Minimum Death Benefit Variable annuities typically promise a guaranteed minimum death benefit (GMDB), which often equals the greater of the cash value or the amount invested in the contract, if the annuity owner dies during the accumulation period. Some insurers offer a “ratchet” GMDB wherein a new minimum death benefit is established periodically or the benefit equals the premiums accumulated at a stated interest rate. Thus, assume the owner pays a premium of $10,000 into the contract, and the cash value escalates to $12,000 over the next two years. Under the traditional GMDB, if the owner dies, his or her beneficiary receives $12,000. If, on the other hand, the cash value declines to $8,000 because of poor investment results, and the owner
dies, his or her beneficiary would receive $10,000—the amount invested in the contract. This guarantee can be important to investors who are concerned about the riskiness inherent in variable annuity investment returns. This benefit has a cost, however, in that the insurer must charge for the guarantee, thus depressing somewhat the effective yield under the policy. Also, most insurers will establish age limits or time limits beyond which the guarantee does not apply.
The feature invites adverse selection in two ways. First, variable annuity owners have an incentive to purchase multiple contracts rather than to seek the identical investments through a single contract. For example, assume that Sam invests $100,000 into a variable annuity and splits the amount equally between two separate accounts. Assume that one account declines in value to $40,000 while the other appreciates to $65,000. If Sam dies under this scenario, his beneficiary will be entitled to $105,000 ($40,000 + $65,000) because the account values are greater than the original investment.
Assume that Sam’s twin, Richard, had purchased two annuities and contributed $50,000 to each. Assume further Richard realized investment results identical to those that Sam realized; that is, one account declined in value to $40,000, while the other increased to $65,000. If Richard dies, his heirs receive $115,000 rather than $105,000. The first annuity will pay $50,000 because the cash value is less than the investment, and the second annuity will pay $65 000 because the cash value is greater than the investment
By undertaking all investment through a single annuity Sam in effect was penalized because gains’ in one account can offset losses in another. By purchasing separate annuities, his twin took advantage of his superior knowledge to gain an additional death benefit. The second way that this feature can invite adverse selection can occur because of the combination of the option to withdraw funds coupled with the wording of some contracts’ death benefit promise. Assume that Sam’s $100,000 investment declined in value to $71,000. The contract promises to pay a minimum death benefit equal to the original contribution less withdrawals. Thus, if Sam died, his heirs would, of course, receive $100,000.
What would they receive if Sam withdrew $70,000 and invested it elsewhere, leaving $1,000 in net cash value? The preceding italicized language would suggest that they should receive $30,000. In other words, he would have a $30,000 death benefit promise supported by a cash value of only $1,000. He has exercised a valuable call option to his benefit and to the insurer’s detriment. Of course, insurers are aware of these possibilities and should price these options accordingly. Alternatively, they could change the option to create less of a financial incentive for the contract owner to select against the company in this way (e.g., use proportional language with respect to withdrawals). The contract owner may find some disincentives here also. For one, surrender charges may be large. Also, the death benefit does not qualify as life insurance under the U.S. tax code, so it would not enjoy favorable tax treatment on death.