Lapse Rate Modeling: A Rational Expectation Approach

Scandinavian Actuarial Journal, Forthcoming

24 Pages Posted: 7 Oct 2007 Last revised: 9 Oct 2008

See all articles by Domenico DeGiovanni

Domenico DeGiovanni

Università degli Studi della Calabria; Aarhus University - School of Business and Social Sciences

Date Written: july 1, 2008

Abstract

The surrender option embedded in many life insurance products is a clause that allows policyholders to terminate the contract early. Pricing techniques based on the American Contingent Claim (ACC) theory are often used, though the actual policyholders' behavior is far from optimal. Inspired by many prepayment models for mortgage backed securities, this paper builds a Rational Expectation (RE) model describing the policyholders' behavior in lapsing the contract. A market model with stochastic interest rates is considered, and the pricing is carried out through numerical approximation of the corresponding two space-dimensional parabolic partial differential equation. Extensive numerical experiments show the differences in terms of pricing and interest rate elasticity between the ACC and RE approaches as well as the sensitivity of the contract price with respect to changes in the policyholders' behavior.

Keywords: Surrender Option, Prepayment Models, Alternating Direction Implicit methods

JEL Classification: G21, G22

Suggested Citation

DeGiovanni, Domenico and DeGiovanni, Domenico, Lapse Rate Modeling: A Rational Expectation Approach (july 1, 2008). Scandinavian Actuarial Journal, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1019630 or http://dx.doi.org/10.2139/ssrn.1019630

Domenico DeGiovanni (Contact Author)

Aarhus University - School of Business and Social Sciences ( email )

Nordre Ringgade 1
Aarhus C, DK-8000
Denmark

Università degli Studi della Calabria ( email )

Ponte Bucci, Cubo 3C
Rende, Cosenza 87036
Italy

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