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

Abstract

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 policy-level data on life insurance backdating. We exploit randomness in the initial tariff size to separately identify the selection and sunk cost effects of backdating on lapse proclivity. We find that consumers who are less likely to lapse self-select into the two-part tariff pricing structure and we also document consumer behavior consistent with sunk cost fallacy.