Academic journal article
By Charupat, Narat; Milevsky, Moshe Arye
Journal of Risk and Insurance , Vol. 68, No. 2
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 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 thi s 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.
The essence of arbitrage-free pricing is that assets with identical payoff patterns should have the same price. The equality of prices, and by extension rates of return, holds true if markets are sufficiently free of frictions. In such markets, investors will be indifferent among the choices of assets with similar payoffs.
In practice, however, market frictions such as transaction costs, income taxes, and asymmetry of information can significantly distort investment decisions by causing one investment alternative to be less costly--thus providing a higher rate of return--than others. Previous research has investigated this possibility, both theoretically and empirically. [See, for example, Jarrow and O'Hara (1989) and Kamara and Miller (1995).]
In this article, the authors document a return discrepancy between the Canadian insurance and fixed-income markets. The authors show that by engaging in seemingly counterintuitive transactions involving two insurance products, one can create a risk-free portfolio whose after-tax return is greater than that of available risk-free securities. The two insurance products in question are (1) a standard term-to-100 life insurance policy and (2) a single-premium fixed immediate life annuity with no guarantee period.
Consider an individual who invests $100,000 in a fixed immediate life annuity and then uses part of the periodic income from the annuity to pay the premium on a life insurance policy whose death benefit is also $100,000. This "back-to-back" transaction, which shall henceforth be referred to as a "mortality swap," will create a constant periodic flow of income and will return the original $100,000 upon the death of the policyowner. This payoff pattern is similar to that of a risk-free investment such as a bank deposit whose principal is redeemed (by the individual's estate) at the time of death. 
In a frictionless market, the individual would be indifferent between a mortality swap and a bank deposit. However, the authors show that in the presence of Canadian personal income taxes, a mortality swap yields a considerably higher after-tax rate of return than the risk-free rate. …