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Lapse rate modeling: a rational expectation approach

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  • Domenico De Giovanni

Abstract

The surrender option embedded in many life insurance products is a clause that allows policyholders to terminate the contract early. Pricing techniques based on the American Contingent Claim (ACC) theory are often used, though the actual policyholders' behavior is far from optimal. Inspired by many prepayment models for mortgage backed securities, this paper builds a Rational Expectation (RE) model describing the policyholders' behavior in lapsing the contract. A market model with stochastic interest rates is considered, and the pricing is carried out through numerical approximation of the corresponding two-space-dimensional parabolic partial differential equation. Extensive numerical experiments show the differences in terms of pricing and interest rate elasticity between the ACC and RE approaches as well as the sensitivity of the contract price with respect to changes in the policyholders' behavior.

Suggested Citation

  • Domenico De Giovanni, 2010. "Lapse rate modeling: a rational expectation approach," Scandinavian Actuarial Journal, Taylor & Francis Journals, vol. 2010(1), pages 56-67.
    • Handle: RePEc:taf:sactxx:v:2010:y:2010:i:1:p:56-67
    DOI: 10.1080/03461230802550649
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    Cited by:

    1. Buchardt, Kristian, 2014. "Dependent interest and transition rates in life insurance," Insurance: Mathematics and Economics, Elsevier, vol. 55(C), pages 167-179.
    2. Debbie Kusch Falden & Anna Kamille Nyegaard, 2021. "Retrospective Reserves and Bonus with Policyholder Behavior," Risks, MDPI, vol. 9(1), pages 1-28, January.
    3. Kochanski, Michael, 2010. "Solvency capital requirement for German unit-linked insurance products," German Risk and Insurance Review (GRIR), University of Cologne, Department of Risk Management and Insurance, vol. 6(2), pages 33-70.

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