The Replacement That Restarts the Clock
Robert, 61, has held a $250,000 whole life policy for 22 years. Cash surrender value is $68,000 and there is an outstanding policy loan of $22,000 bearing 6% interest. He pays $3,100 a year and this is his only life insurance. Fourteen months ago he had a drug-eluting stent inserted; he completed dual antiplatelet therapy, his cardiologist describes him as stable, and he is back at work full-time as a warehouse supervisor. Robert wants to surrender the old contract, use the roughly $46,000 of net cash value as part of a down payment on a house, and buy $500,000 of 20-year term for $6,400 a year. The agent's commission on the new contract would be about $4,800; renewal commission on the old one is negligible.
1. What must the agent do before this application is submitted, and which two contractual protections restart on the new policy?
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Process: This is a replacement. The agent must complete and sign the replacement notice and comparison disclosure, give Robert written reasons why the new contract is better for him, and let the new insurer notify the existing insurer. Nothing is submitted until Robert has signed the disclosure.
What restarts: the new policy begins a fresh two-year incontestability period (during which the insurer can rescind for misrepresentation on the application) and a fresh two-year suicide exclusion. The 22-year-old contract has long since passed both.
The judgement call: Robert's cardiac history will now be underwritten from scratch - he may be declined, rated, or issued with a cardiac exclusion. If he surrenders first and is then declined, he is uninsured. The agent should submit the new application, obtain underwriting, and only surrender the old policy once the new one is issued, delivered and the first premium paid. Note also that the $22,000 loan keeps accruing interest in the meantime.
2. How is the surrender taxed, and does the $22,000 policy loan change the analysis?
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The taxable event is a policy gain, reported on a T5 and taxed as ordinary income - not as a capital gain. It equals the proceeds of disposition (the $68,000 cash surrender value) minus the policy's adjusted cost basis, which only the insurer can confirm.
The $46,000 net figure is a cash-flow number, not a tax number: repaying the loan is not deductible and does not reduce the gain.
A policy loan larger than the adjusted cost basis would already have triggered a taxable gain when the loan was taken, so the agent must ask whether that happened. If there is a gain, it will be added to Robert's income in the year of surrender, which at 61 may be better timed before or after retirement - a conversation worth having with his accountant before signing anything.
3. Robert says: "Leave the stent off the application. It was a warning, not a disease, and my cardiologist cleared me." What does the agent do?
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Refuse, and say so plainly. The agent cannot decide that a stent is immaterial - the insurer does, and it will obtain the medical records anyway through the attending physician's statement and the prescription database.
The explanation to give Robert: if the stent is omitted, the insurer can rescind the contract within the two-year incontestability period, and his beneficiaries could receive nothing at the exact moment the policy is needed. If it is disclosed and he is rated, he knows where he stands. He can also shop the market through a broker before deciding.
If he still insists on an inaccurate application, the agent declines to submit it, documents the conversation in the file, and does not let him sign a form the agent knows to be wrong. Signing or forwarding a known misrepresentation exposes both of them, and the agent's licence.