NataliePace.com Home Page Article
Should
You Exchange Your Life Insurance Policy?
by
FINRA.org.
If
you own a life insurance policy, you may have been approached to exchange it
for another new policy. You need to know that even though the tax laws make
the exchange income tax free and the new policy may appear better to you, you
may be losing—not gaining—if you make the exchange. We are issuing this Alert
because, increasingly, life insurance exchanges may involve variable products.
Variable products are securities, and this Alert will provide information to
help you evaluate whether the exchange is right for you, and how you can find
out what you need to know to make an appropriate decision.
Types
of Life Insurance
There are various
forms of life insurance products. Although features and benefits may vary, the
following is a general description of typical characteristics of various types
of life insurance policies.
- Term Life Insurance.
Term life insurance provides coverage for a specified and limited period
of time (the "term"). Premiums for most term policies increase with age
or at the end of each renewal period. After the policy or term ends, there
is no benefit payment if the insured person survives beyond the policy period.
- Whole Life Insurance.
Whole life or ordinary life insurance is a form of permanent life insurance.
This means it can provide coverage for the life of the insured. It also
can build cash value, which is a savings feature. Premium payments typically
remain level for the life of the insured.
- Universal Life
Insurance. Universal life insurance can also provide coverage for the
life of the insured while at the same time providing flexibility in premium
payments and in insurance coverage. The cost of insurance protection and,
in some cases, other costs are deducted from the cash or policy account
value.
- Variable Life Insurance.
Variable life insurance, a variation of whole life insurance, offers a fixed
premium schedule and a minimum death benefit. But it differs from traditional
whole life insurance in that cash values are invested in portfolios of securities
in an account separate from the general assets of the insurance company.
A policyholder has discretion in choosing the mix of investments the policy
offers. The insurance company does not guarantee investment returns and
your cash value will fluctuate.
- Variable Universal
Life Insurance. Variable universal life insurance combines features
of universal life insurance and variable life insurance.
Most variable
life insurance policies and variable universal life insurance policies are securities
registered with the Securities and Exchange Commission (SEC). Registration requires
that investors receive important financial and other significant information
concerning the securities being offered for sale. This enables investors to
judge for themselves if the securities are a good investment. These regulations
also provide important remedies to investors if they can prove that there was
incomplete or inaccurate disclosure of important information provided to them.
1035
Exchanges
The Internal
Revenue Service allows you to exchange an insurance policy that you own for
a new life insurance policy insuring the same person without paying tax on the
investment gains earned on the original contract. This can be a substantial
benefit. Because this is governed by Section 1035 of the Internal Revenue Code,
these are called "1035 Exchanges."
But this benefit
comes with some important strings.
- The tax code says
that the old insurance policy must be exchanged for a new policy - you cannot
receive a check and apply the proceeds to the purchase of a new insurance
policy.
- The tax code also
says that you can make a tax-free exchange from: 1) a life insurance policy
to another life insurance policy or 2) a life insurance policy to an annuity.
You cannot, however, exchange an annuity contract for a life insurance policy.
A transaction
in which a new insurance or annuity contract is to be purchased using all or
a portion of the proceeds of an existing life insurance or annuity contract
is referred to as a "replacement." A 1035 Exchange is a type of replacement
transaction. Although the term "1035 Exchange" is often used to describe any
form of replacement activity, technically not all replacements are Section 1035
Exchanges and as a consequence are not tax-free.
Reasons
to Exchange an Existing Policy?
There are various
reasons why a life insurance policyholder may want to replace an existing policy
with a new life insurance policy. For example,
- Improved health or
mortality improvements across the general population may result in insurance
coverage at a lower cost.
- You may have concerns
with the solvency of the insurance company that issued the original policy
or with the service of the agent that sold you the policy.
- A new life insurance
policy may have more desirable features or benefits.
Reasons
Not to Exchange an Existing Policy
There are also
various reasons why replacement of an existing insurance policy may not be a
good idea. For example,
- Cash value built up
in the original policy may be applied to the new life insurance policy's
first year expenses, including commissions.
- Life insurance policies
(other than term policies) often include early surrender charges, which
can reduce the amount of cash value available toward the new policy. The
new policy will likely have its own new surrender charge schedule, which
may extend beyond that of the original policy.
- You may pay higher
premiums if, for example, your health has declined since the purchase of
the current policy.
- The new policy typically
will have a new contestability period - a two-year period from the issuance
of the new policy during which the insurance company could challenge a death
claim based upon a misstatement on the application.
- There may be unfavorable
tax consequences caused by surrendering an existing policy, such as a potential
tax on outstanding policy loans.
What
You Should Watch For
You should exchange
your life insurance policy only when you determine, after knowing all of the
facts that the exchange is better for you and not just better for the person
who is trying to sell the policy to you.
Both variable
life insurance and variable universal life insurance are securities. Those who
offer these products must follow SEC, FINRA, and state securities regulations,
in addition to state insurance law. This means that a broker must tell you the
important facts about the pros and cons of the exchange. Your broker or insurance
agent should recommend such an exchange only if it is in your best interest
and only after evaluating your personal and financial situation and needs, tolerance
for risk, and the financial ability to pay for the proposed insurance policy.
Your broker
or insurance agent may recommend that you use insurance policy values, such
as loans or withdrawals, to pay premiums for a new life insurance policy. This
activity is generally called "financing" premiums. It may not be appropriate
for you. For example, withdrawals from existing policies may be subject to federal
income tax and may reduce the death benefit. Borrowing money from an existing
policy will almost certainly reduce the death benefit. Withdrawals or loans
may make it more difficult to keep the original policy in force without additional
out-of-pocket premium payments. If you can't keep the original policy in force,
you will lose the insurance protection and the loans themselves may give rise
to tax consequences. Remember for a transaction to qualify as a 1035 exchange,
the old policy must actually be exchanged for the new policy. Many states and
brokerage firms require forms to reflect customer acknowledgement of a replacement
transaction. These forms typically are signed by the insurance policy owner
and the broker or agent. These forms may provide a comparison of the features
and costs of an existing policy to a proposed policy, and point out what you
need to focus on when considering an exchange. Some brokerage firms may provide
brochures or educational material designed to outline the possible advantages
and disadvantages of the transaction. You should review these forms and materials
closely.
Regardless
of whether such forms are provided, you should specifically ask the person recommending
that you exchange or replace your existing policy to provide you with illustrations
for your existing policy and the new policy. You should also ask:
- What is the total
cost to me of this exchange?
- What are the new features
being offered? Why do I need those features?
- Are these features
worth the cost?
- Can the existing policy
be modified or supplemented to provide some or all of these same features?
- Will you be paid a
commission for the exchange, and if so, how much is it?
You should
not sign any exchange form or agree to exchange or purchase an insurance policy
until you study all of the options carefully, have all of your questions answered,
and are satisfied that the exchange is better than keeping your current policy.
If You
Have Questions or Complaints
If
you have questions or complaints about a life insurance policy exchange, you
can contact FINRA,
the SEC,
your state
securities administrator, or your state
insurance commissioner.
Reference
Material
For additional
information about variable life insurance policies or variable annuity contracts,
go to:
- Press Release: NASD
Regulation Announces Two Enforcement Actions Involving Sales of Variable
Annuity and Life Insurance Contracts
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About FINRA
The Financial Industry
Regulatory Authority (FINRA), is the largest independent regulator for all securities
firms doing business in the United States. All told, FINRA oversees nearly
4,800 brokerage firms, about 170,400 branch offices and approximately 643,000
registered securities representatives.
FINRA believes
investor protection begins with education. Using the Internet, the media and
public forums, we help investors build their financial knowledge and provide
them with essential tools to better understand the markets and basic principles
of saving and investing.
