Life insurance programs are not immune to the challenges of life; unfortunate and unforeseen events can undermine the best-laid plans. What can consumers do if events have put this important financial protection at risk?
With a term life insurance policy, the arrangement is pretty straightforward: the only way to maintain coverage is to continue paying premiums. In contrast, a permanent life insurance policy includes an equity component in the form of cash values, giving policy owners options in regard to maintaining the policy and eventually receiving a benefit. But to slightly paraphrase Peter Parker/Spiderman, “With greater flexibility comes greater responsibility.”
Among the options owners may have with a cash value policy (i.e., whole life, universal life, adjustable life, etc.) are:
- taking loans1 against cash values
- using cash values to pay premiums
- allocating dividends2 (if and when they are paid) to reduce premiums
- surrendering a portion of cash values with a proportional reduction in the life insurance benefit
These options may be a valuable resource to address other needs or opportunities. Sometimes, they simply allow the policy to remain in force in spite of difficult financial circumstances.
However, exercising these options can impact the performance of the policy, both in terms of cash value accumulation and total insurance benefit. And occasionally, policy owners may find that previous decisions to take loans or stop paying premiums have jeopardized the long-term stability of their policies. If this occurs, policy owners have some decisions to make, usually falling into two categories: to unwind the policy, or preserve it.
Unwinding a Policy
Unwinding a permanent life insurance policy typically involves two options: surrendering the policy, or suspending premiums and converting to extended term insurance.
In a surrender, the policy owner receives any remaining cash values and the policy is terminated. If the distribution exceeds total premiums paid, the owner may incur income tax on the excess.
Extended term insurance is a provision that allows the policy owner to use cash values to purchase paid-up term insurance equal to the existing benefit for a limited period. The length of the term depends on the cash value, and will usually be calculated to the day (i.e., “the extended term lasts for seven months, five days”). If the insured dies during the extended term period, the benefit will be paid. When the term ends, so does the protection.
Rejuvenating a Policy
Neglected insurance policies can be preserved or rejuvenated in a variety of ways. The simplest is to re-start premiums and/or repay outstanding loans.
If a policy has been kept in force with automatic premium loans (a typical contract provision that takes loans from cash values to cover unpaid premiums and maintain the benefit), paying premiums again is usually as simple as sending a check or re-establishing automatic withdrawals.
Accrued interest on proportionately large loan balances can cause a policy to collapse, because ongoing premiums and remaining cash values may not be sufficient to cover both insurance and interest costs. Before repaying loans, policy owners should have an agent prepare a projection of policy performance that includes the anticipated repayments. This can determine if the repayment schedule will restore a policy to healthy status or merely extend the date of its eventual lapse.
Some other restoration options vary by company and contract provisions. Restoring policies using these approaches will typically require an in-depth consultation with a life insurance professional. Some common options:
- Elimination or reconciliation of a loan, often accompanied by a reduction of cash values or insurance benefits. In effect, a policy owner sells off a portion of the policy to satisfy the loan.
- Reinstatement. Before submitting new premiums, the insured has to re-establish insurability, either by reporting updated medical information or submitting to a new underwriting exam. If medically approved, the insurance company may also require the payment of missed premiums to restore the policy to good standing.
- A 1035 exchange to a new policy. It may be desirable to update a life insurance program via a 1035 exchange. This process transfers both the cash values and cost basis of the original policy into a new policy. But this option is also dependent on current insurability, and new premiums will be priced at the insured’s current age.
Maximize Insurance Investment Your insurability is an asset, one that should not be forfeited casually, especially since there are no guarantees you will be able to obtain additional coverage at a later date. Life insurance benefits should never be surrendered without careful consideration of the consequences.
If you have stopped paying premiums, accumulated additional interest, or deferred loan payments on a cash value life insurance policy, now might be an ideal time to review its status and consider options to revitalize it.