Lapse-and-Reentry in Variable Annuities

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.