Replacing an old policy when your health has changed

A change in health makes people reconsider every financial promise they have made, including the life insurance they already own. Sometimes the change is bad news and the old policy suddenly looks like the most valuable thing in the file. Sometimes it is good news, such as quitting tobacco or losing weight, and a cheaper class seems within reach. In both cases, the temptation to swap one policy for another is strong, and the mistakes cluster in the same places.

This post lists eight of them: how each one happens, what it can cost, and how to avoid it. It closes with a set of questions worth asking before any replacement. It is general information about how the mechanics work, not advice about your policy. The examples are hypothetical, and every price is an illustration.

What a replacement actually is

A policy replacement occurs when a new life policy or annuity is purchased and an existing one is lapsed, surrendered, reduced or otherwise changed as part of the same transaction. Regulators watch replacements closely because they are the setting for sales abuses, described in twisting and churning: replacement sales abuses. Many states require a notice or disclosure when a replacement is proposed, and the existing insurer is often told so it can respond.

A replacement is not always a mistake. A policy can be a poor fit, the insurer can be in difficulty, or the old product can have defects the buyer was never told about. The question is whether the swap improves your position after you count everything you give up. A health change affects both sides of that count, which is why the mistakes below are specific to it.

Mistake 1: Cancelling the old policy before the new one is in force

How it happens. The new application is submitted, the agent says approval looks likely, and the buyer cancels the old policy to avoid paying twice. Or an automatic payment is stopped to "save the premium."

What it costs. If the new application is declined, rated higher than expected, or delayed, there may be no policy at all. For someone whose health has just changed, there may be no way to buy a replacement elsewhere. That is the single most expensive error on this list because the loss is the entire death benefit.

How to avoid it. Treat the sequence as fixed: apply, be approved, accept the offer, pay the first premium, receive the policy and confirm it is in force. Only then cancel the old one, and do it in writing. Compare it with the sequence in replacing a term policy without leaving a coverage gap. Also use the the free-look period: returning a policy for a refund on the new policy; if you cancel the old one and then return the new one, you are back to nothing.

Mistake 2: Forgetting that a new policy means new underwriting

How it happens. People assume the insurer will take their old health history as the starting point. It will not. A new application is underwritten on today's health, today's medications, today's readings and today's age.

What it costs. If the change is for the worse, the offer can be higher in price, carry a rating or flat extra, or be postponed or declined. The guide to life insurance rate classes: preferred plus to substandard explains the grouping, and the old policy's class, which was set when you were healthier, does not follow you.

A hypothetical. Say Elena, 52, owns a $750,000 term policy bought at 40 with 3 years left, costing $62 a month. After a new heart-rhythm diagnosis, she is offered a replacement with a longer term for an illustrative $210 a month. Over the three years that remain on her old policy, the old one costs 62 x 36 = $2,232 and the new one costs 210 x 36 = $7,560. That is $5,328 more for the same three years, and the new policy buys an extra stretch of coverage she may or may not need. That longer coverage may be worth the money. But she should see it as buying new coverage at today's price, not as a swap that saves anything.

How to avoid it. Ask for a non-binding estimate before you apply, and say plainly that you have a health change. An independent broker can sometimes check how several insurers would treat your condition before a formal application is made.

Mistake 3: Starting new contestability and suicide clocks without realizing it

How it happens. The old policy is several years old, so it is past the contestability period and past the suicide exclusion. A new policy starts its own.

What it costs. For the first two years in most states, the insurer on the new policy can review the application against medical records if the insured dies, and a material misstatement can lead to rescission. The incontestability clause protection you built up on the old policy is gone. If you had a health issue that predates the new application, the exposure is greater, because a records review will find it.

How to avoid it. Know the date the old policy became incontestable and what it was worth to you. Ask the agent in writing whether the new policy restarts both clocks. Most new policies do. replacing a policy resets the contestability clock: what to expect explains the clocks in detail, and the two-year contestability period is the reference guide. If you answer the new application, answer every health question completely. A new application is the moment where a lapse in detail can matter most.

Mistake 4: Giving up guarantees that cannot be rebuilt

How it happens. The new policy looks cheaper or bigger on the first page. What is not on the first page are the features of the old one.

What it costs. Look for these in the old contract before you compare:

• A conversion privilege. The old term policy may allow conversion to permanent coverage without evidence of health. A new term policy has its own conversion window, which starts over, and in a new contract the right is set by the new terms. If your health has declined, this right may be worth more than any premium saving. See converting term life to permanent: how the conversion option works.
• A fixed premium to an older age. You locked in the price when you were younger. A new policy is priced at your age now.
• Riders. A waiver of premium or guaranteed insurability option may not be available on the new policy at the same terms, or at all, after a diagnosis.
• Guaranteed values and dividend history on a permanent policy.
• Favorable loan terms on a cash value policy with an outstanding policy loan.

How to avoid it. Make a two-column list, old policy against new, and put every feature in it, not just price and amount. An item that exists on only one side is a cost of the swap. If you cannot find a feature in the old contract, ask the insurer for a complete policy copy.

Mistake 5: Overlooking surrender charges and taxes on a permanent policy

How it happens. The owner treats the old cash value as a pot of money that moves into the new policy for free.

What it costs. Surrendering a policy with cash value can bring a surrender charge and taxable income. Cash surrender value above what you paid in, after adjusting for dividends and withdrawals, is a taxable gain, generally taxed as ordinary income. In a hypothetical, say a whole life policy has a cash surrender value of $40,000 and you have paid in $28,000 in premiums. The gain is $40,000 - $28,000 = $12,000, which would be taxable if you surrendered for cash. A surrender charge, if the contract has one, reduces what you receive. Suppose a $2,500 charge applies, so you would receive $37,500 before tax.

How to avoid it. Know that a section 1035 exchange moves a life policy to a new life policy or annuity without immediate tax on the gain. 1035 exchanges: swapping policies without tax describes the mechanics. Note what a 1035 exchange does not do: it does not skip underwriting for the new policy. If your health has changed, the new insurer will still ask. Check the surrender charge schedule, and have a tax professional review the numbers before you act. The guide on surrendering a life insurance policy: what you get and what it costs lays out what you receive and what it costs.

Mistake 6: Hiding or rounding the health change on the new application

How it happens. The buyer is anxious about being rated higher, so the new application is answered with less detail than the facts require: a medication left off, a test described as "routine," a diagnosis described as "being monitored."

What it costs. If the application is inaccurate in a material way, the insurer can rescind the new policy during the contestable period and deny the claim. By then the old policy has been cancelled. The family is left with a refund of premiums instead of the death benefit. This is the same trap in the guide on what happens if you lie on a life insurance application, but it is sharper in a replacement, because the old protection is gone.

How to avoid it. Answer exactly, with dates, and ask for clarification if a question is unclear. If a candid answer makes the new offer unattractive, that is information. It is a reason to keep the old policy, not a reason to soften the answer.

Mistake 7: Trusting a recommendation from someone who is paid on the new sale

How it happens. An agent or an online seller points out that the old policy is "outdated," or promises a lower premium or more coverage for the same money. Commissions on new policies are generally higher than the compensation for servicing an existing one, so the seller's incentive tilts toward replacing.

What it costs. A bad replacement is the classic sales abuse. The buyer pays more, loses guarantees and restarts clocks. After a health change, the stakes are larger because the buyer has less leverage to buy again.

How to avoid it. Ask the seller to put in writing why the new policy is better for you, with the comparison of both. Ask how the seller is paid on each. Read the replacement notice that your state requires, and keep a copy. Get a second opinion from someone who is not paid on the outcome, such as a fee-only planner. Neither side of this is villain or hero: some replacements are sound and some sellers give excellent advice. The test is whether the comparison holds up in writing.

Mistake 8: Replacing when a smaller fix would do

How it happens. The real problem is narrow: the policy is too small, the term is too short, or the premium is a strain. The buyer assumes the answer is a new policy.

What it costs. A replacement with a full set of new clocks and new underwriting solves a problem that a narrower step could have addressed.

Options that leave the old policy in place:

1. Add coverage with a new, separate policy and keep the old one.
2. Convert part of a term policy, as described in partial or full term conversion: splitting the face amount.
3. Reduce the face amount of the old policy to cut the premium, if the contract allows it.
4. Use a rider or option already in the policy, such as a guaranteed insurability option, if the dates still work.
5. Ask the old insurer about reclassification if your health has improved. Some insurers consider it and some do not, and the practice varies by company and product.

How to avoid it. State the problem you are trying to fix in one sentence. Then ask whether anything short of a replacement fixes it.

Safer questions to ask before any replacement

Bring these to the seller, the current insurer and, if you have one, an independent adviser.

1. What exactly is wrong with the policy I have, and can it be fixed without replacing it?
2. What do I lose? List the conversion right, riders, guarantees, rate class and contestability status.
3. What does the new policy cost compared with the old for the same period, with the arithmetic shown?
4. Will the new policy restart the contestability period and the suicide clause?
5. Will the new insurer underwrite me on today's health, and what is the earliest I will know the result?
6. If I am declined or rated, what happens to my old policy? (Nothing, if you have not cancelled it.)
7. What are the surrender charges and tax consequences of ending the old policy, if it has cash value?
8. How is the seller paid on the new policy compared with the old?
9. When does the new policy take effect, and when can I safely end the old one?
10. What does the state's replacement notice say, and what happens if I decide not to go ahead?

If a seller cannot answer these in writing, that is itself an answer. For policies with significant cash value or complicated features, see before you replace a permanent policy: a fifteen-point checklist, and consult the state insurance department about your rights.

When replacement can make sense

It would be unfair to leave the impression that replacement is always wrong. Cases where it can be sound include a term policy ending before your need does, with a conversion window that has closed and good health that still lets you buy new coverage; a permanent policy whose cost has risen past what you can pay while a better-fitting product exists; an insurer you have good reason to leave; and a real improvement in health that places you in a lower-priced class, as in Is a better rate class worth waiting for? A premium worksheet. In each, the order of steps and the written comparison are the protections.

Key takeaways

• Never cancel the old policy until the new one is issued, delivered and in force.
• A new policy is underwritten on today's health, so a diagnosis can raise the price, bring a rating or stop the replacement.
• Replacement restarts the contestability and suicide clocks, and gives up guarantees such as the conversion right that may not be available again.
• Surrender charges and taxable gain can hide in a cash value policy; a 1035 exchange defers the tax but not the underwriting.
• Ask what is wrong with the old policy and whether a smaller fix would do, and get the comparison in writing.