Thinking about life insurance replacement? Read this first

Thinking about life insurance replacement? Read this first

Despite its name, life insurance isn’t something you’re locked into for your entire life, which is great for the policyholder. It means you can revisit your coverage and, if it makes sense, replace your policy with a new one.

But if you decide to replace your life insurance, there are some things you should consider first.

The ins & outs of life insurance replacement

Why you might want to replace your policy

A lot of people want to take a "set it and forget it" approach to personal finance. This works well in some regards – investing your money and leaving it to grow thanks to good ol’ compound interest, for example – but at the same time there are products, like life insurance, where you need to be active and show some interest.

"But I bought a 30 year term," you say, "so I don’t need to worry about it until we’re all in flying cars, right?"

Right! Except you got a great deal on premiums because you bought your policy when you were young, single, and renting, so you opted for relatively cheaper coverage. But ten years later you have a spouse, and a kid, and a house, and all of a sudden that policy that seemed like it would pay out so much won’t replace your income or cover mortgage payments or help with Junior’s college fund.

There are a ton of reasons to get life insurance, and just as many reasons to review the life insurance you already have. Some agents and brokers will suggest that you revisit your insurance every year. If that’s too much of a burden, you should at least take a look at your coverage with every major life event. Is it still meeting your needs? You’d be surprised at how often the answer is "no."

Additionally, if you’ve made a positive change to your health (like quitting smoking or losing weight) since you bought your original policy, you might be able to get get a better or cheaper replacement.

Why you might want to keep what you have

There are a few reasons why you wouldn’t want to replace your policy, and they mostly center around the fact that you’re starting the process all over again. Premiums are set based on your health at the time you purchase the policy, so if you redo things when you’re a little older – and probably a little less healthy than you were in your 20s or early 30s – you can expect the premiums to be higher.

You’ll also reset the contestability period during which the insurer can cancel the policy or refuse to pay some or all of the benefit if it finds that you misrepresented yourself during application. It’s all standard fare, but it means some patience on your part until your policy fully kicks in, so to speak.

How to replace your policy

Now that you know the dos and don’ts (or, rather, the whys and why nots) of policy replacement, let’s assume that you’re going through with it. Here’s how you go about it.

Whenever you apply for life insurance, you’ll have to answer some questions right off the bat, like whether you already have a life insurance policy and whether the new one is going to replace the current one. These might seem intimidating – will your new policy be rejected because you already have one in place? – but they basically just flag you so the insurance company knows that you are, in fact, in the replacement game. It’s for your own good as the industry tries to protect consumers from bad-apple agents (more on that in a bit). Some states have extra protection in place for people 65 or older, to keep them from being coerced into unnecessary replacement policies.

After you’ve found a new policy that works for you and it’s in force, you need to drop your current policy. While you can own multiple life insurance policies at the same time, it’s probably not needed (plus, those premiums will add up). So once everything is in place, how do you get rid of the policy you no longer need? Here are a few options:

  1. If you’re near the end of your term on your old policy, you can keep paying for it until it ends. This requires little effort on your part, especially if you’ve set up an EFT (electronic funds transfer) to automate payments. But you should only consider this if you’re okay with temporarily paying premiums on two policies at the same time.

  2. If you’ve still got a while left on your policy or don’t like the idea of paying two premiums at the same time, just stop paying the premium on the old one and it will lapse, meaning that it’s no longer active. When you let your policy lapse there will be a grace period (typically 30 days) when you can reinstate your policy. The grace period is there so policies aren’t automatically canceled every time someone happens to miss a payment due date, or if the policyholder dies and his family doesn’t notice that the next payment is due. This works out well for you, because if something goes awry with your new plan, you can always pick up your old one as long as it’s within the grace period.

  3. You can send a replacement notice to the home office of your current insurance company. So if your carrier is Northwestern, your form will be headed off to their home office in Milwaukee. This will let them know that you won’t be using your current policy any longer and will be switching to a new life insurance policy.

But remember: you need to make sure your new policy is in place before you ditch the old one. The last thing you want is to find out you’re not going to get the coverage you’re looking for, or at the premium price you can afford, but...whoops, you’ve already let your old policy lapse and you’re out of luck.

Section 1035 exchange form

Replacing a term life insurance policy is relatively straightforward, but if you’ve got whole, universal, or variable life insurance – something with annuities or cash value – you’ll need a section 1035 exchange form so the IRS doesn’t come knocking to collect taxes. In order for your money to remain tax-exempt, you have to directly transfer your ownership of the old policy to the new policy (or exchange it). If you’re going this route, definitely talk to your agent or financial advisor about a 1035 exchange, or you could end up losing some of the value you’ve accumulated in the old policy.

Beware of churning

If you’ve done your homework and decided to replace your coverage, that’s great! You’ve already got a better handle on your finances than a lot of your peers, who probably haven’t thought of their policy since the day they signed it and paid the first premium. But if someone else suggests you get a replacement, pump the brakes a little and think twice about it.

Churning is when an agent sells or replaces a policy not for the benefit of the policyholder, but for the commission that the new policy will bring in. It’s only done by those few insurance agents or brokers who’ve gone to the dark side, and not only is it unethical, it’s illegal.

Since most agents and brokers are in fact looking out for their clients’ best interests, this will probably never be an issue for you. But if something doesn’t make sense, or you can’t see how replacing your policy will actually benefit you, don’t go through with it without getting a second opinion.

Unfortunately, older policyholders are at greater risk of churning, so if you’re over 65 or you know of a policyholder who is (your parents, for example), you should make certain you understand the reasons why your agent is suggesting you replace the policy.

Don’t take policy replacement lightly; there’s a lot to consider, and you don’t want to end up with a new policy that’s no better than the one you already had. But make sure you review your coverage periodically. If you’ve bought life insurance you already know that it’s not a one-size-fits-all product, but it also might need to be adjusted over time as the policyholder’s life evolves. Once you know the options that are available and the reasons why you would consider replacing your life insurance policy, you’ll be armed with the right questions to ask your agent or broker when it comes time to make that decision.

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