WHAT POLICY FEATURES DETERMINE LIFE …

1 what POLICY FEATURES DETERMINE life insurance lapse ? AN ANALYSIS OF THE GERMAN MARKET MARTIN ELING DIETER KIESENBAUER WORKING PAPERS ON RISK MANAGEMENT AND insurance NO. 95 EDITED BY HATO SCHMEISER CHAIR FOR RISK MANAGEMENT AND insurance NOVEMBER 2011 WORKING PAPERS ON RISK MANAGEMENT AND insurance , NO. 95 NOVEMBER 2011 what POLICY FEATURES DETERMINE life insurance lapse ? An Analysis of the German Market Martin Eling, Dieter Kiesenbauer* Abstract Considering the largest dataset ever used for this purpose ( million contracts, million POLICY years), we analyze the impact of product and policyholder characteristics on lapse in the German life insurance market.

2 The sample period covers two periods of market turmoil that we incorporate in our generalized linear models. The results show that product characteristics such as product type or contract age and policyholder characteristics such as age or gender are important drivers for lapse rates. Our findings improve the understanding of lapse drivers and might be used by insurance managers and regulators for value and risk based management. 1 INTRODUCTION In this work, we analyze the impact of product and policyholder characteristics on lapse and surrender in the German life insurance industry using generalized linear models (GLMs).

3 1 A proper understanding of lapse drivers and the underlying dynamics is important for insurance managers and regulators. lapse influences an insurer s liquidity and profitability (see Kuo et al., 2003; Prestele, 2006). Firstly, the insurer might suffer high losses from lapsed policies due to upfront investments for acquiring new business (Pinquet et al., 2011). Secondly, the insurer faces the loss of future profits from lapsed contracts. Thirdly, the insurer might face adverse selection with respect to mortality and Fourthly, the insurer might be exposed to a liquidity risk when forced to pay a surrender * Martin Eling is professor of insurance management and director at the Institute of insurance Economics at the University of St.

4 Gallen, Kirchlistrasse 2, 9010 St. Gallen, Switzerland Dieter Kiesenbauer is with the Institute of insurance Science at the University of Ulm, Germany ( @uni ). 1 lapse and surrender both refer to the termination of an insurance contract before maturity, but there is a slight difference between these two terms (see, , Kuo et al., 2003; Gatzert et al., 2009). While lapse refers to the termination of policies without payout to policyholders, surrender usually indicates that a surrender value is paid out to the policyholder. In accordance with Renshaw and Haberman (1986) and Kuo et al. (2003), the term lapse is used throughout to refer to both surrender and lapse .

5 This is consistent with standard measures of lapse as they typically include lapsed policies as well as surrendered ones. 2 For example, customers in poor health condition might be less likely to lapse a contract including death cover as they will hardly find comparable insurance cover at the same premium level. Analyzing long term care insurance , Pinquet et al. WORKING PAPERS ON RISK MANAGEMENT AND insurance , NO. 95 NOVEMBER 2011 value for many lapsed policies at the same time; otherwise a more conservative investment strategy might be used to ensure a sufficient liquidity at any time which reduces investment returns and hence affects the profitability adversely.

6 The importance of lapse is especially discussed in the field of valuation and management of embedded options in life insurance contracts. Historically, the right to lapse a life insurance contract was not explicitly taken into account in the pricing process (Gatzert and Schmeiser, 2008). The possibility to lapse a contract, however, constitutes an implicit option present in life insurance contracts and its value can be quite substantial (see, , Albizzati and Geman, 1994; Grosen and J rgensen, 2000; Bacinello, 2003; Gatzert and Schmeiser, 2008). The decline of Equitable life in the which was related to pension policies including guaranteed annuity options further intensified this discussion (see O Brien, 2006).

7 In the 1990s, market annuity rates in the dropped significantly and fell below the guaranteed level making that option particular valuable for the customer. Therefore, insurers need to pay attention to all embedded options, including the policyholder s option to lapse a life insurance POLICY . Also regulators have identified lapse as one of the major risk components of life insurance companies which needs proper monitoring and management. For example, under the new European Union regulatory framework Solvency II lapse risk constitutes the largest sub module in terms of solvency capital requirement within the life underwriting risk module accounting for almost 40% of the capital requirement in this module (see EIOPA, 2011, p.)

8 77/78).3 The life underwriting risk itself accounts for almost 20% of the total capital requirements constituting the second most material component in terms of capital requirements behind market risk. The existing empirical literature on lapse can be distinguished based on the explanatory variables considered. The first set of literature uses environmental characteristics including macro economic indicators and company data. Initially, only the impact of interest rates and unemployment on lapse has been studied, referred to as interest rate and emergency fund hypotheses (see, , Dar and Dodds, 1989; Outreville, 1990; Kuo et al., 2003).

9 This work has been extended by Kim (2005a,b), Cox and Lin (2006), and Kiesenbauer (2011) considering additional economic indicators (such as gross domestic product and capital markets development) and company characteristics (including company size and legal form). The second set of literature uses single contract data to assess the impact of product and policyholder characteristics on lapse . So far, only a limited number of such analyses are available. Renshaw and Haberman (1986), Kagraoka (2005), Cerchiara et al. (2009), and (2011) find that policyholders lapsing contracts have better health histories compared to their peers continuing the contracts.

10 3 Under Solvency II the capital requirement for the lapse risk sub module is calculated as maximum of three stress scenarios which are broadly defined as follows (see CEIOPS, 2010, p. 155 159, for details): (1) a long term decrease of lapse rates by 50%; (2) a long term increase of lapse rates by 50%; and (3) a mass lapse event of 30% of all policyholders. WORKING PAPERS ON RISK MANAGEMENT AND insurance , NO. 95 NOVEMBER 2011 Milhaud et al. (2010) cover the Scottish, Japanese, Italian, and Spanish life insurance markets. Using generalized linear models, these analyses indicate that factors such as POLICY duration, calendar year, policyholder age, or method of payment significantly influence lapse .