Lapse-and-Reentry in Variable Annuities

Section 1035 of the current US tax code allows policyholders to exchange their variableannuity policy for a similar product while maintaining tax-deferred status. When the variableannuity contains a long-term guarantee, this “lapse-and-reentry” strategy allows the policyholderto 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 repercussionsfor 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 post-tax utilityto the policyholder.We find that a ratchet-type guarantee and a state-dependent fee structure best mitigatethe lapse-and-reentry problem, outperforming the typical surrender schedule. Further, whenaccounting for proper tax treatment, the policyholder prefers a variable annuity with either ofthese three policy features over a comparable stock investment