Academic journal article Journal of Risk and Insurance

Commitment and Lapse Behavior in Long-Term Insurance: A Case Study

Academic journal article Journal of Risk and Insurance

Commitment and Lapse Behavior in Long-Term Insurance: A Case Study

Article excerpt


This article presents a case study of a portfolio of individual long-term insurance contracts sold by a Spanish mutual company. We describe the risk levels, the rating structure, and the implied cross-subsidies on a portfolio of policies providing health, life, and long-term care insurance. We show evidence of reclassification risk through the history of disability spells. We also analyze the lapse behavior and seek to provide a rationale for the portfolio's dynamics. We discuss the lack of commitment from the policyholders (lapses) and from the mutual company (which took a run-off decision). Finally, we draw conclusions regarding the design of such contracts.


This article presents a case study of a portfolio of individual long-term insurance contracts, sold by a Spanish mutual company. The portfolio has been set in a runoff position - that is, has been closed to new business - since 1997. Our reasons for undertaking such an analysis are threefold: (1) empirical studies of complex contracts such as the one studied here are extremely rare, (2) commitment and lapse behavior can be studied here using a data set that includes information on a portfolio for a period extending over more than two decades, and (3) conclusions can be drawn regarding the consequences of closing a portfolio to new business, while keeping the existing contracts in that portfolio. The contract comprises a bundle of three coverages for health, long-term care (hereinafter LTC), and life insurance. The life coverage combines term and whole life insurance. The health coverage is unfunded (i.e., current premiums finance current benefits, and reserves are set only for claims incurred in the current period). By contrast, the life and LTC policies exhibit a more complex funding scheme, which is discussed in more detail below (see the section titled "The Three Coverages: Their Rating Structure, Risk Levels, and Implied Cross-Subsidies"). As is usual with long-term contracts, there is a one-sided commitment in terms of loyalty. So while the policyholders can leave the mutual company, the company cannot cancel the contract. Consequently, the policyholder is insured against reclassification risk, given that experience rating is also forbidden. However, the insurer is not committed to a long-term premium scheme, and the average premium level follows the average loss trend in an unfunded setting. If the premium-benefit ratio only depends on calendar time, the insurance company follows a "community rating" strategy.

Risks related to disability and death increase with age, but are also subject to marked cohort effects. Due to mortality improvements, insurance companies benefit from these effects as regards death benefit insurance (whether term life or whole life insurance). However, as a result of aging, LTC risk increases with calendar time. An insurance company's natural hedge against uncertainty in the Knightian sense is not to commit itself to a long-term premium scheme. In our study, short-term risks increase with age much more rapidly than do the corresponding premiums. Besides, gender is not taken into account. These characteristics entail strong cross-subsidies between genders and generations. The difference between the insurance premium and the corresponding risk level is a subsidy in an unfunded setting, and a savings in a funded scheme. For sake of simplicity, we will use the first terminology in this article, although two of the three components in the bundle do incorporate some funding. Finally, there is a surrender value associated with the death benefit component, but none associated with the LTC coverage.

The article is organized as follows. The section titled "A Review of the Literature on Long-Term Insurance" reviews the literature on long-term insurance. The section titled "A Spanish Portfolio of Long-Term Insurance Contracts" describes the insurance contract and the portfolio analyzed in the empirical study. …

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