Lapse risk (Solvency II)
A sub-module of Solvency II life underwriting risk measuring the loss from a rise, a fall or a sudden wave of surrenders and lapses.
Lapse risk measures what the insurer loses when policyholders do not behave as expected regarding their right to exit the contract. Under the Solvency II standard formula, set by Delegated Regulation (EU) 2015/35, it is calculated as the most adverse of three shocks. A permanent 50 percent rise in lapse rates hits contracts that are profitable for the insurer, whose future margins disappear. A permanent 50 percent fall hits loss-making contracts, which policyholders keep longer than expected, for example a euro fund with a high guaranteed rate in a low-rate world. The mass lapse, finally, assumes the instant exit of 40 percent of individual contracts, and 70 percent of certain group contracts, as in a sudden loss of confidence. For French life insurers, the mass lapse shock often dominates, because a wave of surrenders would force the sale of bonds at a loss when rates rise. Lapse risk is behavioral, and so poorly modeled by past series: surrenders depend on the gap between the credited rate and the market rate, on tax, on the insurer's reputation and on the ease of exit, which digital distribution has greatly increased.
Textbook case: a life insurer holds 50 billion euros of euro funds backed by bonds with an 8 percent unrealized loss. The mass lapse shock, 40 percent of immediate exits, would force it to realize 1.6 billion in losses: this amount, net of loss-absorbing effects, feeds its capital requirement.
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