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Question: Do I replace my life insurance policy?

A lot of my clients have asked me 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 CFP Certified Financial Planner.Typically, when an agent discusses a replacement, it involves moving the cash value from an older policy into a new one — a process known as a Section 1035 exchange. A Section 1035 exchange can take a lot of time and a lot of paperwork, and depending on your state of residence, is often heavily regulated.

These same replacement regulations apply to annuities (and now long-term care) as well. 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 substantially 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 or even better, an indexed UL) 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 “vanish” after some number of years, which could fail to happen if the policy did not achieve the optimistic 12 percent returns originally projected by your insurance company. You may also be able to re-allocate your investment options to mitigate future damage. The new indexed UL policy offers up to 14 percent returns with 0 percent losses.
  • New riders can add substantial benefit to your new insurance policy. For example, some companies have a living benefits rider, which provides for up to $1 million tax-free for terminal, critical and chronic illnesses. There is also a long-term care benefit available.

What are the disadvantages of a policy replacement?

  • Cost. Insurance policies are expensive to issue. 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 will require compliance with California Insurance Code Section 10509.
  • 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.

Regardless of what assurances you may receive about the new policy, you should NEVER drop your existing policy until the new one is issued.

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 CFP