What it means
A policy lapses when the customer stops paying the premium (the regular payment for cover) and the insurer cancels the policy. This is different from a claim being paid or a policy reaching the end of its term.
Lapses are most common in the early years of a policy. Insurers care about the lapse ratio because they pay significant upfront costs to win a customer, such as sales commission, medical checks and administration.
They expect to earn that money back over many years of premiums. If a customer drops out after a year or two, the insurer may lose money on that policy.
The ratio also affects pricing and forecasting. Actuaries (specialists who calculate insurance risk and pricing) assume a certain lapse rate when setting premiums.
If real lapses are higher or lower than assumed, profits move away from plan, and this is a key source of risk in long-term life insurance. The causes of lapses include rising premiums, changes in income, poor service, a better offer elsewhere or a customer deciding that the cover is no longer needed.
Insurers try to reduce them with reminders, flexible payment options, better customer service and loyalty benefits. Brokers and agents may also be paid in a way that rewards keeping customers.
The measure can be calculated in different ways, such as by number of policies or by premium value, and for different time periods. When comparing insurers, it is important to check that the same method is used.
Lapses also reveal something about customers. If lapses jump when premiums are raised, customers are price-sensitive, and if they rise after a claim, service may be at fault.
Many insurers therefore break the ratio down by product, sales channel, policy age and payment method, because the average can hide a problem concentrated in one area.
In practice
Real-world examples.
Example
A life insurer notices that lapses are highest in the second year, when promotional discounts end. It introduces a loyalty discount for customers who stay for three years. The change costs little and aims to reduce cancellations in a vulnerable period.
Example
A health insurance company in Dubai finds that corporate clients lapse less than individuals. It focuses its sales efforts on employers and offers group plans. The result changes how it targets new customers.
Example
A car insurer compares its lapse ratio with the industry average. The comparison shows that its customers are leaving earlier than those of its competitors, which prompts a review of claims service. The review looks at call times, claims decisions and complaint handling.
Formula
Calculation
Lapse ratio (%) = number of policies lapsed during the period / number of policies in force at the start of the period x 100
Worked example: an insurer has 20,000 policies in force at the start of the year, and 1,400 lapse during the year.
Step 1: Divide lapsed policies by policies in force = 1,400 / 20,000 = 0.07.
Step 2: Convert to a percentage = 0.07 x 100 = 7%.
The lapse ratio is 7%. If the average annual premium is $900, the lost premium income is 1,400 x $900 = $1,260,000 a year.Case study
Seen in the real world.
Northstar Mutual is a fictional insurer that sold 10,000 new life policies in a year, each with an average annual premium of $1,200. The sales team was rewarded on volume, and it pushed hard to close deals.
By the end of year two, 2,000 of those policies had lapsed, a 20% lapse ratio. The company had paid out upfront commissions of about $400 per policy, so it had spent $800,000 (2,000 x 400 = 800,000) on policies that earned only a small portion of the expected premiums.
In this illustrative story, the insurer changed its commission plan to pay part of the reward after the second year, and added a follow-up call at six months. Lapses fell to 12% the next year, which the finance team valued at hundreds of thousands of dollars. The finance team now reports the ratio by policy age every month, so it sees problems early.
Watch out
Common mistakes.
- Confusing a lapse with a claim or maturity, when a lapse means the customer stopped paying and the cover ended.
- Comparing lapse ratios without checking whether they are measured by number of policies or by premium value.
- Ignoring early-year lapses, which are usually the most costly because the upfront costs have not been recovered.
Questions
People also ask.
What is a good lapse ratio?
It depends on the type of insurance and the market, but lower is generally better, and insurers compare themselves with industry figures.
How is a lapse different from a surrender?
A lapse happens when premiums stop and the policy ends, while a surrender is when the holder deliberately cashes in a policy that has value.
Can a lapsed policy be reinstated?
Often yes within a set period if the customer pays the overdue premiums and meets the insurer's conditions.
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