State laws and policy provisions combine to provide a number of protective options for the policyowner who stops paying premiums (for whatever reason) after the policy has been in force for a number of years. The policyowners do not lose the equity in their policies (assuming the type of policies in which the premiums exceed the current cost of carrying term insurance), but can use it advantageously in several ways. In other words, in level-premium contracts where policies require that a reserve be established in early years to meet higher insurance costs as the insured grows older and the probability of death grows greater, the insurer releases that reserve to the policyowner when the insurer is no longer obligated under the contract. The policyowner will receive an equitable portion of the total values his or her premiums have helped to accumulate.
How much the policyowner will receive is a function of: (1) a statutory formula; and (2) the insurer’s internal policies (the insurer can promise to pay more than the statutory minimum). The values the insurer will pay are printed in the policy. Generally, at least twenty years’ (or the term of the policy, if less) of values are shown.
The policyowner usually has three nonforfeiture options:
1. Cash surrender – Cashing in (technically called a cash surrender of) a policy is the simplest nonforfeiture option. The policyowner physically surrenders the contract to the insurer and the insurer issues a check to the policyowner for the policy’s cash value. The cash value (also called “cash surrender value”) is the amount shown in the policy itself (sometimes “per thousand dollars” of face amount) as the cash available at the end of specified policy years (reduced by any loans against the policy). The contract will contain a table showing year by year the amount that is available if the policyowner cashes in the policy and will make certain other statements in compliance with state law nonforfeiture rules. Although most states allow the insurer to defer the payment of this cash surrender value for up to six months after the policyowner tenders to contract to the insurer (to insulate insurers from a run on its cash reserves and the consequent self-generating economic crisis such a drain could precipitate), payments are almost always made within days or weeks of the policyowner’s surrender of the policy.
2. Extended term option – If the policyowner elects to use the cash in the policy to create extended term, the face amount of the coverage is undiminished. The same death benefit payable under the original contract remains payable after the option becomes operative (less any outstanding loan). In essence, the insurer takes the policyowner’s cash value in the policy and purchases term insurance for the policyowner (without the payment of commissions or charging of other expenses against the policy). Because the death benefit for the extended term policy is the same as for the original policy, only the term of time for which coverage will last changes. If the insured dies during the term, the insurer must pay. If the insured dies after the term, the insurer has no liability. Once the term expires, the policyowner cannot continue the coverage—except by formal reinstatement according to the provisions of the contract (see below). The extended-term option would be a good choice where the insured had a shortened life expectancy because of an accident or illness. Once policyowners elect the extended term nonforfeiture option, they can no longer take policy loans, because extended term coverage makes no provision for policy loan values.
3. Reduced paid-up insurance option – As its name implies, an insurer takes the cash values of the policyowner’s contract and uses that money to pay up the contract for the life of the insured. Unlike extended term where the face amount is unchanged but the term is shortened, with the reduced paid up option the insurer reduces the face amount to what a net single premium in the amount of the policy’s cash value will purchase at the attained age of the insured. The same type of insurance continues at that reduced amount for the insured’s life no matter how long he lives (up until the maturity date of the policy). The amount of paid-up coverage is listed in the contract itself. The amount of coverage purchased is a function of the insured’s age at the date the policyowner elects as well as the type of coverage being purchased and the level of cash values available. The insurer reduces the death benefit by the value of any loans against the policy (and increase the death benefit by any dividend accumulations). Reduced paid-up insurance, unlike extended term, has both cash and loan values and is, therefore, more flexible than the extended term. The reduced paid-up option would be a good choice where the insured is in average or superior health but, for whatever reason, the policyowner stopped paying premiums.
State law requires that the policy state an “automatic nonforfeiture benefit” if the policyowner has not selected a forfeiture option upon (or within sixty days of) the lapse of a policy. In the case of a rated (premiums adjusted to reflect a higher than standard mortality risk) policy, the automatic nonforfeiture benefit is reduced paid-up insurance. With respect to all other policies, the automatic nonforfeiture benefit is extended-term insurance.
Where an insured dies after selecting a nonforfeiture option but before receiving any benefits from it, the general rule is that, even if the insured dies before the insurer has completed its obligation under the nonforfeiture option, the option and not the death benefit is payable.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM