
Your clients who hold life insurance policies may not realize they have a number of options when they review those policies. They are not necessarily married to policies they chose at a particular time in their life. It’s possible that policy was never appropriate for them or their circumstances may have changed, rendering the policy out-of-synch with their current needs. The policy may also not be performing as expected, as discussed in this companion article. As their financial advisor, you can let them know that their choices may be. Here’s a closer look at the options:
Continuing the Current Policy As Is
Consider whether the coverage is sufficient, if it will stay in force for as long as your client needs it and if the premium affordable. If the answers are yes, then no changes are needed.
Modifying the Current Policy
A policyholder may need to increase the premium if the policy is underfunded, meaning the current premium and assumptions are not sufficient for the policy to continue to maturity. Policyholders should also consider modifying their current policy if the death benefit is too high or if the policy contains riders that are no longer needed. For example, an accidental death benefit rider may be duplicate coverage.
Surrendering the Current Policy
When the client no longer has a need for the policy, they should consider surrendering it. The client may also choose to surrender the policy if they cannot afford to continue it, and modifying it is not a good option. In some instances, the premium to continue the policy to maturity is just too high.
Replacing a Policy
Replacing a policy might make sense when it does not meet the client’s goals, it is underperforming or there is an alternative that works better for the client. The alternative policy may feature a lower premium, more guarantees or other riders. Most policies now offer long-term-care riders which were not available on older policies. The clients may also need a different type of policy that will extent to their anticipated lifespan. (Older policies may have maturity dates as early as age 90.)
Replacing a policy should not be done in haste. Remind your clients that they need to consider:
- What is the reason? Is it necessary?
- Is the type of coverage the same or different?
- What are the premiums and death benefit guarantees?
- What are the cash value projections?
- What is the surrender period?
- Are there policy riders?
- What is the insurance company’s financial strength rating?
Exercising an IRS Section 1035 Tax-Free Exchange
Clients can exchange an existing policy for a new permanent life policy in combination with a long-term-care policy. This might make sense if the policyholder needs long-term-care insurance and would like to preserve their death benefit. The first step is to compare separate life and long-term-care insurance policies. The next step is to compare a hybrid life insurance/long-term-care insurance policy.
If the hybrid policy makes sense, the client can exercise a 1035 exchange which will enable them to fund the new policy with a single premium payment from the current cash value in the original policy. This can be a great option when clients have an overfunded policy (meaning it has a high cash value).
When considering exchanging one policy for another, policyholders need to consider that full underwriting is required at time of 1035 exchange. This means the client will still need to qualify medically for the new policy. Reasonably strong health is a prerequisite.
It’s important to note that IRS Tax Code Section 1035 only permits the exchange of non-qualified contracts. It does not include life insurance policies held in qualified retirement plans. Section 1035 allows certain exchanges to be made without the immediate recognition of gains or losses for income tax purposes. The types of exchanges where no gain/loss would be recognized include:
- An ordinary life insurance contract for another ordinary life insurance contract (one for which the face amount — the death benefit — is not ordinarily payable in full during the insured’s life).
- An ordinary life insurance contract for an endowment contract (one that depends in part on the life expectancy of the insured but may be payable in full in a single payment during the insured’s lifetime).
- An ordinary life insurance contract for an annuity (one payable during the life of the annuitant only in installments).
- An endowment contract for another endowment contract that provides for regular payments beginning at a date not later than the date payments would have begun under the contract exchanged.
- An endowment contract for an annuity contract.
- An annuity contract for an annuity contract.
Doing a Life Settlement
Policyowners may be able to sell their policy through a life settlement. Doing so may allow the policyowner to receive a higher amount than the cash-surrender value. The policy is sold to a third-party investor. The buyer pays the remaining premiums and receives the death benefit. Typically, the insured is over age 70.
Viatical settlements are a type of life settlement that allow an individual to purchase a policy, or part of a policy, from a policyholder who has a life expectancy of less than two years.
Restructure Policy Loans
Policy loans may require a closer look. They can be a useful short-term option when immediate cash is needed – but they are not a long-term solution. On policies with a cash value, the policyowner can typically borrow from the policy’s cash value. The insurance company will charge interest on the borrowed money. Large policy loans where the policy owner borrows the interest can create significant issues. The policy loan also reduces the death benefit. Policy loans are one of the most complex, misunderstood and misued components of a life policy. The interest rates on policy loans can be high (8%-plus). Policy loans an also erode a life policy over time if out-of-control.
In a worst-case scenario, policies with large loans will terminate with no coverage and a significant phantom income tax gain. The IRS considers any policy value over basis to be taxable income.
Case Study
Let’s take a look at how a policyholder reevaluated his options with a universal life insurance policy issued to him when he was 47. At that time, the credited interest rate on the policy was 8.25%. The policy had a death benefit of $750,000 and its annual premiums ($5,661) were projected to be payable for 30 years.
Based on assumptions made at the time of issue, the policy was projected to “endow” (equal its death benefit) when the policyholder turned 95.
But the policy didn’t perform as expected — something the insurance company didn’t mention as the years passed. The chart below shows how the premiums were impacted at certain years as a result of the policy’s poor performance. The premium column reflects the required premium to continue the policy to maturity.
It’s common for insurance companies to neglect to update policyholders about performance. That’s why it’s important for your clients to order in-force illustrations every two to three years. (Read more about that here.)
In this particular situation, the credited interest rate declined from 8.25% at policy issue to 5.65% in year 11. This meant that the cash value would increase at a lower rate. When this happens, a life insurance policy will usually require a higher premium. As a result, the projected premium to endow the policy at age 95 increased from $5,661 at policy issue, to $11,863 in year 11. However, the insurance company did not disclose that the mortality cost (the cost of insurance) had increased.
The insurance company did not confirm it had increased the cost of insurance until after it received two letters from the policyholder’s attorney. Getting this underlying data from insurance companies can be challenging. If the client had in-force illustrations, he would have been able to make a more informed decision earlier.
The client decided to terminate the policy for the cash surrender value in year 26, at which time the mortality costs had increased 38%. By that time, no premium would keep the policy in force to maturity (age 100). That’s because of guidelines stating the maximum premium that could be paid.
Life Events and Stages Impact Life Insurance Planning
A younger person just starting out usually does not need life insurance, as there may be no one financially dependent upon them. Then as they start a family, they will likely need life insurance to provide for their dependents. When their children become adults, you client is likely to need less life insurance, even if they still provide coverage for a spouse.
As your client enters a new life stage or has a life event, question whether the client still needs life insurance. Then consider how much coverage is needed and for what time period. If your client has reached financial independence — which means they have sufficient assets and income to provide for anyone who is financially dependent upon them — it’s possible they may no longer need life insurance. But it all depends on their goals. For example, some people use life insurance to pay their estate taxes so their family won’t lose their inheritance.
Life insurance policies, like life itself, can also change. The original policy assumptions outlined in the in-force illustration may not have been met, just like a client’s goals and needs at the time of purchase might be very different. Interest rate assumptions, policy loans, and protection needs are fluid and change throughout life. A regular policy review by an objective third-party is advisable to determine the best course of action.
Maxwell Schmitz, MSFS, CLTC, is president of Yetworth Insurance Solutions, an agency that specializes in providing practical family benefits strategies in collaboration with financial advisors. Schmitz is also the CEO and co-founder of Dingo Technologies, Inc. Tony Steuer, CLU, LA, CPFFE, an internationally recognized financial preparedness advocate, award winning author and podcaster, is the founder of The Get Ready Money Club. Steuer is also an advisor at Insurance Nerds, Paperwork and Dingo Technologies.