lapse and surrender behavior
Insurers price policies expecting that people will keep paying premiums for years. But policyholders change their minds: they stop paying because money is tight, they no longer need the cover, or a competitor offers something better. When a policy ends early — by missed premiums or by deliberately cashing it in — the insurer's careful long-term plan is disturbed. Studying when and why this happens is the study of lapse and surrender behavior.
A lapse is when a policy terminates because premiums are not paid (after any grace period); a surrender is when the owner voluntarily cashes in a policy with cash value for its surrender value. The flip side, the share of policies still in force, is persistency. These rates are measured by policy year — for example, a block might lose 12 percent of policies in year 1 and 6 percent a year thereafter. Because permanent policies overcharge early to fund later years, an early surrender can actually leave the insurer ahead, while heavy lapses on term business mean it never recovers its acquisition costs.
Actuaries treat lapse as a decrement (like mortality) and build assumed lapse rates into pricing, reserving and profit testing; getting them wrong can turn a profitable product into a loss-maker. Two effects make this subtle and important: deferred acquisition costs (high upfront commissions and underwriting expense) are only recouped if policies persist, and there is a selective-lapse danger — healthy people are likeliest to lapse and replace cover, so the remaining pool may be sicker than the original table assumed, a form of antiselection.
An insurer prices a term product assuming 8 percent of policies lapse each year, so it can spread acquisition costs over the expected lifetime of a policy. If lapses actually run at 15 percent, far fewer policies stay long enough to recoup the big first-year commission, and the supposedly profitable block instead loses money.
Lapse and surrender rates drive whether upfront costs are ever recouped — and who is left in the pool.
Lapse is not always bad for the insurer or always good for the policyholder. An early surrender of a permanent policy often returns far less than premiums paid, while the selective lapse of healthy lives can leave the insurer with a worse-than-expected pool.