Sunk Costs and Screening: Two-Part Tariffs in Life Insurance

Abstract

There are large, upfront, fixed costs to writing a life insurance policy. Both agent commission and direct underwriting costs (e.g., fees for physicals and blood tests) are fully paid a few years into contracts that can last 10-30 years. Because of these upfront costs, insurers can actually lose money on policies when the consumer lapses early into the contract, even if no death benefit is ever paid out. Thus, to properly price contracts, insurers must estimate lapse risks. However, consumers will often have private knowledge of their lapse likelihood, leading to adverse selection. We develop a model of insurance pricing under heterogeneous lapse rates with asymmetric information about lapse likelihood within the context of an optional two-part tariff as a screening device for future policyholder behavior. We then test for consumer self-selection using detailed, policy-level data on life insurance backdating (a common practice that resembles a two-part tariff). We are able to identify, through a control function approach, the information about lapse risk a consumer reveals when they choose to backdate. Our contribution to the literature is twofold: we are the first to consider life insurance lapsing as a form of adverse selection; we also explore, both theoretically and empirically, the role of optional two-part tariffs as a screening mechanism using life insurance backdating as our primary example. We find that consumers who are less likely to lapse self-select into the two-part tariff pricing structure and also document consumer behavior consistent with sunk cost fallacy.