The Role of Commitment in Dynamic Contracts: Evidence from Life Insurance

Abstract

We look at the life insurance industry to study the properties of long term contracts in a world where consumers cannot commit to a contract. The main issue is how contracts are designed to deal with classification risk. We present a model that captures the main features of this industry. The data is especially suited for a test of the theory since it includes information on the entire profile of future premiums. The lack of commitment by consumers shapes contracts in the way predicted by the theory. All types of contracts involve front-loading. This generates a partial lock-in of consumers. Contracts that are more front-loaded have a lower present value of premiums over the period of coverage. This is consistent with the idea that more front-loaded contracts retain better risk pools. The estimates suggest that classification risk is almost completely insured by long term level-premium contracts.