Commitment Versus Flexibility and Sticky Prices: Evidence from Life Insurance

Abstract

Life insurance premiums display significant rigidity in the data, on average adjusting once every 3 years by more than 10%. This contrasts with the underlying marginal cost which exhibits considerable volatility due to the movements in interest and mortality rates. We build a model where policyholders are held-up by long-term insurance contracts, resulting in a time inconsistency problem for the firms. The optimal contract balances commitment and flexibility and takes the form of a simple cutoff rule: premiums are rigid for cost realizations smaller than the threshold, while adjustments must be large and are only possible when cost realizations exceed it. We use a calibrated version of the model to show that it matches the data and captures several aspects of premium rigidity in the cross-section and over time.

Keywords: Life insurance, Time inconsistency, Hold-up problem, Commitment, Flexibility

JEL Classification: G22, L11, L14