ShanghaiTech SEM Working Paper No. 2018-011
Hanming Fang
ShanghaiTech University - School of Entrepreneurship and Management
Edward Kung
University of Colifornia, Los Angeles
Abstract
We investigate why life insurance policies in practice either do not have a cash surrender value (CSV), or have cash surrender values that are small and are not adjusted for health status. We show that including health-contingent CSVs to a life insurance contract causes a dynamic commitment problem, which makes it more costly up front for policyholders to purchase long term contracts (because some poor risks who would otherwise have lapsed can and will now capture the cash surrender value instead). To the extent that life insurance policyholders’ incomes tend to increase over the course of the policy, policyholders are not willing to accept higher ex ante premium costs in return for the extra liquidity provided by the cash surrender value. Because health-contingent CSVs act in a similar way to a life settlement market, we also study the life insurers’ equilibrium choice of cash surrender values in the presence of a life settlement market. We find that optimally chosen cash surrender values can partially mitigate the consumer welfare loss caused by the settlement market (as in Daily et al., 2008), but only if the cash surrender values are allowed to be contingent on health status.
Keywords: Life insurance, cash surrender values, life settlement market, reclassification risk insurance.
Date Written: July 19th, 2018
Available at SSRN: https://ssrn.com/abstract=3216405
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