The previous discussions of the various policy comparison methods and the summary table of the common policy comparison methods suggest which of these methods is potentially suitable or evaluating replacement policies. As those discussions indicate, some of the comparison methods are not suitable for comparisons between existing and new policies, and planners may need to adjust or modify a method when applying it in certain circumstances.
Even those methods planners can use to compare existing to new policies may give ambiguous results. In addition, there are broader implications and considerations that insureds and planners should address when evaluating whether to replace an existing policy with a new policy.
When evaluating whether to replace an existing policy, insureds and planners should return to the original admonition: “MATCH THE PRODUCT TO THE PROBLEM.” Often when an insured’s objectives change and an existing policy is not entirely suitable for the revised objectives, it may be best to keep the existing policy in place and to purchase additional coverage with the flexibility and features one needs. Sometimes it may be wise to keep an existing policy in place and to use borrowing from the cash value to pay premiums on new supplemental coverage, rather than to exchange the old policy for a new policy.
In almost all replacement cases where the old policy is just not suitable and must be replaced (or where replacement is being considered because of the financial weakness of the company that issued the old policy), the insured should consider using the provisions of Internal Revenue Code section 1035 to assure that the exchange is treated as a nontaxable event. If the insured surrenders the old policy and uses the cash surrender value to help finance the new policy, two adverse tax consequences could ensue.
First, to the extent of gain in the policy (that the cash value exceeds the net premiums paid), the surrender value will be subject to income tax at the policy owner’s ordinary tax rate.
Second, if a large after-tax surrender value is placed in the new policy, the new policy could be treated as a modified endowment contract (MEC) with very adverse tax consequences with respect to any lifetime withdrawals or loans. Even if the policy is not treated as a MEC, the insured may be subject to the fifteen-year rule with respect to withdrawals, where amounts withdrawn within the first fifteen years may be taxed on the interest-first rule rather than the cost-first rule.
Finally, whenever an old policy is exchanged for a new policy, the insured surrenders certain rights. For example, the new policy generally is issued with a new suicide period and a new incontestable period, even if the old policy had long surpassed the reach of those provisions. In addition, the insured may forfeit more favorable guarantees as to minimum rates credited to the cash values, and more favorable provisions and rates for policy loans. The insured and the planner should compare the relative merit of all the provisions of the existing policy as compared to the provisions and promises of the new policy.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM