Conversion, Contestability, and the Life Settlement
Dwight, 58, bought a $500,000 15-year level term policy nine years ago. The contract lets him convert, without evidence of insurability, to any whole life plan the insurer sells, provided he converts before the end of policy year 10. He has just been diagnosed with ALS; his physician certifies a life expectancy of 18 to 24 months. He has paid $41,000 of premium. He wants to convert, pay one annual whole life premium, and then sell the policy to a settlement provider that has offered $310,000. Separately, he now recalls that when he applied nine years ago he “forgot” to list a hospitalization for chest pain that had occurred two years before the application.
1. Can the insurer refuse the conversion or use the omitted hospitalization to deny a claim on the term policy?
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Conversion: the right is contractual and expressly “without evidence of insurability.” ALS is therefore irrelevant to whether he may convert. The insurer cannot underwrite the conversion.
What it can do: price it. Unless the contract includes an original-age conversion feature, the whole life premium is at his attained age of 58, which is exactly why the cost matters here.
The omitted hospitalization: the term policy is nine years old, far past the typical two-year contestability period. A material misstatement no longer voids the contract; the insurer pays the $500,000. (Fraud-based exceptions exist in some states - but the exam answer is that the incontestability clause bars the defense.)
The trap: the converted policy is a new contract. It will have its own contestability and suicide provisions, and if any conversion paperwork asks health questions, a false answer creates new exposure. The safe path is to invoke the no-evidence conversion in writing and answer nothing beyond identity and plan selection.
2. Should Dwight convert and sell, or simply let the term policy pay his beneficiaries? Show the comparison.
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Option A - do nothing: beneficiaries receive $500,000, income-tax-free under the general death benefit exclusion. Cost: $0 more.
Option B - convert and settle:
- One annual whole life premium at age 58 (illustratively $12,000–$20,000 for $500,000 of coverage)
- Settlement proceeds: $310,000
- Net to Dwight: roughly $290,000–$298,000, minus any advisor fee
The arithmetic favors Option A by about $200,000 - unless Dwight needs liquidity during his life, which is the only real reason to sell. If his motive is cash for care, the question becomes: is $310,000 now worth $500,000 later to people who do not need it now?
Timing risk that decides it: if he dies before the conversion is completed, the term policy pays $500,000 and the settlement evaporates. With an 18–24 month prognosis and a settlement process that takes weeks to months, the conversion must be submitted immediately, and he should confirm the settlement offer is not contingent on the converted policy being past its contestability period.
3. How is the $310,000 taxed, and what changes if the settlement is completed before the terminal-illness certification?
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If he is terminally ill (physician certifies an illness expected to result in death within 24 months), the sale is treated like an accelerated death benefit. Proceeds are excluded from income - he pays no tax on the $310,000, and there is no gain measured against his $41,000 of basis.
If he were neither terminally nor chronically ill: basis = premiums paid (about $41,000 plus any whole life premium). The $269,000 gain over basis is ordinary income, not capital gain, and a loss would not be deductible.
Practical checkpoints:
- Get the certification in writing, dated before the sale, and keep it in the file.
- The exclusion is on the proceeds; it does not convert the transaction into a tax-free exchange, so document basis anyway.
- Confirm the settlement provider is licensed in Arizona and that the disclosure document states the gross offer, the fee, and the alternatives (accelerated death benefit, surrender, lapse).
- The accelerated death benefit rider on the converted policy may pay less than $310,000 but costs nothing and avoids the sale entirely - compare the two before signing.