Monday, July 22, 2019

Monday, July 22, 2019 — 4:00 PM EDT

Negative Marginal Option Values: The Interaction of Frictions and Option Exercise in Variable Annuities

Market frictions can affect option exercise, which in turn affects the value of a marginal option to the writer—and may even yield negative marginal option values. We demonstrate the relevance of this mechanism in the context of variable annuities with popular withdrawal guarantees, both theoretically and empirically. More precisely, we show that in the presence of income and capital gains taxation for the policyholder, adding on a common death benefit option—allowing to continue the withdrawal guarantee in case of death—changes the policy- holder’s optimal withdrawal behavior. As a consequence, the total value of the contract from the perspective of the insurer may decrease, i.e. the marginal option value is negative. This explains the common practice of including death benefit options without additional charges in these products.

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