Most individual life insurance policies lapse, with lapsers cross-subsidizing non-lapsers. We show that policies and lapse patterns predicted by standard rational expectations models are the opposite of those observed empirically. We propose two behavioral models consistent with the evidence: (i) consumers forget to pay premiums and (ii) consumers understate future liquidity needs. We conduct two surveys with a large insurer. New buyers believe that their own lapse probabilities are small compared to the insurer’s actual experience. For recent lapsers, forgetfulness accounts for 37.8 percent of lapses while unexpected liquidity accounts for 15.4 percent.

The conventional wisdom since Yaari (1965) is that households without a bequest motive should fully annuitize their investments. Numerous frictions do not break this sharp result. We modify the Yaari framework by allowing a household's mortality risk itself to be stochastic due to health shocks. A lifetime annuity still helps to hedge longevity risk. But the annuity's remaining present value is correlated with medical costs, such as those for nursing home care, thereby reducing annuity demand, even without ad-hoc liquidity constraints. We find that most households should not hold a positive level of annuities, and many should hold negative amounts.