Lapsing is OK, but not the best idea
By Paul Bannister • Bankrate.com

Once upon a time that insurance policy seemed like a good thing. Now it seems like a financial burden and you're thinking of deep-sixing it.

Should you simply stop paying on it or is there a smarter approach?

You may think you're paying too much for coverage you no longer want, or the policy's cash value isn't growing fast enough, or it isn't needed any more, or you've found a better deal elsewhere.

Other circumstances can apply, too. You might need to pay for rising health-care costs, or the policy's beneficiary has been changed through divorce or death. Perhaps you face a forced liquidation because of bankruptcy or financially tough times, or maybe you just have a simple wish to live your later years in greater financial comfort.

You basically have three options: You can let the policy lapse by ending premium payments, you can surrender it or you can tap the hidden value in the policy through a life settlement.

Allowing a policy to lapse is the easiest thing to do, but probably the least attractive.

A life insurance policy cancels itself, or lapses, when you stop paying the premiums. If it's a term policy, the owner receives nothing. It ends when you stop sending the checks or cancel that standing order.

If it's a whole life policy that has accumulated some cash value, the insurer will use whatever value is in the policy to pay the monthly premiums until that value is used up, and then the policy becomes void.

But that isn't exactly the end of it. And lapsing a policy can have its drawbacks.

"Multiple lapses of policies can suggest to an insurer that you are financially unstable. Because an insurer often pays its agent a commission of more than half of the first year's premium, lapsing a policy early can cost the company money," says Kerry Williams a consumer advocate and information officer in the consumer education and outreach program for the state of California.

"The company pays to insure you, the agent makes his commission, but the company isn't making anything if you get out before they can pass the break-even point.

"The next time you want to insure, you might find yourself rejected for too many lapses, or at the very least have to pay a year's worth of premiums upfront so they are sure of their money.

So lapsing is not the best option. What's next? If it's a whole life or permanent contract, you can turn it in, or surrender the policy.

In that case, you'll receive the cash surrender value of the contract, walk away with a fraction of the policy's worth and start again. But keep in mind, you've been paying to build up your policy's value, you've paid the agent's commission and you've paid for life insurance. Just when you might start to approach the break-even point, you hand it over to the insurer. It's good profit to them.

You get something, but not the handsome return you can expect under option three, if circumstances are right.

Remember, a life insurance policy is property just like a house, stocks, bonds, or a car. You can legally sell the policy to a third party who will continue to pay the premiums for you -- and that third party will get the eventual benefit of the policy's full value when the policy holder passes away.

Typically, the sale, which is called a life settlement, gives you, the policy holder, a lump sum of cash that is less than the face amount of the policy, but is more than the cash surrender value.

Lori Friedman, a financial planner and CEO of Innovative Underwriters Inc., Philadelphia, Pa., says the strategy works best for policies with a minimum face amount of $500,000, when the insured has less than a 12-year life expectancy, has had a change in health since the policy was purchased, and when the policy can be enhanced for the purpose of its sale.

"It's a win-win situation. The policy holder gets more, the purchaser of the policy gets a profit, and the insurer gets the use of the funds during the policy's life," she explains.

In one example provided by Friedman, a 75-year-old hotel developer left his $10 million enterprise to his two sons, and planned to fund his retirement partially through a consultant's salary from the company.

The sons squabbled, the business started to sink and a $4 million life policy on the patriarch's life was in danger of lapsing because the sons could not afford the premiums of $100,000 a year.

By agreeing to sell the policy in a life settlement for 30 percent of its face value, Dad got $1.2 million for his retirement fund and saved $100,000 a year in premiums.

The ownership of the policy transfers to the "funder," who pays the annual premiums until the patriarch's death, when the full $4 million in benefits goes to the purchaser.

For the client, the key question is: What will you get for your policy?

That depends on your age, your life expectancy and your medical condition, plus factors like the insurance company's own rating, what type policy you have and what sort of premiums you're paying.

Most types of life insurance policies, including universal, whole life and converted term, can qualify for a life settlement. You could sell the policy to a friend, but a licensed broker will probably get you a better offer and steer you into a legal deal that will not be challenged later by the insurer.

The broker will not require you to take a medical examination or to pay fees and will complete the transaction in 30 to 45 days. The proceeds are tax free up to the amount of your annual premiums.

Paul Bannister is a freelance writer based in Oregon.

-- Posted: July 28, 2004