Abstract
Life insurance often embeds a surrender option that gives the policyholders a right to exchange an existing contract for its cash surrender value. Similar to mortgage prepayment option that imposes a cash-flow risk to MBS investors, this surrender option is a source of concern for life insurers. While prior studies have attempted to quantify this surrender risk by pricing the surrender option, a common theoretical assumption imposed is a fully rational response of policyholders to only interest rates. However, actual surrender experience indicates that interest rates are just one of the multiple factors that drive the surrender decision and policyholders' response is not necessarily optimal. This paper integrates an empirical surrender function into the option pricing framework by employing a novel data set from a large life insurance industry experience study. It shows, for the first time in the literature, that policy vintage is a particularly significant and meaningful factor in addition to macroeconomic variables that impact surrender activity. Using these empirics, I find that the experience-based value of the surrender option is substantially less than its fully rational counterpart. In addition, the competitive landscape of the life insurance industry and the interest rate environment both play an important role in assessing the surrender risk exposure of life insurers.
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