A few years ago, as South African life insurers were experiencing sharp spikes in lapse rates as a result of the GFC, some analysts and actuaries raised concerns about the impact of selective lapsation on mortality experience.
The principle is sound: Policyholders who know their health is very poor are less likely to lapse than policyholders who have no concerns about their health. Thus, those who lapse are likely to be healthier than those who remain. The mortality (and morbidity and disability) experience of those who remain will be worse than expected based on past experience.
The higher the lapses, the more significant this impact becomes. As an example, let’ say we have the following mix of policyholders by underwriting class (best to worst)
|underwriting class||Mix of population||mortality experience as % of best|
I’ve approximated the experience here based on some past CSI presentations on mortality experience – could definitely be fine-tuned.
This would give rise to experience on average of 125% of “best underwriting class experience”. If 10% of policyholders lapse and we assume these are all “best class” lives, the average experience increases by just 2.8% to 127.8%. A pretty modest impact even assuming 100% of lapses are very healthy.
In practice, some lapses would be driven by affordability and other issues so it wouldn’t be as dramatic as this. If only half the lapses were selective, the impact drops to 1.4%.
If lapses rise to 25%, then experience might be 8.3% worse, which is only just larger than the compulsory margin. And again, this is likely a worst case scenario. The “50% selective impact” is still only 4.2%.
So where does all the fuss come from? At a recent conference in the US I discovered some products where lapse rates at certain durations are as high as 90%. This relates to points where the premiums jump up dramatically after an extended period of being level and continue to rise from thereon out.
With a 90% lapse rate, assuming the best 90% of policyholders lapse, results in future mortality experience of 175% higher than before or 300% of the best class mortality experience. The impact is still a nearly doubling of experience under the 50% selective scenario.
So yes, selective lapsation can be a genuine risk, but the lapse rates where this becomes a major issue are higher than most insurers will experience under normal scenarios.
Last postscript here is that none of this would have an impact if the insured population were completely homogenous – I’ll have another post on the need to dig into populations and understand how combining heterogeneous populations is dangerous when I discuss the misuse of SA85/90 “combined”.