Replacement and Honest Sales Practices

Understanding Policy Replacement and Financed Purchases

Replacement may occur when a consumer buys a new life insurance policy or annuity and, in connection with that purchase, takes one of the specified actions affecting an existing contract, such as surrendering it, reducing its benefits, or borrowing against its value. This occurs when an existing policy is surrendered, lapsed, or completely terminated. It can also occur when, in connection with a new purchase, an existing life policy is converted to reduced paid-up insurance or extended term insurance, whether or not that change frees up funds. Furthermore, replacement can include amending an existing policy to reduce its benefits or shorten its coverage period, as well as pledging an existing policy as collateral or borrowing substantially against its values as defined by state law.

A financed purchase is a specific form of replacement. It involves using funds obtained by withdrawing money, borrowing against, or surrendering an existing policy or annuity to pay premiums on a new contract. Using withdrawals, surrender proceeds, or policy loans from existing coverage to fund a new purchase generally triggers state replacement rules.

The primary purpose of replacement regulations is to protect consumers from unnecessary or harmful policy exchanges. These regulations mandate full and fair disclosure of all relevant facts so applicants can make informed decisions. While replacing a policy is not illegal, it can often disadvantage the client. A replacement may reduce early cash values because a new cash value policy incurs upfront expenses and commissions that reduce early accumulation, even when value from the old contract is transferred. Premiums are also frequently higher because the insured is older than when the original policy was purchased. Additionally, existing policies may contain favorable settlement options or guaranteed interest rates that are not offered in modern contracts. A replacement policy generally establishes its own contestability period and may start a new suicide exclusion period if the contract includes that exclusion, subject to state law.

In certain situations, a replacement may be justified. For example, an insured whose term policy is expiring may have an ongoing need for permanent coverage. A replacement may also be justified if the existing insurer has experienced severe financial instability. However, state replacement regulations typically exempt specific transactions. Credit life insurance policies are commonly exempt. Group life insurance and group annuities are generally exempt when there is no direct solicitation of individuals by a producer. Transactions where a new policy is issued by the same insurer under an existing contractual conversion right are also generally exempt.