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 this is frequently optimal and has severe repercussions for pricing and hedging of the guarantee. We analyze various policy features that may help mitigate the incentive to lapse, and compare them regarding the residual risk exposure to both policyholder and insurer.