Replacing a 27-Year-Old Whole Life Policy for a Client With a Recent Stroke
Margaret, age 71, has held a $150,000 whole life policy since 1998. It carries $48,000 of cash value against $70,200 of premiums paid, and her current premium is $2,650 a year. A producer she met at a seminar proposes replacing it with a $250,000 universal life policy funded at $11,400 a year; the new contract has a 10-year surrender charge schedule beginning at $11,400. Margaret had an ischemic stroke 14 months ago and takes three medications. She has a $30,000 CD maturing next month, no other life insurance, and a daughter who depends on her. She tells the producer to write it up so the new policy starts right away.
1. Before any application is signed, what must the producer do under Oregon's replacement rules, and what must the replacing and existing insurers do?
Read the worked answer
This is a replacement: an existing life policy would be lapsed or surrendered to obtain new life insurance.
Producer duties before the application
- Present and read the Notice Regarding Replacement to Margaret; both she and the producer sign it.
- List every policy being replaced (insurer, policy number, face amount, cash value).
- Leave a copy of the notice with her, and give her a Buyer's Guide plus a policy summary or comparison of the existing and proposed coverage.
- Submit the signed notice with the application to the replacing insurer.
- Recommend replacement only if it is actually in her interest, and never use the notice or comparison as a misleading sales tool.
Insurer duties
- The replacing insurer must notify the existing insurer within the period the regulation allows (commonly 5 business days of receiving the application) and forward the replacement notice, giving the existing insurer a chance to conserve the business.
- The new policy must be delivered with an extended free-look right - 30 days on a replacement under the NAIC replacement model that Oregon follows, longer than the standard 10-day life free look - and the notice must disclose it.
- Both insurers must keep replacement records available for examination.
Because Margaret is 71 with a stroke 14 months ago, the producer must also document suitability; replacements at older ages draw extra insurer scrutiny and the producer's file should show the comparison she was given.
2. Identify the specific risks this replacement creates for Margaret, and state whether she should surrender the old policy when she signs the application.
Read the worked answer
She should not surrender anything when she signs. The facts create five distinct risks:
- Underwriting risk (the decisive one). A stroke 14 months ago makes her a likely postpone, table rating, or decline. If she surrenders the 1998 policy first and the new one is declined or heavily rated, she is 71 with a dependent daughter and no coverage.
- Fresh contestability and suicide clauses. The 27-year-old contract has been incontestable since 2001. The new policy restarts a two-year contestable period on a 71-year-old's health history.
- Price and guarantees. $11,400 versus $2,650 is $8,750 more per year - $87,500 over ten years - for a universal life contract whose illustration assumes current interest and charges. At her age, adverse credited rates or rising cost of insurance can force a lapse, while the whole life contract has guaranteed premiums and guaranteed cash values.
- Lock-in. A 10-year surrender charge starting at $11,400 means the decision cannot be cheaply reversed.
- Lost value. She gives up a contract with a known dividend and guaranteed history and pays new acquisition costs at the worst possible age.
Correct sequencing: apply first; do not lapse or surrender the old policy until the new policy is issued, delivered, and the free-look period has expired. Even then, compare holding the old policy and using the $30,000 CD for any additional need. If replacement is genuinely justified, use a 1035 exchange rather than a surrender.
3. Does surrendering the old policy create a taxable event, and is a 1035 exchange necessary?
Read the worked answer
No taxable gain arises, and tax should not drive this decision.
- Cash value is $48,000 against $70,200 of premiums paid, so a surrender produces no income - there is a loss of about $22,200. Gain inside a life policy is ordinary income when received; a loss on the surrender of a personal policy is generally not deductible.
- Because there is no gain, surrender and 1035 exchange are tax-equivalent on these numbers. The 1035 exchange (IRC 1035, life to life, same insured) is still mechanically preferable: it carries the $70,200 basis into the new contract, avoids constructive receipt, and keeps the transaction from being reported as a taxable surrender.
- The genuine cost of this replacement is not tax. It is the surrender charge, the loss of guarantees, the underwriting exposure on a recent stroke, and $8,750 a year of added premium.
- One future trap: if the new universal life policy later lapses with a loan outstanding, the loan can become taxable income at that time to the extent it exceeds basis.