Lapse‐and‐Reentry in Variable Annuities

• Author: Nan Zhu,Thorsten Moenig
• DOI: http://doi.org/10.1111/jori.12171
• Date: 01 December 2018
• Published date: 01 December 2018

©2016 The Journal of Risk and Insurance. Vol.85, No. 4, 911–938 (2018).

DOI: 10.1111/jori.12171

Lapse-and-Reentry in Variable Annuities

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 in-

crease the value of the embedded guarantee. We show that for a return-of-

premium death benefit guarantee this is frequentlyoptimal, which has severe

repercussions for pricing. Weanalyze 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 surren-

der schedule. Further, when accounting for proper tax treatment, the poli-

cyholder prefers a variable annuity with either of these three policy features

over a comparable stock investment.

Introduction

Investment flexibility,favorable tax treatment, and long-term guarantees have moved

variable annuities (VAs) among the most popular long-term savings vehicles in the

United States in recent years. A typical VA policy may entail an initial lump-sum

investment that is placed into a financial stock or mutual fund, according to the

policyholder’s choosing. To protect the policyholder from adverse market scenarios,

the insurance company selling the VApolicy enhances the product with a Guaranteed

Minimum Death Benefit (GMDB) rider that promises to return the larger of the VA

Thorsten Moenig is at the Department of Risk, Insurance, & Healthcare Management, Fox

School of Business, 1801 Liacouras Walk,TempleUniversity,Philadelphia, PA 19122. Moenig can

be contacted via e-mail: moenig@temple.edu. Nan Zhu is at the Risk Management Department,

Smeal College of Business, Pennsylvania State University,University Park, PA 16802. Zhu can

be contacted via e-mail: nanzhu@psu.edu. We areindebted to two anonymous referees whose

suggestions have led to a much improved article. Moreover,we are thankful for practical advice

from Adam Brown and Gary Hatfield and for helpful comments from participants at the 2015

Perspectives on Actuarial Risks in Talksof Young Researchers winter school and the 2015 World

Risk and Insurance Economics Congress, and in particular from our discussant CaroleBernard,

as well as from seminar participants at the University of Minnesota, the University of Georgia,

Michigan State University, and Temple University. Support from the University of St. Thomas

and Illinois State University is greatly appreciated.

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account value and a prespecified “guaranteed” amount upon the policyholder’s

death. To cover its expenses and the cost of the GMDB rider, the insurer collects a fee,

continuously and (typically) in proportion to the concurrent VA account value.1

However,as recent events have demonstrated, VAs are posing tremendouschallenges

to life insurers (Reuters, 2009; ING, 2011; Manulife Financial, 2011; Sun Life Financial,

2011). In addition to their exposure to long-term financial risk, insurers are particu-

larly troubled by their poor understanding of policyholder behavior.2For instance,

according to Section 1035 of the U.S. tax code, the policyholder typically has the right

to surrender his existing VA policy and use the cash value to purchase a new one,

without incurring additional tax obligations. In the case of a GMDB, it may be opti-

mal to do so when the VAaccount value has risen (significantly) above the guaranteed

amount. In that case, the GMDB has little value, yet the policyholder is paying a larger

amount of fees for it. This so-called lapse-and-reentry strategy can have a detrimen-

tal effect on the insurer’s profit; from the company’s perspective, the policyholder’s

market reentry constitutes the sale of a new VA policy that triggers large payments in

the form of commissions and other policy acquisition expenses.

It is noteworthy that the prevalence of this lapse-and-reentry strategy is facilitated by

the absence of up-front sales charges in most VA products sold in the United States

today.3As a result, the policyholder does not pay directly the expenses resulting

from his decision to lapse and reenter; instead, these costs are “socialized” among all

policyholders in the form of a (substantially) increased fee rate. Therefore, accounting

for the policyholder’s lapse behavior is critical in determining the proper fee rate.

In this study, we present and contrast the standard return-of-premium GMDB rider

with a variety of additional policy features that can help mitigate the policyholder’s

incentives to lapse: in practice, insurers typically impose a surrenderschedule, so that for

a number of years the policyholder must pay a percentage of the current VA account

value when lapsing. A second common feature—though usually offered as an add-on

1For a detailed description of this and other guarantees available in the U.S. VAmarket we refer

to Bauer, Kling, and Russ (2008).

2In a recent study,Moody’s Investors Service concludes that policyholder behavior is a “weak

spot” for insurers, and that “unpredictable policyholder behavior challenges U.S. life insurers’

variable annuity business” (Moody’s, 2013). Moreover,in the year 2000, the U.K.-based mutual

life insurer Equitable Life—the world’s oldest life insurance company—was closed to new

business due to problems arising from a misjudgment of policyholder behavior with respect

to exercising guaranteed annuity options within individual pension policies (Boyle and Hardy,

2003).

3This is in contrast to, for example, equity-linked insurance products in parts of Europe. In-

stead, typically U.S. VA providers initially pay their policy acquisition costs out of pocket

and use the recurring fee to recover these expenses over time (Morgan Stanley, 2015). To our

knowledge, A-shares are the only VA class in the U.S. that applies an up-front sales charge.

However, A-share VAs make up only around 1 percent of current VA sales. We refer to the

Insured Retirement Institute (http://irionline.org/government-affairs/annuities-regulation-

industry-information/annuities-glossary) for a complete listing of VA classes and to Morn-

ingstar for current VAsales statistics (http://www.morningstar.com).