Lapse-supported life insurance and adverse selection

TL;DR

This paper examines how lapse-supported premiums can amplify adverse selection in life insurance, especially when high-risk individuals are less likely to lapse, using models of 'Term to 100' and genetic testing.

Contribution

It introduces a model analyzing the impact of lapse-supported premiums on adverse selection, considering various management methods and heterogeneous populations with limited risk identification.

Findings

Adverse selection losses are small without lapse support.

Lapse-supported premiums can significantly increase adverse selection.

Different lapse modeling approaches are broadly equivalent and robust.

Abstract

If individuals at the highest mortality risk are also least likely to lapse a life insurance policy, then lapse-supported premiums magnify adverse selection costs. As an example, we model 'Term to 100' contracts, and risk as revealed by genetic test results. We identify three methods of managing lapse surplus: eliminating it by design; disposing of it retrospectively (through participation); or disposing of it prospectively (through lapse-supported premiums). We then assume a heterogeneous population in which: (a) insurers cannot identify individuals at high mortality risk; (b) a secondary market exists that prevents high-risk policies from lapsing; (c) financial underwriting is lax or absent; and (d) life insurance policies may even be initiated by third parties as a financial investment (STOLI). Adverse selection losses under (a) are typically very small, but under (b) can be increased by multiples, and under (c) and (d) increased almost without limit. We note that the different approaches to modeling lapses used in studies of adverse selection and genetic testing appear to be broadly equivalent and robust.