Dynamic Bequest Motives and Secondary Markets for Life Insurance

Abstract

Life insurance contracts can be exceptionally long term and are typically written with a level premium structure. Because death risk increases with age, the actuarial value of a life insurance policy increases over time and becomes positive far enough into the policy. Life insurance is also unique in that the payout is valued through a bequest motive. If bequest preferences are dynamic and subject to unexpected shocks, the consumer's value of a life insurance contract can become negative even when the actuarial value is positive. Thus, there are potential gains from trade from a secondary market for life insurance policies. While these markets do exist, they are limited and controversial. In this paper, I propose and estimate a life-cycle savings model for the life insurance lapse decision with dynamic, heterogeneous bequest motives. I then perform a counterfactual analysis with competitive secondary markets and find them to be Pareto improving for my sample with an average value increase to consumer's welfare by $1,346 per policy-holder.

Keywords: Lapsed Policies, Credit Constraints, Life Cycle, Approximate Dynamic Programming

JEL Classification: C45, C61, D14, D81, D82, G22