lost CAD 309 million “related to updates to

lapses and other policyholder behavior assumptions for segregated fund business”

(see Manulife Financial, 2011), while Sun Life Financial reported major losses “which

were reflected primarily in the individual life and variable annuity businesses in SLF

U.S. Updates to . . .actuarial methods and assumptions ...reducednet income by $203

million”1(see Sun Life Financial, 2011).

In several simulation studies, the importance of dynamic surrender behavior for

solvency capital requirements (Kochanski, 2010) and for the effectiveness of hedg-

ing (Kling, Ruez, and Russ, 2010) has been shown. Swiss Re (2003) suggests that com-

pared to traditional participating life insurance products,lapse rates will be higher and

more volatile for unit-linked policies because policyholders are more sensitive with

regard to changes in market conditions and the account value of the underlying fund.

However, to the best of our knowledge, there has been no empirical investigation of

dynamic policyholder behavior for variable annuities to date (see Eling and Kochan-

1Sun Life Financial reports in Canadian dollars.