Taxation and Policyholder Behavior: The Case of Guaranteed Minimum Accumulation Benefits

Taxation and Policyholder Behavior: The Case of Guaranteed Minimum Accumulation Benefits

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This paper considers variable annuity contracts embedded with guaranteed minimum accumulation benefit (GMAB) riders promising the return of the premium paid by the policyholder, or a higher stepped up value at the end of the investment period when policyholder’s proceeds are taxed. A partial differential valuation framework which exploits the numerical method of lines is used to generate fair fees that render the policyholder and insurer profits neutral. Two taxation regimes are considered; one where capital gains can offset losses and a second where gains cannot offset losses, reflecting the institutional arrangements in Australia and the US respectively. We find that most insurance providers highlight the tax-deferred feature of a variable annuity and show that the regime under which it is taxed affects the supply and demand prices. Allowing for losses to offset gains enhances the market, narrowing the gap between fees, or even producing higher demand than supply fees. On the other hand, the no offset case increases the demand-supply gap. Yet, if charging the demand price we observe that insurance companies would be profitable on average, especially benefiting from the introduction of tax when the Sharpe ratio is 0.25.

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