Surrender Contagion in Life Insurance

Abstract

This paper incorporates contagious surrender behavior into the valuation and risk management of participating life insurance contracts, allowing for structural default of the insurance company. The insurance pool features a financially sophisticated (professional) policyholder and many retail (non-professional) policyholders. A surrender-history-dependent intensity process is introduced to capture the non-professionals’ contagious surrender behavior. While contagion aligns the non-professionals’ surrender behavior with the optimal surrender of the professional, it jeopardizes the non-professionals’ financial position in favor of equity holders as a strict regulatory intervention or a risky investment strategy is imposed.

Keywords: Contagion, Bounded Rationality, Insurance Regulation, Early Default