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Lapse‐and‐Reentry in Variable Annuities

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  • Thorsten Moenig
  • Nan Zhu

Abstract

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.

Suggested Citation

  • Thorsten Moenig & Nan Zhu, 2018. "Lapse‐and‐Reentry in Variable Annuities," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 85(4), pages 911-938, December.
    • Handle: RePEc:bla:jrinsu:v:85:y:2018:i:4:p:911-938
    DOI: 10.1111/jori.12171
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    Cited by:

    1. Zhenyu Cui & Anne MacKay & Marie-Claude Vachon, 2022. "Analysis of VIX-linked fee incentives in variable annuities via continuous-time Markov chain approximation," Papers 2207.14793, arXiv.org.
    2. Wang, Gu & Zou, Bin, 2021. "Optimal fee structure of variable annuities," Insurance: Mathematics and Economics, Elsevier, vol. 101(PB), pages 587-601.
    3. Fabio Baione & Davide Biancalana & Paolo Angelis, 2021. "An application of Sigmoid and Double-Sigmoid functions for dynamic policyholder behaviour," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 44(1), pages 5-22, June.
    4. Andrea Molent, 2019. "Taxation of a GMWB Variable Annuity in a Stochastic Interest Rate Model," Papers 1901.11296, arXiv.org, revised May 2020.
    5. David Landriault & Bin Li & Dongchen Li & Yumin Wang, 2021. "High‐water mark fee structure in variable annuities," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 88(4), pages 1057-1094, December.
    6. Ulm, Eric, 2020. "Analytic Valuation of GMDB Options with Utility Based Asset Allocation," Working Paper Series 8566, Victoria University of Wellington, School of Economics and Finance.
    7. Moenig, Thorsten, 2021. "Variable annuities: Market incompleteness and policyholder behavior," Insurance: Mathematics and Economics, Elsevier, vol. 99(C), pages 63-78.
    8. Thorsten Moenig, 2021. "Efficient valuation of variable annuity portfolios with dynamic programming," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 88(4), pages 1023-1055, December.

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