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.