Life Insurance Policy Replacements: Dos and Don’ts

Journal of Financial Planning: July 2014


Peter C. Katt, CFP®, LIC, is a fee-only life insurance adviser and sole proprietor of Katt & Company in Kalamazoo, Michigan. His website is

Publication Date: July 2014

Policy replacement refers to terminating an existing policy in favor of a new one. It is absolutely mandatory the existing policy remains in place until the new one is in force. If a taxable gain is associated with the existing policy (cash value exceeds the cost basis), it should be transferred using Section 1035, which allows for a tax-free exchange. Often not recognized is the value of using Section 1035 in the absence of a gain to transfer the existing policy’s cost basis. This allows the cost basis from the existing policy, and possible additions to cost basis within the new one, to be withdrawn income tax free in the future, if the policyowner wishes to do so.

For life insurance agents, policy replacement is the easiest sale. The policyowner doesn’t need to decide if they want more life insurance. The agent makes the claim that the new policy will be a better deal, but this isn’t always the case.

Three Considerations

There are three considerations when advising a client about a possible replacement of an existing policy. One is to determine the current health status of the insured and compare it with the underwriting on the existing policy. For example, if the existing policy has a preferred rating but the insured’s health has declined and he or she is no longer a preferred candidate, replacement will probably not be in the client’s best interest. Without an updated health status, I would be working in the dark.

Another issue is assessing the pricing quality of the existing policy. With some companies, the pricing remains excellent, with some fair, and others poor. If the insured’s health has remained similar to the rating demonstrated in the existing policy, it would be logical to examine a replacement when an existing policy’s pricing is fair or poor. In that case, obtaining comparative illustrations from excellent companies may disclose if a replacement should be considered. But this step comes with a big caveat. The comparative illustrations must be based on realistic pricing assumptions—no smoke-and-mirrors pricing; the comparison must be credible. 

Even if the existing policy’s pricing is excellent (and assuming health isn’t an issue), the final replacement element can trump pricing. If the existing policy’s type (whole life, UL, or VUL) is no longer compatible with the client’s goal, he or she may wish to replace on this issue alone. The most common switch of goals is exhibited in the following two case studies.

Case Study: Current Coverage Becomes Unnecessary

Bob was in excellent health. He had a $3,865,500 level death benefit UL policy with a cash surrender value of $388,516 purchased in 2002. He was not paying premiums on the policy, and it was underfunded.

I obtained an authorization from the trustee so the insurance company would provide me information on this policy. I learned that based on current pricing and no further premiums, this policy would fail at age 79 when there is an 81 percent probability of Bob being alive. Another illustration for the existing policy I obtained showed premiums of $92,783 (every year) needed to provide lifetime coverage.

Next, I obtained illustrations from two excellent companies showing the $388,516 cash value transferred and illustrated premiums needed for a death benefit of $3,865,000. These were for a pricing comparison only, because I knew Bob didn’t want to pay further premiums. One illustration was based on current assumption pricing (changing interest crediting rates, and if managed correctly, changing premiums). From the other company I obtained a guaranteed UL quote. Both were designed to provide lifetime coverage. Both comparisons showed premiums of about half the $92,783 for the existing policy. This proved that the existing policy was greatly overpriced.

Besides not wanting to pay further premiums, Bob’s estate liquidity situation had improved, making the need for $3,865,000 of coverage unnecessary. I advised him that because he wanted level death benefits with only the transfer of the existing policy’s cash value, that the current assumption UL wasn’t appropriate (more on this later). The only logical choice was the ULG. Based on Bob’s health and cash value transfer, the ULG would provide guaranteed lifetime death benefits of $2 million. This ULG was written by an agent and the replacement was completed.

Case Study: Aggressive Pricing

John’s attorney/trustee retained me to review his existing life insurance policies and a proposal from an agent to replace all of them using a single premium 1035 transfer of their cash values. The new policy would have a level death benefit. The proposed replacement policy was current assumption.

John’s existing policies included six participating whole life policies from two excellent mutual companies and two current assumption UL policies. The combined cash value for these policies was $790,000 with combined death benefits of $2.3 million. Both UL policies’ premiums would need to be adjusted, because interest crediting rates changed. The participating whole life policies’ death benefits were illustrated to increase modestly without premiums based on current dividends.

John was near the finish line of his career and wanted an end game to his life insurance program that the current policies wouldn’t allow. The current policies needed to be managed with respect to target premiums for the ULs and possible continuation of contract premiums for the whole life policies, and continuing so-called Crummey notices to the trust’s beneficiaries.

The agent, Sam, proposed a $2,947,000 (level death benefit) current assumption UL with 1035 transfers from the existing policies’ cash values. Sam represented that his new policy was the end game that John was looking for. Sam quickly moved to underwriting for the proposed new policy, establishing that John was still in excellent health.

The insurance company for the UL Sam was proposing had illustrated pricing that was, to say the least, optimistic. With any current assumption UL, pricing is going to change. For a level death benefit/single premium policy, if the crediting rate goes down, there won’t be a “single premium” because additional premiums will be needed (so much for an end game). If interest crediting ultimately soars, this policy will be overfunded. It is never a good idea to use current assumption UL with level death benefits and a single premium. It is impossible to thread such a needle.

But Sam’s proposal took this problem to a new level. As noted, this UL’s pricing was extraordinarily aggressive. Not only was the illustrated crediting rate aggressive for 2014 at 4.75 percent for 10 years, then 5.25 percent, but the illustrated mortality costs were even more aggressive. This aggressive pricing resulted in the “promised” level death benefit of $2,947,000 being miles ahead of other current assumption UL proposals I checked.

I re-engineered the mortality costs from the illustration for Sam’s proposal. I then compared them to mortality costs I re-engineered from a current assumption UL illustration from a stellar company known for decades to have among the best mortality experience.

What I found was eye opening. Sam’s proposed current assumption UL’s mortality was 300 percent to 400 percent lower than the contrast mortality costs, beginning around age 85. If this company is fudging the late year’s mortality costs, it has an enormous impact. If the mortality costs can’t be sustained, insureds living to life expectancy (if not otherwise discovered sooner) could be faced with premiums so high they would be difficult to sustain in their late 80s. This is an issue that has become the single most common engagement I am asked to deal with.

Unlike Sam, I analyzed the pricing of John’s existing policies. The whole life policies had excellent current pricing. John’s UL pricing was quite poor.

I recommended that John’s trust reject the current assumption UL proposal because it was not in sync with a single-premium/level death benefit, especially considering how unrealistic I believed the illustrated pricing was. Instead, I proposed that the trust consider choosing from two options.

The first was to keep the participating whole life policies, converting them to paid-up. This means they are guaranteed to have no further premiums. The benefits at death will depend on future dividends that are not guaranteed. The other part of the first option was to replace the ULs with a ULG from the same excellent company recommended to Bob in the first case study. Both components to the first option create an end game for John.

The second option was to replace all policies using a Section 1035 transfer of cash values to the ULG. Again, this would be an end game for John. John’s trust selected the 100 percent ULG option with guaranteed death benefits of $2.52 million. The trust was very happy to have John’s life insurance safely tucked away with no more Crummey notices or surprises.

Risk Management & Insurance Planning