Lapse‐and‐Reentry in Variable Annuities

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.

Where Less Is More: Reducing Variable Annuity Fees to Benefit Policyholder and Insurer

“…We extend the lapse‐and‐reentry model of Moenig and Zhu () by allowing the annual VA fee rate to be time dependent. We first recall here the assumptions made regarding the financial market and present the VA contract that we will study throughout the article.…”

“…Currently, VA providers charge a “time‐invariant” base fee (formally, the “mortality and expense risk charge” and the “administration charge”) in order to recover their expenses over the duration of the policy. The high level of this fee is a consequence of the large policy acquisition expenses (e.g., commissions), in combination with frequent policy lapses (Paris, ), which give providers less time to recover their up‐front expenses (Pinquet, Guillen, and Ayuso, ; [Moenig and Zhu], ). We demonstrate that a partial front‐loading of the fees can potentially reduce lapses by rewarding and encouraging long‐term consumer participation in the policy.…”

“…This would increase the guaranteed amount to the current VA account value, without changing any of the other contract parameters. Moenig and Zhu () show that this “lapse‐and‐reentry” strategy—known commonly as a “1035 exchange”—is frequently optimal and persists even in the presence of a typical VA surrender fee schedule. The strategy is quite costly, though, as the policyholder's market reentry constitutes the sale of a new policy.…”

“…The consensus is that policyholder behavior poses a tremendous risk for VA providers. Our work builds particularly on recent studies that analyze some specific VA policy features with respect to their effectiveness in mitigating incentives to surrender (Moenig and Zhu, ; MacKay et al, ). As noted, for instance, by Moenig and Zhu (), a ratchet‐style guarantee and a state‐dependent fee structure can be similarly effective in this regard.…”

Risk Management of Policyholder Behavior in Equity‐Linked Life Insurance

“…However, we find that these minimal surrender penalties are generally too high to lead to a marketable VA product. To address this issue, we consider the state‐dependent fee structure introduced by Bernard, Hardy, and MacKay (), where the fee is paid to the insurer only when the account value is below a certain threshold (see also Delong, ; Moenig and Zhu, ; Zhou and Wu, ) 5 . The motivation is the following: since the state‐dependent fee structure reduces the incentive to lapse the VA contract, it can be combined with smaller surrender charges to achieve our goal of removing the surrender incentive.…”