Lapse Rate

The Lapse Rate is the annual rate at which insurance policyholders voluntarily terminate their policies before their stated maturity date. Think of it as the “cancellation rate” for an insurance company. This can happen for various reasons: a customer might stop paying their premium, decide to surrender the policy for its cash surrender value, or get lured away by a competitor's sweeter deal. While it might seem like a simple statistic, for an insurance company, the lapse rate is a critical vital sign. A high lapse rate can signal underlying problems, while a low one often points to a healthy, well-run business with happy customers. For investors, understanding this metric is key to peering under the hood of an insurance business and assessing its long-term stability and profitability.

Imagine you run a subscription business, like a streaming service. Your entire model depends on customers sticking around month after month. Insurance is no different. The lapse rate is a powerful indicator of an insurer's health and competitive standing, directly impacting its financial performance.

Insurance companies spend a great deal of money upfront to acquire a new customer. These expenses—including sales commissions, marketing, and medical underwriting—are known as deferred acquisition costs (DAC). The company plans to recover these costs and earn a profit from the stream of future premium payments over many years. When a policy lapses early, that future income stream vanishes. The company not only loses the expected profit but may fail to even recoup its initial investment. A high lapse rate can be a wrecking ball to an insurer’s profitability, eroding its return on equity and turning a promising business model into a leaky bucket. It's a classic case of one step forward, two steps back.

A consistently low lapse rate is often a sign of a strong economic moat. It tells you that:

• Customers are satisfied: They value the product and the service they receive.
• Products are competitive: The policies offer good value, preventing customers from defecting to rivals.
• The brand is trusted: Customers believe in the company's long-term stability and promises.

Think of legendary insurers like GEICO, which built a fortress on customer loyalty and competitive pricing, resulting in enviable retention rates. Conversely, a high or rising lapse rate is a major red flag. It can indicate poor product design, overly aggressive sales tactics promising unrealistic returns, shoddy customer service, or simply that competitors are eating the company's lunch.

Looking at the lapse rate in a vacuum is useless. A raw number means nothing without context. To get the real story, you need to do a little detective work.

The first step is comparison. You should analyze a company's lapse rate against:

• Its direct competitors: How does it stack up against other companies selling similar products?
• The industry average: Is it performing better or worse than the market as a whole?
• Its own history: Is the rate stable, improving, or deteriorating over the past five to ten years? A sudden spike is a serious warning sign that demands investigation.

You can typically find this information in a company's annual financial reports (like the 10-K) or investor presentations, often in the management discussion and analysis (MD&A) section.

Not all lapses are created equal. The rate can vary significantly based on several factors:

• Product Type: Basic term life insurance policies often have different lapse patterns than complex whole life insurance or annuity products.
• Policy Age: Lapses are often highest in the first few years of a policy, after which they tend to stabilize.
• Economic Conditions: During a recession, lapse rates across the industry may rise as financially squeezed households cut back on expenses. It's crucial to distinguish an industry-wide trend from a company-specific problem.

For the value investor, the lapse rate is far more than an obscure insurance term; it's a window into the soul of an insurance company. It reflects the quality of its products, the satisfaction of its customers, and the durability of its business model. A company that consistently maintains a low and stable lapse rate relative to its peers likely has a sticky customer base and a genuine competitive advantage. This quality is the bedrock of long-term value creation. So, the next time you're analyzing an insurer, don't just focus on the investment portfolio—check the lapse rate. It might just be the most honest story the company is telling.