Modeling lapse risk using cointegration and error correction approach
Abstract
Policy lapse, in life insurance, is the ratio of the number of policies that default
during a period to the average number of policies written within that period. It
is a phenomenon that occurs during the activity of insurance operations and one
that causes negative e ects for those activities: deterioration of business or record
insurance losses a ecting functionality. Individually closed contracts in life and
pensions industry are associated with several risks ranging from underwriting and
nancial risks to operational risks. This research focuses on one of these risks, more
speci cally the risk of termination of a policy by the policyholder- the 'lapse'risk.
This study provided the Error Correction Model as a suitable choice given its key
bene ts; convenience in measuring the correction from disequilibrium from the
previous years'periods and the ability to eliminate trends.
The ECM analysis revealed a long run causality running from all the explanatory
variables to the dependent variable. The ndings also indicated that the GDP
growth and stock market performance a ect lapse behaviour in the short run.
Impulse response analysis further found that the lapse rate responds far more
strongly to the random shocks from the GDP growth than to the shocks from
the stock market index. In other words, the GDP growth has a more signi cant
economic impact upon the lapse rate than the stock market index and therefore
the emergency fund hypothesis is more favored against the interest rate hypothesis
in interpreting the lapse rate dynamics.