Be Wary When Exchanging Insurance Policies
Insurers, regulators and agents complain that unscrupulous insurance salespeople are using worries about life insurance company failures to persuade consumers to trade in their current insurance policies for new ones.
These exchanges benefit insurance agents because they earn commissions on each new life insurance policy sold. And generally speaking, agents get more money for writing new business than for maintaining old business.
Occasionally, consumers also benefit by switching their policies. However, a number of costs are involved in trading in an insurance policy; sometimes they outweigh the benefits of so-called 1035 tax-free exchanges.
What is a 1035 exchange? It is the tax-free transfer of funds from one life insurer to another. To make such a transfer, a consumer need only fill out the appropriate form, obtainable from his or her insurance agent. The forms differ from insurer to insurer, but they essentially just say you authorize the “assignment” of your policy to a new life insurer.
The old insurer then transfers the cash value of your account, minus any surrender fees, to the new insurer.
The only other thing the consumer need do is notify the IRS about the exchange when filing an annual tax return. Normally, individuals get a 1099 form from the first insurer noting their interest earnings. That gain must be reported on that year’s tax return. But then the consumer deducts it back to show the net gain as a zero.
You then attach a separate page--essentially a note to the IRS--saying this was a 1035 tax-free exchange. The numbers of both policies should be specified on the note, says Jeff Kaylor, a personal finance manager at the accounting firm Deloitte & Touche.
It’s pretty straightforward.
What’s far less simple is figuring out whether to do such an exchange. For most people this boils down to a personal analysis of the costs and the benefits.
There are a number of expenses--some clear, others hidden. And the benefits are often difficult to quantify.
The costs: Consumers must often pay “surrender” fees to the first insurer, which can subtract a substantial chunk of the policy’s value.
In addition, life insurance policies generally have a front-end “load,” says Bob Eddy, a regional manager of Manulife Financial. What that means is that many of the fees and charges associated with writing the policy, such as the agent’s commissions, the underwriting costs and other incidentals, are paid for up front. But these fees can be hidden behind sales projections delineating what your account will be worth in a given period. To put it clearly:
“The first premium or two usually disappears to pay the commissions and underwriting costs,” Eddy says. “It might be a few years before the premiums you pay make up for the front-end load.”
Consumers also need to consider what they’ll pay to buy new insurance. On many life policies, part of your premium buys insurance for death benefits. The rest of the premium is used to build up a cash value.
The cost of that death benefit is very much affected by your age and your health. If it has been some time since you bought the first policy, you should shop around to find out whether they are insurable and, if so, at what cost before you even consider a 1035 exchange.
What are the benefits of such an exchange?
In some cases, you can earn a higher rate of interest with a new insurer. And that, over time, might turn out to be a good deal even after all the expenses of the exchange are considered.
But right now, many individuals seem to be considering these exchanges because they are worried about the health of their present insurer and want to move their money to a company that’s safer.
If that is your concern, it is much more difficult to weigh the financial benefits.
Why? When you buy insurance, you are buying a long-term contract, so you need to determine not only how healthy your insurer is today but also how healthy it will be 10 years from now. And even the experts have a hard time doing that.
Additionally, a number of rating services give insurers letter grades to rank how strong these institutions are now. But you should be aware that these letter grades don’t usually mean what they meant in school. For example, a “C” means “average,” right? Wrong. When Standard & Poor’s rates insurers “C” it means that these companies may not be paying their bills and they may have been seized by regulators.
A Standard & Poor’s “A” doesn’t mean excellent, it means “good financial security, but (the insurer’s) capacity to meet policyholder obligations is somewhat more susceptible to adverse changes in economic or underwriting conditions than more highly rated insurers.”
Indeed, for an insurer to truly be considered “excellent,” it needs at least a “AA” or “A+” score. And even that does not ensure that the company will still be healthy six or seven years from now.
Because you will probably still have to pay a surrender fee in six years if you want to transfer your policy, the insurer’s long-term health is germane to the long-term viability of your investment.
The bottom line: If you panic or get pushed into a 1035 exchange, it could cost you a bundle. These transactions might make sense, but you need to sit down with pad and pencil and run through the numbers before you decide.
