If you own a life insurance policy, you may have been
approached to exchange it for another new policy. You need
to know that even though the tax laws make the exchange
income tax free and the new policy may appear better to you,
you may be losing - not gaining - if you make the exchange.
NASD is issuing this Alert because, increasingly, life
insurance exchanges may involve variable products. Since
variable products are securities, NASD wants to give you
information to help you evaluate whether the exchange is
right for you, and how you can find out what you need to
know to make an appropriate decision.
Types Of Life Insurance
There are various forms of life insurance products. Although
features and benefits may vary, the following is a general
description of typical characteristics of various types of
life insurance policies.
Term
Life Insurance. Term life insurance provides
coverage for a specified and limited period of time (the
"term"). Premiums for most term policies increase with
age or at the end of each renewal period. After the
policy or term ends, there is no benefit payment if the
insured person survives beyond the policy period.
Whole
Life Insurance. Whole life or ordinary life
insurance is a form of permanent life insurance. This
means it can provide coverage for the life of the
insured. It also can build cash value, which is a
savings feature. Premium payments typically remain level
for the life of the insured.
Universal
Life Insurance. Universal life insurance can also
provide coverage for the life of the insured while at
the same time providing flexibility in premium payments
and in insurance coverage. The cost of insurance
protection and, in some cases, other costs are deducted
from the cash or policy account value.
Variable
Life Insurance. Variable life insurance, a
variation of whole life insurance, offers a fixed
premium schedule and a minimum death benefit. But it
differs from traditional whole life insurance in that
cash values are invested in portfolios of securities in
an account separate from the general assets of the
insurance company. A policyholder has discretion in
choosing the mix of investments the policy offers. The
insurance company does not guarantee investment returns
and your cash value will fluctuate.
Variable
Universal Life Insurance.
Variable universal life insurance combines features of
universal life insurance and variable life insurance.
Most variable life insurance policies and variable universal
life insurance policies are securities registered with the
Securities and Exchange Commission (SEC). Registration
requires that investors receive important financial and
other significant information concerning the securities
being offered for sale. This enables investors to judge for
themselves if the securities are a good investment. These
regulations also provide important remedies to investors if
they can prove that there was incomplete or inaccurate
disclosure of important information provided to them.
1035 Exchanges
The Internal Revenue Service allows you to exchange an
insurance policy that you own for a new life insurance
policy insuring the same person without paying tax on the
investment gains earned on the original contract. This can
be a substantial benefit. Because this is governed by
Section 1035 of the Internal Revenue Code, these are called
"1035 Exchanges."
But this benefit comes with some important strings.
The
tax code says that the old insurance policy must be
exchanged for a new policy - you cannot receive a check
and apply the proceeds to the purchase of a new
insurance policy.
The
tax code also says that you can make a tax-free exchange
from: 1) a life insurance policy to another life
insurance policy or 2) a life insurance policy to an
annuity. You cannot, however, exchange an annuity
contract for a life insurance policy.
A transaction in which a new insurance or annuity contract
is to be purchased using all or a portion of the proceeds of
an existing life insurance or annuity contract is referred
to as a "replacement." A 1035 Exchange is a type of
replacement transaction. Although the term "1035 Exchange"
is often used to describe any form of replacement activity,
technically not all replacements are Section 1035 Exchanges
and as a consequence are not tax-free.
Reasons To Exchange An Existing
Policy?
There are various reasons why a life insurance policyholder
may want to replace an existing policy with a new life
insurance policy. For example,
Improved
health or mortality improvements across the general
population may result in insurance coverage at a lower
cost.
You
may have concerns with the solvency of the insurance
company that issued the original policy or with the
service of the agent that sold you the policy
A
new life insurance policy may have more desirable
features or benefits.
Reasons Not To Exchange An Existing Policy
There are also various reasons why replacement of an
existing insurance policy may not be a good idea. For
example,
Cash
value built up in the original policy may be applied to
the new life insurance policy's first year expenses,
including commissions.
Life
insurance policies (other than term policies) often
include early surrender charges, which can reduce the
amount of cash value available toward the new policy.
The new policy will likely have its own new surrender
charge schedule, which may extend beyond that of the
original policy.
You
may pay higher premiums if, for example, your health has
declined since the purchase of the current policy.
The
new policy typically will have a new contestability
period - a two-year period from the issuance of the new
policy during which the insurance company could
challenge a death claim based upon a misstatement on the
application.
There
may be unfavorable tax consequences caused by
surrendering an existing policy, such as a potential tax
on outstanding policy loans.
What You Should Watch For
You should exchange your life insurance policy only when you
determine, after knowing all of the facts that the exchange
is better for you and not just better for the person who is
trying to sell the policy to you.
Both variable life insurance and variable universal life
insurance are securities. Those who offer these products
must follow SEC, NASD, and state securities regulations, in
addition to state insurance law. This means that a broker
must tell you the important facts about the pros and cons of
the exchange. Your broker or insurance agent should
recommend such an exchange only if it is in your best
interest and only after evaluating your personal and
financial situation and needs, tolerance for risk, and the
financial ability to pay for the proposed insurance policy.
Your broker or insurance agent may recommend that you use
insurance policy values, such as loans or withdrawals, to
pay premiums for a new life insurance policy. This activity
is generally called "financing" premiums. It may not be
appropriate for you. For example, withdrawals from existing
policies may be subject to federal income tax and may reduce
the death benefit. Borrowing money from an existing policy
will almost certainly reduce the death benefit. Withdrawals
or loans may make it more difficult to keep the original
policy in force without additional out-of-pocket premium
payments. If you can't keep the original policy in force,
you will lose the insurance protection and the loans
themselves may give rise to tax consequences. Remember for a
transaction to qualify as a 1035 exchange, the old policy
must actually be exchanged for the new policy. Many states
and brokerage firms require forms to reflect customer
acknowledgement of a replacement transaction. These forms
typically are signed by the insurance policy owner and the
broker or agent. These forms may provide a comparison of the
features and costs of an existing policy to a proposed
policy, and point out what you need to focus on when
considering an exchange. Some brokerage firms may provide
brochures or educational material designed to outline the
possible advantages and disadvantages of the transaction.
You should review these forms and materials closely.
Regardless of whether such forms are provided, you should
specifically ask the person recommending that you exchange
or replace your existing policy to provide you with
illustrations for your existing policy and the new policy.
You should also ask:
What
is the total cost to me of this exchange?
What
are the new features being offered? Why do I need those
features?
Are
these features worth the cost?
Can
the existing policy be modified or supplemented to
provide some or all of these same features?
Will
you be paid a commission for the exchange, and if so,
how much is it?
You should not sign any exchange form or agree to exchange
or purchase an insurance policy until you study all of the
options carefully, have all of your questions answered, and
are satisfied that the exchange is better than keeping your
current policy.
What Regulators Do To Protect You
NASD and the SEC have been conducting a series of special
sales practice examinations that have focused on the sales
of variable contracts - variable annuities and variable life
insurance.
These examinations have resulted in cases that have found
that some firms had failed to establish and maintain
adequate written supervisory procedures relating to the
suitability of recommendations of variable life insurance
policies.
In addition, NASD's examinations of its members selling
variable contracts routinely investigate for inappropriate
sales of variable contracts, including unsuitable variable
contract exchanges or replacements.
Remember, however, that no matter how much regulators try to
protect you, you are your own best protection by knowing
what to avoid in the first place.
If You Have Questions Or Complaints
If you have questions or complaints about a life insurance
policy exchange, you can contact NASD, the SEC, your state
securities administrator, or your state insurance
commissioner.
Source: Investor Alert, "Should You Exchange Your Life
Insurance Policy?" September 23, 2002 - Copyright © 2003.
National Association of Securities
Dealers, Inc. All rights reserved. NASD is a
registered trademark of NASD Inc.
