An Introduction to Section 1035 Exchanges

Insurance programs must be flexible enough to change as an insured’s financial status, family responsibilities, and business needs change. Furthermore, as new types of policies are developed, ethical agents will seek, when appropriate, to match the product to the problem. If a new product solves the problem in a more cost effective manner than the old product, a client should be apprised of the opportunity and should be given the chance to exchange the old policy for the new. This is particularly important if the insurer that sold the existing contract is financially unstable. Federal income tax law facilitates certain exchanges by providing that in some instances they may be made without the immediate recognition of gain. Although such transactions are sometimes referred to as section 1035 tax-free exchanges the gain at the time of the transaction is deferred rather than forgiven.

Factors indicating that a Code section 1035 exchange should be considered include the following:

  1. A client feels that a higher rate of return can be realized with a new policy.
  2. A client is concerned that the present insurer may become insolvent or that its investment experience will not warrant the dividends projected and that a more stable insurer can be obtained through a policy exchange or that diversification of insurance carriers will increase safety or return.
  3. The client’s current policy is subject to a substantial loan, the interest paid on the policy is nondeductible, costs are increasing, and the client needs to continue coverage.
  4. The client would like to change from an individual to a group product.
  5. The death benefit under a new product will exceed the death benefit under the old product.
  6. The client would like to change an ordinary life policy into a single premium policy to eliminate the premium paying burden, obtain a higher rate of return on the underlying cash values, and obtain a higher death benefit.
  7. A newly-developed type of policy (perhaps one with a more flexible premium structure or with a more adjustable death benefit) is more suitable to the client’s needs, circumstances, or investment philosophy than the policy presently owned. For instance, a client may want to exchange an ordinary life contract for a universal, variable, or interest sensitive policy.
  8. Premium rates on the new policy are lower due to such factors as improved mortality tables, a nonsmoking discount, a volume discount for several policies aggregated into one, or other factors.
  9. The client’s risk tolerance may have changed since they originally took out the policy (e.g., changing from variable to a guaranteed policy).
  10. The client desires policy riders that provide additional benefits, such as long-term care (LTC) or chronic illness, that were not available at the time the original policy was taken out.
  11. The client is concerned about the existing policy endowing during their life (e.g., at age 95) and potentially creating adverse income tax consequences and would like a policy that matures later (e.g., age 100 or age 120).
Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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