A policy holder who is insured by a financially troubled insurer may consider switching insurers. Whether this is a good idea depends on many factors, including the type of policy and the method of switching. In most cases, surrendering an ordinary cash value life insurance policy with the intention of investing cash values more safely elsewhere and acquiring a new policy from a more financially stable company is inadvisable. A policyowner who hangs onto the policy may earn a lower rate of dividend interest and may be inconvenienced if the company fails, but the death benefit is generally safe up to the limit of the state’s guaranty fund.
Switching might even be expensive. For example, a whole life policyowner switching policies (i.e., surrendering the old policy and purchasing a new one) will enter the new policy at a higher age and higher premium. In addition, the policyowner will pay a new commission, probably have to take a new medical exam, and, if the old policy has been in force for a number of years, may have to pay tax on the excess of the cash surrender value over the amount of premiums paid.
However, if the company becomes insolvent, the policyowner may not be able to borrow against cash values. Therefore, it may be advisable to borrow cash values and invest them somewhere else. The cost of assuring this liquidity is essentially the difference between the borrowing rate in the policy and the rate earned on the invested proceeds (also, some companies will reduce the amount earned on cash values by about 2 percent).
For similar reasons, it is probably inadvisable to surrender universal life or interest-sensitive policies in financially troubled companies. The principal risks of keeping a policy are that the interest credited to cash values may be reduced to the guaranteed rate (typically 4 percent) if the insurer becomes insolvent and, in the case of universal life policies, mortality and expense charges may be increased to their maximums. In general, it may be wise to put universal life policies into term mode and use accumulated cash values to continue premiums or to pay only the minimum amount necessary to maintain the face amount of coverage.
The amount that would otherwise be paid in premiums may be invested elsewhere. As with whole life and universal life policies, death benefits on variable life policies are generally secure to the level set by the state guaranty fund. Since the cash values are secured by the specific assets of the separate account, rather than the company’s general portfolio, variable life policyowners may always cash their policies in at market value. Possible risk of keeping the policy with a financially troubled company is that borrowing against the policy may be restricted during a period of reorganization if the company becomes insolvent.
Using a Section 1035 Exchange
Although surrenders of cash value policies held by financially troubled companies with the intent of purchasing policies in more financially secure companies do not seem advisable, Section 1035 exchanges should be seriously considered. Such an exchange may avoid taxation of gain, if any, and avoid some, but generally not all, of the expenses associated with the purchase of a new policy.
In addition, it may be advisable to consider the reduced paid-up insurance option or the extended term option for existing policies together with the purchase of new policies with more financially secure companies to cover the difference.
In the case of term policies held by financially troubled insurers, death benefits are generally secure to the level set by the state’s guaranty fund. The principal risk is that the company will raise renewal premiums to the maximum permitted under the policy, which may be considerably higher than premiums charged by more financially secure competitors. Also, if the policyowner is in poor health and the company becomes insolvent, another company can refuse to pick up the coverage. Therefore, if the policyowner is healthy and can qualify for coverage from a more financially secure company, it is advisable to switch. Annuity contracts present more difficult problems.
If a financially troubled company becomes insolvent during the accumulation phase, the new guarantor may pay interest at a lower rate than the original insurer. Annuity owners who surrender an annuity contract within the first seven years will usually pay a surrender charge ranging from about 7 percent in the first year to 1 percent in year seven. In addition, annuity owners must pay income tax on gains and a 10 percent tax penalty on the taxable portion of the distribution if it is received before age 59 1/2 (and none of the other exceptions to the premature distribution penalty applies). These tax disadvantages can be avoided if the contract is properly exchanged.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM