Life Insurance and Life Settlements: The Case for Health‐Contingent Cash Surrender Values
33 Pages Posted: 28 May 2020
Date Written: March 2020
We investigate why life insurance policies in practice either do not have a cash surrender value (CSV), or have CSVs that are small and are not adjusted for health status. We show that including health‐contingent CSVs in a life insurance contract causes a dynamic commitment problem, which makes it more costly up front for policyholders to purchase long‐term contracts (because some poor risks who would otherwise have lapsed can and will now capture the CSV instead). To the extent that life insurance policyholders’ incomes tend to increase over the course of the policy, policyholders are not willing to accept higher ex ante premium costs in return for the extra liquidity provided by the CSV. Because health‐contingent CSVs act in a similar way to a life settlement market, we also study the life insurers’ equilibrium choice of CSVs in the presence of a life settlement market. We find that optimally chosen CSVs can partially mitigate the consumer welfare loss caused by the settlement market (as in Daily, Hendel, and Lizzeri, 2008), but only if the CSVs are allowed to be contingent on health status.
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