What is it?
You own a life insurance policy, having purchased it some time ago after you researched all the issues involved and evaluated the different available policies. You were sure you made the right choice, and you probably did.
However, don’t be fooled into thinking you can forget about life insurance now. The policy that once seemed so perfect for you may no longer suit your needs, and it may be time to replace or exchange it.
Replacement is the act of terminating a life insurance policy and taking out a new one with a different insurance carrier.
Exchanging is the act of switching to a different life insurance policy with the same insurance carrier. Either way, you’re canceling an old policy and taking out a new one.
Not surprisingly, some of the guidelines that you should follow to determine if and when to replace/exchange a policy are similar to the guidelines for choosing a policy in the first place.
There are important differences, however.
The big difference is that when you are deciding whether to replace or exchange a policy, you base your decision on what has actually happened since you selected the policy.
You look at any changes in your own circumstances and assess the extent to which you have been happy with the insurance company and various aspects of the policy itself. If one or more of the conditions described below applies to you, you should at least give some thought to replacing or exchanging your existing life insurance policy.
If you do decide to replace or exchange, make sure your new policy is in effect before you cancel the old one.
Tip: You may not need to worry about the income tax ramifications of replacing or exchanging your policy. Section 1035 of the Internal Revenue Code generally allows you to replace or exchange one life insurance policy with another without tax consequences and provides that the tax basis of the old policy be rolled over into the new one. There may be exceptions to this general rule, however, so you’ll want to consult your tax advisor.
Reasons to replace/exchange: company/policy performance considerations
1. The company’s quality rating declines
You can obtain a quality rating of an insurance company from several respected rating services. These ratings are based on a combination of factors, including the company’s financial soundness and its reputation for providing quality products and client services.
More specific factors may include the company’s record of dividend payments, its history of interest rates, and policyholder satisfaction as reflected in assets held and the percentage of policies retained or terminated in a given year. If your company’s quality rating has fallen considerably since you first adopted your policy, it may be time to think about switching to a new policy with a different company.
2. You haven’t been satisfied with your company-client relationship
Whether your insurance company’s quality rating remains constant or its rating has gone up since you took out your policy, you may have your own reasons for wanting to change.
A big reason may be that you simply haven’t been happy with the way the company has treated you as a client. Life insurance is so complex that you will almost certainly have ongoing questions about your policy. While your CPA, financial planner, or insurance agent will be able to answer most of your questions, you may want to direct some questions to the insurance company itself.
If the company fails to adequately resolve your concerns and generally delivers poor customer service, you may decide to switch companies to get the service you want and deserve.
3. Disclaimers come back to haunt you
Many life insurance policies contain disclaimers or qualifiers as to the features and benefits of the policy. Generally speaking, they read like this: “This policy can give you x benefit at some point in the future, but there are no guarantees,” although the language of the policy usually makes the disclaimer harder to detect than that.
One common example is when a policy offers you implied benefits (e.g., interest bonuses at some future date or premium refunds based on projected mortality rates) without actually making any promises. If you choose a policy based largely on implied perks that never materialize, you may want to consider switching to a policy that absolutely guarantees the benefit(s) you are seeking.
4. You haven’t been satisfied with the policy’s performance as an investment
Most people purchase life insurance to provide for a spouse or family members in case of their premature death.
Others buy life insurance as an addition to their investment portfolios, while still others combine investment reasons with their insurance needs. If you see your life insurance policy as both investment and protection, then how the policy performs will be an important factor in your decision of whether to replace or exchange it.
Performance of the overall rate of return will depend on several factors. An insurance company’s ability to correctly predict and effectively manage its operating expenses will directly affect the performance of its life policies, as will the accuracy of its mortality assumptions.
If the company makes unrealistic mortality assumptions and more of its insured parties die than projected, the company will pay more in death benefits than expected. This, in turn, will detract from the performance of the company’s policies.
Finally, performance hinges on the company’s earnings on its assets. The more wisely the company invests its assets, the greater the interest earned and the higher the rate of return on each policy.
One specific aspect of policy performance is the issue of dividends. If you own a participating life insurance policy, it may pay dividends that represent a return of excess premiums already paid.
You can receive such dividends in cash, use them to offset premiums due, or use them to buy additional life coverage. While most policyholders realize–and many policies make it clear–that dividends are never guaranteed, most insurance companies do make projections on their future dividend payments.
If you chose a policy based on such projections and then never received the anticipated dividends, you may want to consider switching to a company with a better track record of meeting its projected dividends, although there are still no guarantees.
This is particularly true if you plan to receive dividends in cash and rely on them to supplement your income. A better overall policy performance will usually mean an increased cash value of your policy, as well as reduced premiums. As with any investment, when you are disappointed with the performance of your policy, consider switching to a different policy with a company that invests its assets more shrewdly.
Caution: If you decide to trade in your existing policy for one that has a better performance record, remember that life insurance policies are no different from other investments–past results do not always predict future performance accurately.
Caution: Variable life insurance and variable universal life insurance policies are offered by prospectus, which you can obtain from your financial professional or the insurance company issuing the policy. The prospectus contains detailed information about investment objectives, risks, charges, and expenses. You should read the prospectus and consider this information carefully before purchasing a variable life insurance policy.
Reasons to replace/exchange: financial considerations
Since you originally chose a policy with your financial situation in mind, it makes sense that any changes may call for a new policy. This could mean a number of things.
Your income level may have changed after losing a job or getting a promotion with a higher salary. It could also mean that your asset holdings have either increased or decreased.
Perhaps you’ve lost a bundle of money on the stock market or, on a more upbeat note, you may have won a great deal of money in the lottery. A change in financial circumstances could also come in the form of large expenses, such as a child’s college education costs, that you never had to deal with before.
Variations in your premium may be another financial consideration. The type and degree of the financial change will determine whether you should replace or exchange a policy and what you should replace or exchange it with.
5. Your income changes
A change in income may simply mean that you have to switch to a more- or less-expensive policy. If you make more money, you can afford the higher premiums that come with a better, more comprehensive policy. Conversely, a drop in income may force you to cut back to a less expensive policy.
6. Your asset holdings change
A change in your asset holdings may require replacement or exchange for different reasons. If you lose money on investments that were intended to supply retirement income and you are now concerned about your spouse’s financial future, you may have to pay the higher premiums needed for a policy that will provide your spouse with a greater amount in death benefits.
You may also want to base your choice on whether the policies you are considering will pay the death benefits to your spouse in a lump sum or installment payments.
Conversely, if you win the lottery or make a greater return on your investments, the projected earnings on your assets may be sufficient to reduce the need for life insurance death benefits. You can then replace or exchange your existing policy with one that has a lower coverage amount.
7. Your expenses change
If you anticipate being saddled with college tuition and other hefty expenses, you may want to switch to a policy that will build cash value more quickly. This way, you are more likely to have large amounts of cash available when you need to draw on it.
Additional replacement or exchange considerations will come into play with this type of scenario. Since your expenses will require that you either withdraw from or borrow against whatever new policy you choose, you will want to look closely at the specific rules governing both the cash surrender of the new policy (all or part of it) and loans drawn against it.
For instance, a withdrawal from the policy’s surrender value may trigger a reduction in death benefits that is disproportionate to the amount of the withdrawal. With policy loans, the loan may reduce dividends until it is repaid in full. Moreover, look at whether the policy’s loan provisions call for a fixed loan rate or a variable rate.
Tip: Some of the financial changes described above do not necessarily require that you replace or exchange a policy. For example, you can often alter the death benefit coverage amount within the same policy and take other steps to customize your existing policy to your changing financial situation.
8. Your premium changes
Many life policies have annual premiums that are subject to change. Either an increase or a decrease in your premium with no change in your financial situation could warrant a replacement or exchange of your policy.
While an increased premium may be the result of changes in your health or other circumstances, it can also stem from the fact that the company has mismanaged its expenses, made unrealistic mortality assumptions, or erred in other ways.
Whatever the reason, if the increased premium means that you will have to spend more on life insurance than your budget allows, you should probably switch to a less expensive policy that provides similar coverage.
A decrease in your premium appears to be good on the surface and may mean that your company has simply done a good job of managing its expenses and assets. In such a case, there is no reason not to stick with your existing policy. However, you should always be wary of a decreased premium.
Do some research and read between the lines to find out exactly why your company is lowering the premium. Maybe they are lowering premiums across the board because they have made unrealistic mortality assumptions, in which case premiums may jump back up and total return may dwindle when those assumptions prove false. In other words, lower premiums can end up costing you more in the long run. If your research indicates that this will happen, switch to another policy before it does.
Tip: With universal life and variable universal life policies, you can adjust premiums to fit your situation. You can easily increase, decrease, or skip premium payments as long as the policy’s cash value can cover the cost of protection.
Other reasons to replace/exchange
9. Your coverage needs change
The world of life insurance offers a wide range of different types of policies and each is designed to meet specific coverage needs.
For more information, see the discussion of policy types. Since you probably selected a policy tailored to your coverage needs, you should think about replacing or exchanging the policy when those coverage needs change.
The terms and provisions of a new policy may be much more favorable to your new situation than those of your existing policy. For example, changes in your health may give you reason to consider switching from a term life policy that can’t be renewed under certain medical conditions to a permanent cash value policy.
And, as mentioned earlier, certain changes in your circumstances may require that you switch policies in order to obtain a higher level of death benefit coverage.
Caution: If your health is an issue, one factor in your decision should be whether the old and new policies you are weighing offer level death benefits or an increasing death benefit option. Some policies require evidence of insurability before you can change to the increasing death benefit option.
Tip: In some cases, if your circumstances change and require a different type of coverage, it may be easier and less costly to modify your existing policy rather than to replace or exchange it.
For example, if you purchased a retirement income policy when you were single and you are now married with a family, a straight life policy may be more appropriate for your new situation. If so, you may be able to simply change your existing policy to a straight life policy as of its original issue date.
Or, if you need a different coverage amount, you may be able to simply increase or decrease your death benefit. The point is that replacing or exchanging is clearly not your only option if your current coverage is no longer appropriate. It will often be to your advantage, financially and for other reasons, to keep your existing policy and just alter the type or amount of coverage it provides.
10. Cash value approaches death benefit
This consideration applies specifically to cash value policies. Generally speaking, the closer the cash value of your policy is to the amount of the death benefit, the less life insurance protection you actually have.
Thus, if the cash value approaches the death benefit, you have little protection. Under this general guideline, a policy that has death benefit coverage of $100,000 and has built a cash value of $95,000 offers minimal protection and should be viewed more as an investment than as insurance protection.
So if you die, the death benefit triggered from such a policy will barely exceed the policy’s cash value as an investment. This may be a case where replacement or exchange is a viable option if you determine that your protection needs are not being met.
Tip: Of course, if you have little protection for this reason but don’t think it’s wise to replace or exchange, you may be able to simply withdraw from your existing policy’s cash value or take other steps to widen the gap between its cash value and the death benefit.
11. You want to consolidate policies
If you have multiple small policies that are collectively designed to match your life insurance needs, you may want to consolidate them. This will involve trading in the individual smaller policies for one larger, more comprehensive policy.
If the new policy meets all your needs by itself, consolidation may make sense as a way of cutting your administrative costs even while eliminating the headaches associated with maintaining more than one policy.
Caution: While consolidation can cut your administrative costs and generally streamline your life insurance, it can be an expensive option because of the new commissions and fees associated with purchasing a larger policy.
You already paid commissions and fees on the multiple smaller policies you had before, and now you’ll have to pay them again on the new policy, not to mention possible surrender charges on the old policies. The applicable costs of consolidation should therefore be weighed against the perceived advantages of consolidating.
You can avoid the new sales commissions that normally come with replacement or exchange
One disadvantage of replacing or exchanging your life policy is that you have to start from scratch. Incontestability and suicide periods, for example, will start over again with the new policy instead of picking up where the old policy left off.
Also since replacement or exchange essentially involves purchasing a new policy, it will ordinarily trigger unwanted acquisition costs to you in the form of new sales commissions on the new policy bought. In some cases, however, you can avoid these costs if you purchase your new policy without going through a broker.
This is called no-load life insurance, and, assuming you are eligible for it, it may tip the scale if you are unsure about whether or not to keep your existing policy.
Tip: If you find that replacement or exchange will trigger new sales commissions, don’t let that fact deter you from going through with the replacement or exchange. In particular, if the new policy you are considering is far more inexpensive than your old policy, replacement or exchange will probably save you money in spite of the acquisition expenses you will incur.