Lapse Rate Modeling: A Rational Expectation Approach
Scandinavian Actuarial Journal, Forthcoming
24 Pages Posted: 7 Oct 2007 Last revised: 9 Oct 2008
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: Suggested Citation
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