Retaining Life Insurance Policy Requirements: How Long Is Necessary?

Life insurance is an important financial decision that requires careful consideration of one's needs and circumstances. While it can provide financial protection and peace of mind for individuals and their loved ones, it is not a one-size-fits-all solution. As life changes, individuals may find themselves re-evaluating their coverage and exploring alternatives. This is where the option to replace life insurance policies comes into play.

Replacing a life insurance policy involves swapping an existing policy for a new one, often driven by reasons such as changing financial needs, improved health, or the desire for better rates and coverage. However, it is not a decision to be taken lightly, as there are potential drawbacks and regulations in place. Understanding the requirements and implications of replacing life insurance is crucial for making an informed choice.

Weigh the benefits and risks of replacing your policy

Weighing the benefits and risks is essential when considering replacing your life insurance policy. While a new policy may offer better coverage, lower premiums, or features that align with your lifestyle, there are also potential drawbacks to keep in mind. Here are some key points to consider:

Benefits of Replacing Your Policy:

• Improved Coverage or Reduced Premiums: Replacing your life insurance policy can lead to better coverage, such as increased death benefits or additional riders like accelerated death benefits or long-term care coverage. Lower premiums can also be achieved by switching to a new insurer with more competitive rates.
• Changing Financial Needs: Significant life events, such as the birth of a child, buying a home, or nearing retirement, can change your financial circumstances. Replacing your policy allows you to adjust your coverage and benefits to meet these evolving needs.
• Switching from Term to Permanent Coverage: If you initially opted for term life insurance due to affordability, you may now prefer the lifelong protection offered by permanent life insurance policies (e.g., whole life or universal life). These policies often include cash value accumulation and a lifetime death benefit.
• Improved Health: If your health has significantly improved since purchasing your current policy (e.g., quitting smoking, losing weight, or managing a chronic condition), you may qualify for lower rates with a new policy.

Risks of Replacing Your Policy:

• New Contestability Period: Replacing your policy restarts the contestability period, typically lasting two years. During this period, the insurer can review your application and deny claims if any misrepresentations are found. This period also includes a suicide exclusion, allowing the insurer to deny claims if the insured's death is caused by suicide within the first two years.
• Higher Premiums Due to Age: When replacing an old policy, you are applying at your current age, which may result in higher premiums. This increase in cost could outweigh the expected benefits of switching policies.
• Loss of Existing Benefits: Older life insurance policies may have features no longer available in newer plans. Replacing your policy could result in the loss of valuable riders or benefits.
• Surrender Charges: Cancelling a permanent life insurance policy within a certain surrender period can incur surrender fees. Switching policies may also result in surrender charges, potentially negating the advantages of a new policy.
• Time for Cash Value Accumulation: Cash value in a permanent life insurance policy can take many years to grow. Replacing your policy may set back this accumulation, impacting the timing and frequency of withdrawals or loans.
• Income Tax Implications: Replacing your policy may have income tax consequences, especially when dealing with cash value policies.
• Churning: Churning is the unethical practice of a life insurance agent persuading a policyholder to replace their current policy to earn a new commission. Be cautious of agents who encourage frequent replacements without a strong rationale for doing so.

Understand the contestability period

When you buy life insurance, the insurer agrees to pay your beneficiary a lump sum if you die while the policy is active. However, if you die during the first two years of the policy, the insurer has the right to investigate your application for fraud and misrepresentation before they pay out. This is called the contestability period.

During the contestability period, the life insurance company can be exempt from paying out the death benefit if it finds intentional misrepresentations in your application. For example, if you purposefully concealed a diagnosis of depression, the company could deny or reduce the amount your beneficiary receives.

The contestability period allows your life insurance company to review your application for intentional errors after a death claim. It usually lasts for the first two years of the policy, though this can vary depending on the state. For instance, under California law, the contestability period is no more than two years.

If you get a new policy or reinstate your policy after a lapse, the contestability period restarts.

The contestability period helps protect the life insurance company from fraud. Statistically speaking, it’s very unlikely that you will die during the first two years of a life insurance policy. It helps the insurer to confirm that you didn’t withhold or lie about any health or lifestyle-related information during the application process.

The misrepresentations don’t have to be related to your cause of death. For example, if you die in a car accident but also failed to disclose a history of alcohol abuse, the life insurance company can deny your death claim.

The best way to ensure that your beneficiaries are taken care of in the event of your death is to be honest and forthcoming on your life insurance application. That way, the insurer won’t have any concerns during the contestability period.

Be aware of surrender fees

Surrender fees are an important consideration when thinking about replacing life insurance. These fees are charged when a policy is surrendered or cancelled and are used to cover the costs of keeping the policy on the provider's books. They are also known as surrender charges.

Surrender fees are typically waived if the insured party informs the insurer in advance of the cancellation and continues to pay for a period before cancelling. However, if you are replacing a policy, you will need to pay the fee to transfer the cash value from one policy to another.

The surrender fee is charged on any amount of cash value surrendered above a certain amount, such as 10% of the account value. The fees start high at the beginning of the surrender period and reduce each year until they reach zero. For example, a typical surrender fee schedule could be: 7% in the first year, 6% in the second, 5% in the third, and so on until it reaches 1% in the seventh year, and 0% in the eighth year and beyond.

Surrender fees can apply for time periods ranging from 30 days to 15 years on some insurance products. For life insurance, the surrender fee often starts at 10% if you cash in during the first year, and it goes down to 1% if you cash in during the ninth year. After the ninth or tenth year, there are typically no surrender fees.

It's important to be aware of surrender fees when considering replacing life insurance, as they can impact the advantages of a new policy.

Understand the role of the National Association of Insurance Commissioners (NAIC)

The National Association of Insurance Commissioners (NAIC) is a standard-setting organization that has been supporting state insurance regulators and the public interest for over 150 years. The NAIC assists state insurance regulators in serving the public interest and protecting consumers, as well as ensuring fair, competitive, and healthy insurance markets.

NAIC members come from diverse backgrounds, politics, and geographies but are united in their shared commitment to protect consumers. They do this by establishing standards, conducting peer reviews, providing data reporting, licensing, analysis, and financial assessments, and coordinating regulatory oversight.

The NAIC offers guidelines and model acts to help ensure state consistency in the insurance sector. However, individual state regulators may modify or expand upon these regulations. For example, the NAIC lays out model regulations for replacement policies, but each state department of insurance can issue its own specific rules and procedures, provided they adhere to the minimum requirements set out by the NAIC.

The NAIC's model regulation for life insurance replacement policies includes a specific set of questions to be asked on an insurance application and a system for the insurer to monitor replacement activities. This helps to ensure that consumers are protected and are making informed decisions when considering replacing their life insurance policies.

Know the regulations in your state

While the National Association of Insurance Commissioners (NAIC) lays out model regulations for replacement policies, each state department of insurance is allowed to issue its own specific rules and procedures. These are some of the regulations in place in California and Illinois.

California

In California, the activities of insurers and agents with respect to the replacement of existing life insurance and annuities are regulated. The state has established minimum standards of conduct to be observed in replacement transactions, which include:

• Assuring that the purchaser receives information with which a decision can be made in his or her own best interest.
• Reducing the opportunity for misrepresentation and incomplete disclosures.
• Establishing penalties for failure to comply with the requirements.

Illinois

In Illinois, insurance companies and agents must follow certain requirements when replacing a policy or annuity. Here are some key points to consider:

• Make sure you are still insurable: Check the medical and other qualification requirements of the new company.
• Understand the potential disadvantages: There may be no advantage to replacing a life insurance policy or annuity with another as it may take years for the cash value in the new policy to reach the level in your current policy.
• Compare provisions: Newer policies may not have the same provisions as your old policy, such as low-interest rates for loans.
• Be aware of limits and clauses: Understand that you may have to satisfy limits in your new policy that have already been satisfied under your current policy, such as the two-year "incontestable" clause.
• Consider the cost: Remember that a new policy will likely cost more due to your age.
• Notify your current agent or insurance company: They may be able to match or beat the offer with their own new or updated products.

Frequently asked questions