The Single-Premium Exchange on a Declining UL
Dana, age 62, owns a universal life contract with a $250,000 death benefit, $62,000 of cash value, and a $41,000 cost basis. She pays $3,200 a year, and the current illustration shows the policy lapsing at age 79 if crediting rates hold. Her agent proposes a 1035 exchange into a single-premium guaranteed universal life policy with the same $250,000 death benefit, funded with $58,900 after a $3,100 surrender charge that the new insurer will not absorb. Dana was hospitalized for a cardiac event five months ago and wants the paperwork finished "before the end of the month." The new contract carries a two-year contestability period and a two-year suicide clause.
1. Is this exchange suitable? Quantify the trade-offs and name the facts that would change your recommendation.
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What the exchange solves. The real problem is not cash value; it is the projected lapse at 79. Dana's current policy is not guaranteed, so the $250,000 death benefit could disappear in her early eighties. A guaranteed contract removes that risk permanently, which is the strongest argument in favor.
What it costs.
- Surrender charge: $3,100 of value destroyed and not recovered.
- Tax: realized gain would be $62,000 − $41,000 = $21,000. Section 1035 defers that gain, but only if the funds move directly insurer-to-insurer. If any of the $58,900 is paid to Dana first, the $21,000 is ordinary income.
- Contestability: the new two-year clock restarts. Given a cardiac hospitalization five months ago, any material omission on the application gives the new carrier a rescission right for 24 months. A death at month 18 from an unrelated cause does not protect the claim; the test is material misrepresentation, not cause of death.
Facts that would flip the answer: if the old policy has a no-lapse guarantee rider already, the exchange destroys guaranteed coverage; if Dana needs the cash value for liquidity; if she cannot truthfully qualify under the new application.
2. Because this is a replacement, what must the agent do and document? What is different about the free look?
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Replacement file. The agent must present and read the Notice Regarding Replacement, have Dana sign it, list every policy being replaced, and leave her a copy. The replacing insurer notifies the existing insurer within five business days of the application, and the existing insurer must furnish its policy summary within five business days. The agent keeps the signed notice, the proposal, and the reason for replacement in the file. The "finish it this month" pressure is itself a documentation issue: suitability files that show a deadline imposed by the agent, not the client, are the ones that fail examination.
Free look is the real safety net. On a replacement Dana gets an unconditional right to return the new contract for a full refund of the premium and restoration of the old coverage. That right is why the $3,100 surrender charge and the underwriting risk are recoverable - but only if the agent tells her the deadline in writing rather than burying it in the delivery packet.
Sequencing. Do not surrender the old policy until the new one is issued and delivered. If Dana is declined or rated, she still owns a functioning contract.
3. Dana asks whether she can borrow from the new policy in year three for a kitchen renovation. What does the single-premium design imply?
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It is almost certainly a modified endowment contract. A $58,900 single premium on a $250,000 death benefit funds the contract far faster than the seven-pay limit allows, so the contract fails the 7-pay test and is a MEC. The 1035 exchange itself is still tax-free - moving from a non-MEC to a MEC does not trigger gain - but the access rules change:
- Loans and withdrawals are taxed income first (LIFO), not basis first.
- Pre-age-59½ amounts are also subject to a 10% penalty on the taxable portion.
- If the policy lapses with an outstanding loan, the full loan amount becomes taxable income.
Her old policy permitted basis-first, penalty-free access. That liquidity loss is a genuine cost of the exchange and belongs in the suitability note. If liquidity matters, the alternatives are a lower single premium funded over several years to stay under the 7-pay limit, or a smaller face amount with a larger death benefit retained elsewhere.