No 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.

No abstract

In the United States, variable annuities (VAs) are popular long‐term personal investment vehicles. Recently, however, sales have begun to dwindle. In fact, financial advisers have long argued against investing in VAs due to the products’ high fees. VA providers charge these fees—typically at a constant rate throughout the policy period—to cover their expenses and the costs of embedded guarantees, and lowering this constant fee rate could make the VA unprofitable. Instead, we propose and analyze a simple change to the fee “structure” that would lower fee rates overall (and thus make the product more attractive to investors) without reducing the insurer's profit. The key insight is that this time‐dependent fee rate (with moderate front‐loading) implicitly discourages policy lapses and exchanges, which reduces the providers’ policy acquisition expenses. Taking into account financially optimal lapse (and reentry) decisions, we determine the optimal timing and rate of the fee reduction for a competitive as well as for an innovative VA provider. An important characteristic of this feature is that it can be implemented easily and effectively to both new and existing VA policies.

The paper presents a review of structural models of policyholder behavior in life insurance.We first discuss underlying drivers of policyholder behavior in theory and survey the implications of different models. We then turn to empirical behavior and appraise how well different drivers explain observations. The key contributions lie in the synthesis and the systematic categorization of different approaches. The paper should provide a foundation for future studies, and we describe some important directions for future research in the conclusion.