Why do people let life insurance policies lapse?

Life insurance is complex matters, and some say this is why you need the visit of an insurance salesman to understand the policy option (and other say this is to trick you into paying too much). But it is true that people sometimes make pretty stupid choices with their life insurance. One of them is to lapse their policy: stop paying their premium. The reason this is stupid is that policies are front-loaded: as risk of death increases with age but premiums are constant, a policy holder pays more than an actuarially fair rate during the first years and is rewarded in the later years. A lapsing policy is thus pure profit for the insurance industry, and it is factored in in premium calculations.

Hanming Fang and Edward Kung report that all this is now subject to upheaval due to the emergence of the life settlement industry, which takes policies about to lapse over, pay cash to the holder and continue paying premiums to the end of the policy. Because of the lack of lapsing profits, life insurance companies thus do have to increase premiums or leave the market. The latter would probably mean a loss of welfare for households. But the cash payment may be a welfare improvement, depending on the circumstances of lapsing. If it is because a policy holder lost interest in leaving a bequest, welfare is lower because he does not really need the cash plus faces insurance reclassification risk. If it is because of an income shock, then a cash payout is of course welfare improving.

Fang and Kung study how the life settlement industry should be regulated to maximize household welfare, under the constraint that one cannot observe why a policy holder is lapsing the life insurance policy. They try to find whether one or the other shock dominates and thus which way welfare would go. For the old policy holders, who are the huge majority, it appears the no shocks emerges as more important, thus they do not really have an answer.