What Is a Lapse?

A lapse is the removal or expiration of a privilege, right, or policy due to the passage of time or some sort of inaction. A lapse of a privilege due to inaction occurs when the party that is to receive the benefit does not fulfill the conditions or requirements set forth by a contract or agreement.

When an insurance policy lapses, it usually occurs because one party fails to act on its obligations, or one of the terms on the policy is breached; an insurance policy will lapse if the holder does not pay the premiums, for example. Similarly, in derivatives trading the right given by an options contract will lapse when the option reaches maturity, at which time the holder will no longer possess the right to buy or sell the underlying asset.

Key Takeaways

  • A lapse occurs when the benefits and rights stated in a contract no longer remain active due to the contract holder failing to honor requirements and conditions set forth by a contract or agreement.
  • A lapse can occur, for instance, due to inaction, the passage of time, or failure to pay what is due.
  • Examples of lapses can occur in insurance policies, but can also apply to employee stock compensation or other benefits.

Understanding Lapses

When something has lapsed, the benefits and everything stated in the lapsed contract or agreement no longer remain active.

Lapse is most often used in the context of insurance, where the term implies a "lapse in coverage," a direct translation of how a lapsed policy no longer confers benefits or provides coverage. Lapsing can also occur in other contexts.

Lapsed Insurance Policies

When policyholders stop paying premiums and when the account value of the policy has already been exhausted, the policy lapses. A policy does not lapse each and every time a premium payment is missed. Insurers are legally bound to give a grace period to policyholders before the policy falls into a lapse. The grace period is usually 30 days. Insurers provide policyholders a period of 30 days to pay for the missed premium deadline.

Whole life, variable universal life, and universal life insurance policies use existing cash values of policies if payments are missed. If policyholders still do not pay within the grace period, a policy may use its own account value to pay for the unpaid premiums. If the account value is not sufficient to pay for the policyholder’s premiums, then the policy will be considered lapsed. Once a policy lapses, the insurer is not under any legal obligation to provide the benefits stated in the policy.

Term life insurance does not have this benefit because it does not gain cash value. In this case, when premium payments are missed, the policy goes straight to the grace period and then falls into a lapse when the grace period is over.

Most insurers offer policyholders the benefit of reinstating a policy during a grace period. The requirements for reinstating a policy depend on the time that the policy has lapsed. For example, insurers do not require documentation or proof of health if the policyholder wants to reinstate a policy in less than 30 days after it lapsed. Documentation regarding health and finances may be required in cases, if the lapsed period for a policy is between 30 days to six months. Any period longer than six months up to five years would be dependent on the insurance company.

A lapse ratio, or expiration ratio, is a measure of the number of policies issued by an insurance company that are not renewed compared to the number of policies that were active at the beginning of that same period. The ratio serves as an important indicator in the insurance industry because it reveals how efficient a company is at retaining its customers and earnings.

Lapses in Shares of Stocks

Stock shares or stock options are sometimes granted to employees as a form of incentive compensation. These normally come with a restriction that stops employees from selling or trading shares for a particular period of time. These restrictions vary between companies and are mostly dependent on the vesting period or the duration of time that the employee has spent with the company. When the restrictions are lifted, employees become direct owners of the shares. Lapsing in shares of stocks refers to the actual restrictions and limits.

Example of a Lapse

Say that Sam has a term life insurance policy with a $1 million death benefit that requires a monthly premium be paid of $100 for a period of 10 years. For the first two years of the policy, Sam makes the monthly payments for the policy as required. After two years, however, Sam is laid off and can no longer afford to make the payments. The grace period on the policy is 30 days over but Sam still does not pay the premiums due; and so, the policy lapses. If Sam were to pass away at this point, there would be no insurance coverage.

Shortly thereafter, Sam finds another job and requests the insurance company to reinstate the policy. The insurer agrees and Sam resumes paying the premiums, thus restoring the lapsed coverage.