Replacing a life insurance policy: when it makes sense

Replacing a life insurance policy means ending, shrinking or borrowing against an existing policy to buy a new one. It makes sense in a few cases, such as a better product for the same need or a sharply lower price on term coverage you are still healthy enough to requalify for. It is often a poor move, because a new policy resets the contestability and suicide clauses, uses your current age and health, and may carry new charges. The rule of thumb is simple: do not cancel anything until the new policy is issued, paid for and in force.

State replacement rules, which build on the NAIC model, exist because replacement is the setting for the sales abuses described in twisting and churning: replacement sales abuses.

What counts as a replacement

The NAIC Life Insurance and Annuities Replacement Model Regulation (#613) defines a replacement broadly. A transaction is a replacement when, because of the new purchase, an existing policy is lapsed, surrendered, assigned to the new insurer, converted to reduced paid-up or extended term coverage, amended to reduce benefits or term, reissued with less cash value, or used to finance the new purchase (see the NAIC model regulation text). Borrowing from the old policy to pay for the new one counts. So does an exchange under section 1035 (see 1035 exchanges: swapping policies without tax), even though it is tax-free.

When replacing can make sense

• Same need, lower price, still healthy. If you hold an older term policy with years left and your health has improved or prices have fallen, a new policy may cost less. Check the remaining level period first; the new one starts a new term at your current age.
• The product no longer fits. A universal life policy in danger of lapsing, or one whose costs have risen, may be better replaced than propped up (see why universal life policies lapse, and how to prevent it). Confirm that you can still qualify.
• Better features. A policy with a conversion option, a rider you need, or a stronger insurer.
• Moving between permanent policies without tax. A 1035 exchange lets you swap one life policy for another without recognizing gain, though surrender charges and a new underwriting review may apply.
• A business or estate plan has changed, and the old structure is the problem rather than the carrier.

When replacing usually backfires

• You are older or less healthy. Premiums are based on current age and health. A condition diagnosed since you bought the old policy can make the new one costly or unavailable.
• The old policy has a long-built cash value that the surrender charge or tax would reduce.
• You would restart the clocks. A new policy has its own two-year the two-year contestability period and suicide clause. Misstatements on the new application can come back at claim time.
• The agent earns a commission on the new sale, while the old policy's costs are already paid. That conflict is why the rules exist (see how life insurance agents are paid).
• You compare the new policy's projections with the old policy's guarantees. Non-guaranteed illustrated values are not comparable with guaranteed ones (see how to read a life insurance illustration).
• The old policy has a guarantee you cannot get again, such as a low loan rate, a no-lapse guarantee or a rider on favorable terms.

What the NAIC model requires

Many states have adopted versions of Model #613. The details differ by state, but the model's structure is common.

The producer must:

• Submit with the application a statement, signed by the applicant and the producer, saying whether the applicant has existing policies or contracts.
• If the answer is yes, present and read a notice regarding replacements, signed by both, and leave it with the applicant. The notice lists each policy proposed to be replaced by insurer, insured and policy number, and says whether each will be replaced or used as a source of financing.
• Leave with the applicant all sales material, including illustrations; electronic sales material must be provided on paper no later than delivery.
• Send the insurer copies of these documents.

The replacing insurer must:

• Notify the existing insurer within five business days of receiving a completed application that indicates replacement, and send a copy of the available illustration or policy summary within five business days of a request from the existing insurer.
• Give the owner a notice of the right to return the new policy within 30 days of delivery for a full refund of premiums and fees. Under the model, this is the extended free-look right, longer than the 10 days common for ordinary new policies. State law can set a different length; New York, for example, requires 60 days on replacements under 11 NYCRR 51.6, and North Carolina gives 20 days on replacements. See the free-look period: returning a policy for a refund and New York.
• When the new and old policies are with the same company or affiliates, credit time already served under the old policy's incontestability and suicide periods up to the old face amount.

The existing insurer must:

• Send you a letter offering information on your current policy's values, including an in-force illustration or policy summary, within five business days of receiving the replacement notice, then provide the information within five business days of your request.
• Warn you when you ask to borrow, surrender or withdraw that doing so may affect guaranteed elements, face amount or surrender value.

Direct-response (mail or online without an agent) sales have their own versions of the notice. The regulation is a baseline; ask your state insurance department for local specifics (see state insurance departments: what they do for you).

A step-by-step replacement checklist

1. Request an in-force illustration and current values from your existing insurer (see how to request and read an in-force illustration). Note the cash value, loans, surrender charges and any guarantees.
2. Get the full replacement quote in writing, with guaranteed and non-guaranteed values shown separately.
3. Compare cost and benefit, not just premium: age, rate class, term, riders, conversion rights, charges and the insurer's financial strength.
4. Apply for the new policy and complete underwriting while the old policy stays in force.
5. Read the replacement notice before you sign, and confirm it lists every policy affected.
6. Receive the policy, pay the first premium and check the contents against the application (see policy delivery: what to check when your policy arrives).
7. Use the free-look period to review it, still without cancelling the old policy.
8. Only then end the old policy, through a written request. If it holds cash value, check the tax effect (see how cash value is taxed: withdrawals, loans and surrenders) and the surrender terms (see surrendering a life insurance policy: what you get and what it costs).

The annual life insurance policy review checklist and keep, surrender or sell your policy? can help structure the comparison.

Key takeaways

• A replacement is any transaction that ends, reduces, or borrows against an existing policy in order to fund a new one.
• Do not cancel the old policy until the new one is issued, paid and in force.
• A new policy restarts the contestability and suicide periods and prices you at current age and health.
• Under NAIC Model #613, the producer must give a signed replacement notice, and the replacing insurer must notify the old insurer within five business days.
• The model gives a 30-day free look on replacements; states vary, and New York's is 60 days.