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Lapse Rate Modeling: A Rational Expectation Approach

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Lapse Rate Modeling: A Rational Expectation Approach 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 mort- gage 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 corre- sponding two{space{dimensional parabolic partial di®erential equa- tion. Extensive numerical experiments show the di®erences in terms of pricing and interest rate elasticity between the ACC and RE ap- proaches as well as the sensitivity of the contract price with respect to changes in the policyholders' behavior.

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  • De Giovanni, Domenico, 2007. "Lapse Rate Modeling: A Rational Expectation Approach," Finance Research Group Working Papers F-2007-03, University of Aarhus, Aarhus School of Business, Department of Business Studies.
    • Handle: RePEc:hhb:aarbfi:2007-03
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    1. Peter Løchte Jørgensen & Domenico De Giovanni, 2010. "Time Charters with Purchase Options in Shipping: Valuation and Risk Management," Applied Mathematical Finance, Taylor & Francis Journals, vol. 17(5), pages 399-430.
    2. Høg, Esben, 2008. "Volatility and realized quadratic variation of differenced returns : A wavelet method approach," Finance Research Group Working Papers F-2008-06, University of Aarhus, Aarhus School of Business, Department of Business Studies.

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