Don’t lapse into temptation: a behavioral explanation for policy surrender

Many policyholders surrender their life insurance policies early, leading to substantial monetary losses for private households. Surrender can be explained rationally if it constitutes the last resort providing liquidity in the event of an urgent need of cash. Yet we find clear evidence in German panel data that for more than half of all surrendered contracts investors had cheaper options available to provide the required liquidity. This finding demonstrates that there must be other factors influencing this important life decision. We provide a behavioral explanation, focusing on the role of individual decision heuristics, financial literacy, and financial advice. In particular, we show that financial literacy and financial advice can mitigate the behavioral temptation to lapse, while the tendency to rely on heuristics increases lapse probability.