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Tune Up: Sometimes It Makes Sense to Exchange a Client’s Life Insurance Policy

Tune Up: Sometimes It Makes Sense to Exchange a Client’s Life Insurance Policy

You might be surprised what you find if you review your clients’ insurance needs.

Many universal and variable universal life insurance policies underperformed over the past 10 to 15 years due to falling interest rates and huge stock market losses in 2002 and 2008.

“You want to begin talking to clients about insurance,” says Kevin Kimbrough, principal with Saybrus Partners, a Hartford–based insurance consulting firm that works with broker- dealers. “A lot of times clients put their insurance policy in a drawer and forget about it. But often, a policy’s rate of return assumptions have not held up. Some may be forced to pay extra premiums to keep the policy in force because the cash value does not generate enough interest to cover the cost of the insurance.”

Kimbrough says that based on his work conducting policy insurance reviews, many with life insurance coverage don’t believe they can update or improve their coverage. They cite the cost issues attributed to age and health concerns since they first bought the policy. But today, many with health problems can get coverage due to more advanced insurance company medical underwriting. And today’s life insurance policy may provide more benefits at a lower cost than coverage purchased more than a decade ago.

If it’s advantageous for a client to make a change, there are some benefits a client can receive under section 1035 of the Internal Revenue Code. With a “1035 exchange,” a client can exchange annuities or life insurance contracts without incurring taxable capital gains.

Before conducting a 1035 exchange, however, understand that an exchange may result in the deduction of a commission from the cash value of the exchanged policy. The policyholder may incur a surrender charge when exiting the old policy. Premiums for a new policy may be higher due to the policyholder’s health. Plus, there could be tax consequences caused by the policy surrender if there are any outstanding policy loans. Do all the math first and make sure that whatever savings you will get by changing the policy will not be wiped out with these charges and higher premiums.

Steven Weisbart, Ph.D., senior vice president with the Insurance Information Institute, New York, says financial advisors need to examine all other options before recommending a 1035 exchange. Among those:

· Cashing out the policy. Clients can stop paying the premiums and collect the available cash value. While they won’t have life insurance coverage, they, at least, may save some of the policy proceeds. Taxes may be owed on some of the cash value if the sum exceeds the amount of premiums paid into the policy.

· Non-forfeiture options. There may be a “reduced paid-up” option. This means that a client can stop paying premiums completely in return for a reduced death benefit and no cash savings. A client also may be able to convert the permanent policy to an extended term policy for a period based on the accumulated cash value in the policy.

· Allowing the policy to lapse. If this happens, the policy still may be able to be reinstated. Some insurers may allow this if it is reinstated within five years of lapsing. The client most likely will need to pass a physical examination for the reinstated policy and pay premiums owed plus interest. Nevertheless, annual premiums for the reinstated policy may be lower than those for a new, comparable policy.

Insurance agents add that a policyholder may be able to stop or reduce premium payments in return for a lower death benefit.

In some cases, Kimbrough says, an existing policy may be modified.

On the other hand, Kimbrough cites situations, in which an advisor should consider recommending an IRS Section 1035 tax-free exchange.

Among those:

· If a client’s existing life insurance policy is in danger of lapsing because the cash value earnings do not cover the cost of insurance. Under this circumstance, you may not want a client to be forced to kick in extra premiums.

· The client needs more coverage because his or her financial situation has changed.

· Improved health of a policyholder or mortality improvements across the general population may result in new insurance coverage at a lower cost from a new policy.

· A new policy has more attractive features, such as long-term care insurance.

· An advisor has concerns about the solvency of insurance company.

If a 1035 exchange is warranted, advisors must make sure the client doesn’t cash out the policy or write a check to buy a new policy or annuity. To obtain the tax benefit, policies must be exchanged insurance company to insurance company.

In addition, the tax rules say that an insurance policyholder can exchange one life insurance policy for either another life insurance policy or an annuity. However, the policyholder can’t exchange an annuity contract for a life insurance policy.

Kimbrough cites one case in which a 1035 exchange truly helped.

At an annual meeting with her financial advisor, a 68 year-old female client in good health revealed she had a policy purchased in 1986.

Upon reviewing the in-force illustration of the existing universal life policy, the advisor discovered that the policy would lapse in 12 years when the client reached age 80.

Based on product enhancements and new features, Kimbrough recommended that the advisor’s client exchange her old universal life policy for a new “no-lapse” guaranteed universal life policy. For the same premium she was paying, the client was able to increase the death benefit from $188,000 to $260,000 and have it guaranteed through age 121. In addition, the new policy featured a long-term care rider. In the event that the client may need nursing home or assisted living care, this rider provides the flexibility to accelerate the death benefit and access up to $10,000 monthly to cover these costs.

“Without increasing the client’s existing premium, she received a policy with an increased death benefit and additional features/flexibility,” Kimbrough says.

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