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Lapse‐and‐Reentry in Variable Annuities
Author(s) -
Moenig Thorsten,
Zhu Nan
Publication year - 2018
Publication title -
journal of risk and insurance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.055
H-Index - 63
eISSN - 1539-6975
pISSN - 0022-4367
DOI - 10.1111/jori.12171
Subject(s) - annuity , variable (mathematics) , economics , actuarial science , payment , liberian dollar , life annuity , reentry , incentive , business , microeconomics , finance , pension , medicine , mathematical analysis , mathematics , cardiology
Section 1035 of the current U.S. tax code allows policyholders to exchange their variable annuity policy for a similar product while maintaining tax‐deferred status. When the variable annuity contains a long‐term guarantee, this “lapse‐and‐reentry” strategy allows the policyholder to potentially increase the value of the embedded guarantee. We show that for a return‐of‐premium death benefit guarantee this is frequently optimal, which has severe repercussions for pricing. We analyze various policy features that may help mitigate the incentive to lapse and compare them regarding the insurer's average expense payments and their posttax utility to the policyholder. We find that a ratchet‐type guarantee and a state‐dependent fee structure best mitigate the lapse‐and‐reentry problem, outperforming the typical surrender schedule. Further, when accounting for proper tax treatment, the policyholder prefers a variable annuity with either of these three policy features over a comparable stock investment.