Converting a Term Policy to Fund a Buy-Sell
Marcus, 57, owns 60% of a commercial HVAC company valued at $3.2 million; his partner owns 40%. Their buy-sell agreement requires each owner to carry $1.2 million of life insurance payable to the other. Marcus's $1.5 million 10-year term policy expires in 14 months and is convertible through age 65. He was recently diagnosed with Type 2 diabetes (A1c 7.4) and obstructive sleep apnea; he takes metformin and uses CPAP. His current term premium is $2,400 annually. He wants total life premium under $18,000 per year and also needs $500,000 for his spouse. He has $250,000 in a 401(k), $180,000 in taxable savings, and $300,000 home equity. The company's EBITDA is $1.1 million. His partner is healthy. Marcus asks whether to convert the term, apply for new coverage, or rely on savings and the business to fund the obligation.
1. Compare conversion, a new underwritten policy, and self-funding for the buy-sell obligation. What underwriting and policy information do you need before recommending?
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Start with the funding target: $1.2 million for the buy-sell plus $500,000 for the spouse, or $1.7 million total. The buy-sell obligation is contractual and due at death, so 'self-funding' with $430,000 of savings and illiquid business value is not reliable; the surviving partner may not have cash when it is needed.
Conversion is valuable because it preserves insurability and does not require new medical evidence, but the permanent premium for $1.2 million at age 57 may consume most of the $18,000 budget. Request a conversion illustration showing guaranteed and current premiums to age 100 and any limited-pay options. Confirm the conversion deadline and whether the converted policy has a no-lapse guarantee.
A new policy requires full underwriting: attending physician statement, A1c history, sleep study and CPAP compliance, build, medications, and financial justification. Diabetes and sleep apnea usually produce a table rating rather than an automatic decline, but the offer may still be more expensive than expected. A new policy also carries a new contestability and suicide clause for two years. Submit informal inquiries to two carriers while protecting the conversion window. Do not surrender or lapse the term until replacement coverage is delivered.
2. How should the buy-sell policy be owned and beneficiary-designated, and what happens if Marcus dies after the term expires but before replacement coverage is in force?
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The ownership must match the buy-sell agreement. In a cross-purchase arrangement, each owner owns the policy on the other owner and names the other owner as beneficiary. When Marcus dies, his partner receives the $1.2 million income-tax-free and uses it to buy Marcus's shares from his estate. The policy on Marcus is owned by the partner, so it is not included in Marcus's estate. In an entity-owned arrangement, the company owns the policies, receives the death benefit, and redeems the deceased owner's shares; premiums are not deductible, and basis and corporate tax issues must be reviewed.
If the term expires before replacement coverage is issued, the buy-sell is unfunded. The estate may be forced to sell on a promissory note, or the surviving partner may have to borrow. The agreement may permit a lower price or a delayed payment schedule, which is exactly the outcome the funding was meant to prevent. Calendar the expiration date and begin underwriting at least six months before expiration. Keep the existing term in force until the new policy is delivered and the first premium is paid. If conversion is the only viable path, convert enough to cover the $1.2 million obligation and use separate term coverage for the $500,000 spousal need.
3. If the conversion offer is guaranteed universal life at $16,800 for $1.2 million and a new policy is quoted at $9,600 but may be rated Table 4, what do you recommend and why?
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The $16,800 conversion fits the stated premium budget and is guaranteed, but it leaves little room for the $500,000 spousal policy. The $9,600 new-policy quote is not a real offer until underwriting is complete; a Table 4 rating can materially increase the premium, and the policy will be contestable for two years. A table-rated offer might still be cheaper, but the client is trading guaranteed acceptance and guaranteed premium for underwriting uncertainty and a new contestability period.
A practical recommendation is to lock the conversion for the $1.2 million buy-sell amount before the deadline, then apply for a separate $500,000 term policy or a smaller permanent policy for the spouse. If the new policy receives a formal offer that is both guaranteed and substantially cheaper, the client can compare it against the conversion illustration and decide before the conversion deadline. Do not let the term expire while waiting for underwriting. The decision should be documented: the buy-sell obligation is the non-negotiable need; the spousal coverage can be layered with term if premium budget is tight.