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Journal Article

Mortality Swaps and Tax Arbitrage in the Canadian Insurance and Annuity Markets

Narat Charupat and Moshe Arye Milevsky
The Journal of Risk and Insurance
Vol. 68, No. 2 (Jun., 2001), pp. 277-302
DOI: 10.2307/2678103
Stable URL: http://www.jstor.org/stable/2678103
Page Count: 26
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Mortality Swaps and Tax Arbitrage in the Canadian Insurance and Annuity Markets
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Abstract

The authors analyze a tax arbitrage opportunity that results from engaging in two seemingly counterintuitive transactions in the Canadian insurance market. Specifically, if an individual acquires a fixed immediate life annuity and then uses the periodic annuity income to fund a term-to-life insurance policy, these two transactions, which the authors refer to as a "mortality swap," will generate a payoff pattern that is risk-free. In other words, a mortality swap replicates a risk-free security, albeit one with a stochastic liquidation date. The authors show theoretically that the rate of return on a mortality swap is equal to the risk-free rate on a before-tax basis, but exceeds it on an after-tax basis. This is confirmed by the results of the empirical test, which uses observed annuity and insurance quotes that already reflected adverse-selection and transaction costs. The authors also observe that the older an individual is and/or the higher his/her marginal tax rate is, the more he/she stands to gain from this tax arbitrage. This advantageous investment opportunity exists because of the arguably lenient method that Canadian authorities use to tax annuity income. The authors provide two major reasons that this method leads to an arbitrage opportunity. The authors then compare this method to that under the U.S. tax rules and show that the U.S. method renders tax arbitrage very unlikely. The demand for life insurance and annuities is usually attributed to risk aversion, consumption smoothing, and the desire for household protection. The authors' findings provide an arbitrage-based reason for their demand. As a natural by-product, the authors' research contains policy implications for the optimal taxation of annuities and insurance policies.

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