Term Replacement After a Diabetes Diagnosis
Daniel, 58, is married, earns $180,000, and has a $220,000 mortgage, $600,000 in retirement savings, and two independent adult children. Six years ago he bought a $750,000 20-year level term policy at preferred rates. He has just been diagnosed with Type 2 diabetes (A1c 8.1%) and hypertension, and his physician added two medications. A producer proposes replacing the term with a $1 million indexed universal life policy with an $18,000 annual premium for 10 years, funded partly by a $40,000 1035 exchange from an old whole life policy and a loan against the new policy's cash value in years 3-5. The producer says, 'The new policy is in force the day it is delivered, so you are covered immediately, and the old term is just wasting money.' Daniel likes the idea of permanent coverage but is worried about cost. He asks whether he can keep the term and buy something smaller.
1. Evaluate the replacement recommendation using a needs analysis and replacement standards. What should the producer do before submitting an application?
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The producer should first identify the need. Daniel's main exposures are income replacement until retirement, the $220,000 mortgage, final expenses, and any desire to leave a legacy. The existing $750,000 term covers the mortgage and income needs for the remaining 14 years at a known preferred rate. There is no obvious permanent need that requires a $1 million policy with an $18,000 premium.
Replacement standards require a comparison of the existing and proposed contracts, disclosure that replacement is occurring, and documentation of why it is suitable. The producer should compare guaranteed premiums, cash-value assumptions, surrender charges, policy-loan risk, the new contestability and suicide periods, and the loss of the term's convertible features. The health change matters: Daniel may no longer qualify at preferred rates, and the new policy may be rated or declined. Funding a policy with loans in years 3-5 increases lapse risk, especially if illustrated crediting rates are not guaranteed.
Before submitting, the producer should give Daniel a written replacement notice, illustrate a smaller permanent policy or a conversion of part of the term, and document Daniel's decision. The recommendation should not be driven by the commission difference. Keeping the term and buying a smaller guaranteed permanent policy may be more suitable than a full replacement.
2. Explain how the contestability period and suicide clause would apply if Daniel died in month 18, and how the producer's 'covered immediately' statement is misleading.
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Delivery and first premium put the contract in force, but 'in force' does not mean the insurer has given up its right to review the application. In most states, a life policy has a contestability period, commonly two years, during which the insurer may rescind for a material misrepresentation. Daniel's diabetes and hypertension are material. If the application disclosed them and the insurer issued the policy anyway, the claim should be paid subject to the suicide clause. If the application omitted or understated them, the insurer may rescind and return premiums.
The suicide clause commonly excludes death by suicide during the first two years, usually returning premiums instead of the face amount. Month 18 falls inside that period. State law varies, so the policy and state rules control.
The producer's statement is misleading because it suggests immediate unconditional coverage. It also distracts from the real risks: replacement restarts contestability and the suicide period, and the new policy may have surrender charges and loan provisions. Daniel should be told that the old term policy's contestability period has already run, which is a significant advantage of keeping it.
3. Suppose Daniel insists on the replacement and the insurer later discovers the producer submitted the application without the diabetes diagnosis. Analyze the duties and consequences.
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The producer has a duty to record the applicant's answers accurately, have Daniel review the application, and correct errors before submission. Submitting an application that omits a known diagnosis is a material misrepresentation, even if the producer thought it would help Daniel 'get issued.' It is not advocacy; it is a false application.
If the omission is discovered during contestability, the insurer may rescind the new policy and return premiums. Daniel's beneficiaries could receive only the premium refund rather than the death benefit. The insurer may also take action against the producer, and the producer faces licensing discipline, errors-and-omissions exposure, and possible civil liability. The replacement notice and suitability file would become evidence.
The proper response is to disclose the diagnosis before submission. If the application has already gone in, the producer should notify the insurer and correct the record immediately. Daniel should understand that a rated or modified offer is better than a policy that can be rescinded. The insurer, not the producer, decides whether the risk is acceptable.