Finance Research Group Working Papers,
University of Aarhus, Aarhus School of Business, Department of Business Studies

Abstract: 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.

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

34 pages, October 31, 2007

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