What Policy Features Determine Life Insurance Lapse? An Analysis of the German Market

• Author: Martin Eling,Dieter Kiesenbauer
• Date: 01 June 2014
• DOI: http://doi.org/10.1111/j.1539-6975.2012.01504.x
• Published date: 01 June 2014

©

DOI: 10.1111/j.1539-6975.2012.01504.x

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WHAT POLICY FEATURES DETERMINE LIFE INSURANCE

LAPSE?ANANALYSIS OF THE GERMAN MARKET

Martin Eling

Dieter Kiesenbauer

ABSTRACT

With the largest data set ever used for this purpose (covering more than

1 million contracts), we analyze the impact of product and policyholder

characteristics on lapse in the life insurance market. The data are provided

by a German life insurer and cover two periods of market turmoil that we

incorporate into our proportional hazards and generalized linear models.

The results show that productcharacteristics such as product type or contract

age and policyholder characteristics such as age or gender are important

drivers for lapse rates. Our findings improve the understanding of lapse

drivers and might be used by insurance managers and regulators for value-

and risk-based management.

INTRODUCTION

In this work, we analyze the impact of product and policyholder characteristics on

lapse and surrender in the German life insurance industry using proportional hazards

and generalized linear models (GLMs).1A proper understanding of lapse drivers and

their dynamics is important for insurance managers and regulators. Lapse influences

an insurer’s liquidity and profitability (see Kuo et al., 2003; Prestele, 2006). First, the

insurer might suffer high losses from lapsed policies due to up-front investments for

acquiring new business (Pinquet et al., 2011). Second, the insurer faces the loss of

future profits from lapsed contracts. Third, the insurer might face adverse selection

with respect to mortality and morbidity.2Fourth, the insurer might be exposed to

a liquidity risk when forced to pay a surrender value for many lapsed policies at

Martin Eling is with the University of St. Gallen. Dieter Kiesenbauer is with the University of

Ulm. The authors can be contacted via e-mail: martin.eling@unisg.ch and dieter.kiesenbauer@

alumni.uni-ulm.de.

1Lapse and surrender both refer to the termination of an insurance contract before maturity,

but there is a slight difference between these two terms (see, e.g., Kuo et al., 2003; Gatzert

et al., 2009). While lapse refers to the termination of policies without payout to policyholders,

surrender usually indicates that a surrender value is paid out to the policyholder. In accor-

dance with Renshaw and Haberman (1986) and Kuo et al. (2003), lapse is used throughout

this article to refer to both surrender and lapse. This is consistent with standard measures of

lapse as they typically include both lapsed policies and surrendered ones.

2For example, customers in poor health might be less likely to lapse a contract including death

cover as they will hardly find comparable insurance coverage at the same premium level.

The Journal of Risk and Insurance, 2013, Vol. 81, No. 2, 241–269

242 THE JOURNAL OF RISK AND INSURANCE

the same time. On the one hand, lapses influence the flow of futures premiums for

contracts with periodic premiums, which in turn determine the embedded value

of the company. On the other hand, asset–liability mismatches stem from possible

discrepancies between contract values and market values, which should be a major

issue for endowment policies, but not for unit-linked contracts.

The importance of lapse has been discussed in the field of valuation and manage-

ment of embedded options in life insurance contracts. Historically, the right to lapse

a life insurance contract was not explicitly taken into account in the pricing process

(Gatzert and Schmeiser,2008). The possibility to lapse a contract, however, constitutes

an implicit option present in life insurance contracts and its value can be quite sub-

stantial (see, e.g., Albizzati and Geman, 1994; Grosen and Jørgensen, 2000; Bacinello,

2003; Gatzert and Schmeiser, 2008). The decline of Equitable Life in the United

Kingdom, which was related to pension policies including guaranteed annuity op-

tions, intensified this discussion (see O’Brien, 2006). In the 1990s, market annuity

rates in the United Kingdom dropped significantly below the guaranteed level, mak-

ing that option particularly valuable for the customer,an aspect especially relevant for

endowment policies. Therefore, insurers need to pay attention to all embedded op-

tions, including the policyholder’s option to lapse a life insurance policy. In addition,

regulators have identified lapse as one of the major risk components of life insurance

companies and hence lapse behavior should be monitored and managed carefully. For

example, under the new European Union regulatory framework Solvency II, lapse

risk constitutes the largest submodule in terms of solvency capital requirement within

the life underwriting risk module, accounting for almost 40 percent of the capital re-

quirement in this module (see EIOPA, 2011, pp. 77–78).3The life underwriting risk

itself accounts for almost 20 percent of the total capital requirements, constituting the

second most material component in terms of capital requirements (behind market

risk).

The empirical literature on lapse can be distinguished based on the explanatory

variables considered. The first set of literature uses environmental characteristics,

including macroeconomic indicators and company data. Initially, only the impact of

interest rates and unemployment on lapse has been studied; these are the interest rate

and emergency fund hypotheses (see, e.g., Dar and Dodds, 1989; Outreville, 1990;

Kuo et al., 2003). This work has been extended by Kim (2005a, 2005b), Cox and Lin

(2006), and Kiesenbauer (2012) considering additional economic indicators, such as

gross domestic product, and capital markets development as well as company char-

acteristics, including company size and legal form. The second set of literature uses

single contract data to assess the impact of product and policyholder characteris-

tics on lapse. So far, only few such analyses are available. Renshaw and Haberman

(1986), Kagraoka (2005), Cerchiara et al. (2009), and Milhaud et al. (2010) cover the

Analyzing long-term care insurance, Pinquet et al. (2011) find that policyholders lapsing

contracts have better health histories than do their peers continuing the contracts.

3Under Solvency II, the capital requirement for the lapse risk submodule is calculated as

maximum of three stress scenarios defined as follows (see CEIOPS, 2010, pp. 155-159, for

details): (1) a long-term decrease of lapse rates by 50 percent, (2) a long-term increase of lapse

rates by 50 percent, and (3) a mass lapse event of 30 percent of all policyholders. For more

details on Solvency II, see also European Parliament and Council (2009).