Many clients have come to me with this question over the years, and there is no simple answer. When an insurance agent recommends a replacement, it may be a good idea for you and your family - or it may just be a good idea for the agent. Careful analysis is required, and you should seek the help of a financial planner.
Most of the time when an agent discusses a replacement, it involves moving the cash value from an older policy into a new one - a process called a Section 1035 exchange. This is a process that can take a lot of time and a lot of paperwork, and is often heavily regulated - as in New York with the Regulation ("Reg") 60 procedures, which will be discussed here. These procedures require your agent to disclose that you intend to replace a policy, and obtain current information and projections from your existing insurance company. After the information is received (usually within about three weeks), the agent can then give you a side-by-side projection and comparison of your existing and proposed policies. It is only at that point that the agent may accept your application.
These same replacement regulations apply to annuities (and now long-term care) as well, but this is another complicated topic that we'll save for next month. In either case, the advantage of a 1035 exchange is that any gain in your existing policy is moved into the new one tax-deferred. The IRS allows insurance-to-insurance, annuity-to-annuity, and insurance-to-annuity exchanges. Annuity-to-insurance exchanges are not allowed.
What are the potential advantages of a policy replacement?
- A higher death benefit. Mortality rates have dropped many times over the years, and it may be possible to obtain a higher death benefit for the same premium, even if you're older - which of course, you inevitably are! There are also differences in the cost of insurance from one company to another. However, most often this will require the use of the cash value accumulated in your existing policy.
- A lower premium. For the same reasons, it may be possible to reduce your ongoing premium for the same death benefit in a new policy. With a sufficiently funded 1035 exchange, eliminating future premiums altogether may even be possible.
- Change of policy type. Some older life insurance contracts (particularly variable universal life) may have performed poorly over the years, and it may make sense to move any remaining cash into a policy with a guaranteed interest rate (such as universal life) in order to keep your coverage alive. In this case, be sure that your agent first obtains an in-force ledger on the existing policy to see if it's worth saving: you can see how long your coverage would last if you did nothing, or perhaps paid some additional premium into the policy. Sometimes insurance policies were sold with the promise that your premiums would "disappear" after some number of years, which could fail to happen if the policy did not achieve the rosy 12 percent returns originally projected by your agent. You may also be able to re-allocate your investment options to mitigate future damage.
What are the disadvantages of a policy replacement?
- Cost. Insurance policies are expensive to issue. The insurance company will incur new underwriting costs (paying for your medical exam, paying your doctor for your records, etc.) and your agent will be paid around half of your first-year's premium as a commission. These costs are not charged separately, but rather reduce the cash value in your contract for the first 10 years or so after issue. Money that would have been available for withdrawal from the old policy will be substantially reduced in the new one. (Note that we're discussing cash value, or permanent insurance; although term insurance replacements still require Reg. 60 paperwork, there is no cash to be moved by a 1035 exchange and therefore, perhaps, not as much incentive for an agent to recommend the replacement.)
- Loss of features. Your old policy may include features or riders that are unavailable with the new policy: bundled family coverage, guaranteed insurability increases, higher guaranteed minimum interest rates, etc. Your agent should explain the meaning of anything that would be lost in the new policy.
As part of the Reg. 60 disclosures, your agent is required to itemize the reasons for the replacement. Bear in mind, however, that this material is not scrutinized by the state unless there is an issue down the road, and a sales supervisor may sign off on "reasons" that an arbitrator may later find invalid.
Regardless of what assurances you may receive about the new policy, you should NEVER drop your existing policy until the new one is issued. Otherwise, you might end up with no coverage at all, and no ability to obtain any if it turns out that you're currently uninsurable. Also, you may find that the new policy will only be issued with a less favorable rating than your old one (standard vs. preferred, smoker vs. non-smoker, etc.) - which may make the promised death benefit increase or premium savings vanish into thin air.
These are only a few of the issues involved. Whenever you're considering the replacement of an insurance policy, you should seek the advice of a financial planner to help you plan and work through all of your options.
FPA member Tim Sobolewski , CFP®, is President of The Financial Planning Center in Amherst, N.Y.
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