Surrender Contagion in Life Insurance

Abstract

This paper incorporates contagious surrender behavior, a critical risk on life insurance markets, into the valuation and risk management of life insurance policies, allowing for structural default of the insurance company. Our heterogeneous policyholder pool contains a minority of financially guided policyholders and a majority of individual policyholders. In a calibrated model, we demonstrate that contagion cannot provide an informative benefiting signal to individual policyholders who follow the optimal surrender of financially guided policyholders once their surrenders trigger public attention. Contagion robustly benefits the insurance company at the expense of individual policyholders but leaves the default probability largely unchanged.

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