Surrender Risk in Life Insurance Policies

46 Pages Posted: 21 Sep 2017

See all articles by Karen Liu

Karen Liu

Zicklin School of Business, Baruch College, City University of New York; Washington University in Saint Louis, John M. Olin Business School, Students ; Peking University, Guanghua School of Management, Department of Finance, Students

Suying Liu

Washington University in St. Louis

Date Written: April 19, 2015

Abstract

Life insurance often embeds a surrender option that gives the policyholders a right to exchange an existing contract for its cash surrender value. Similar to mortgage prepayment option that imposes a cash-flow risk to MBS investors, this surrender option is a source of concern for life insurers. While prior studies have attempted to quantify this surrender risk by pricing the surrender option, a common theoretical assumption imposed is a fully rational response of policyholders to only interest rates. However, actual surrender experience indicates that interest rates are just one of the multiple factors that drive the surrender decision and policyholders' response is not necessarily optimal. This paper integrates an empirical surrender function into the option pricing framework by employing a novel data set from a large life insurance industry experience study. It shows, for the first time in the literature, that policy vintage is a particularly significant and meaningful factor in addition to macroeconomic variables that impact surrender activity. Using these empirics, I find that the experience-based value of the surrender option is substantially less than its fully rational counterpart. In addition, the competitive landscape of the life insurance industry and the interest rate environment both play an important role in assessing the surrender risk exposure of life insurers.

Suggested Citation

Liu, Karen and Liu, Suying, Surrender Risk in Life Insurance Policies (April 19, 2015). Available at SSRN: https://ssrn.com/abstract=3039562 or http://dx.doi.org/10.2139/ssrn.3039562

Karen Liu (Contact Author)

Zicklin School of Business, Baruch College, City University of New York ( email )

One Bernard Baruch Way, Box 10-225
New York, NY 10010
United States

Washington University in Saint Louis, John M. Olin Business School, Students ( email )

St. Louis, MO
United States

Peking University, Guanghua School of Management, Department of Finance, Students ( email )

Beijing
China

Suying Liu

Washington University in St. Louis ( email )

One Brookings Drive
Campus Box 1208
Saint Louis, MO MO 63130-4899
United States

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