The previous article in this series reviewed the first two sections of the RQ. In this document, Richard Weber examines the next section of the RQ that explores possible differences between two policies and gets to the critical bottom line: How many years from now before the proposed policy’s cash surrender values and death benefits exceed those benefits in the current policy?
There’s an important continuum between the Society of Financial Service Professional’s IQ and the American Society of CLU & ChFC’s Replacement Questionnaire (RQ). The IQ helps the agent understand the assumptions the insurance carrier has made in developing and selling the policy and which are then incorporated into a sales illustration. This is especially important because many of the key pricing assumptions are not part of the disclosures in the illustration. But since agents often use the illustration as the basis of a recommendation to substitute a new policy for an old one, the RQ needs to keep reminding the agent of the important disclosures needed for the client to make the right decision.
The second article in this series reviewed the first two section so the RQ. This article will complete the review. The third section of the RQ gets to the critical bottom line: How many years from now before the proposed policy’s cash surrender values and death benefits exceed those benefits in the current policy? Also, if the proposed policy is a variable policy, the RQ recommends that the agent consider the rationale for selecting the illustrated growth rate on the illustration.
The next section of the RQ explores possible differences between the two policies that might not be immediately obvious, such as term and/or paid-up additions riders that might be incorporated into one or the other. Guarantees of both the policy itself and the premiums needed to maintain those guarantees are also explored.
Another troublesome issue in replacements is the nearly ubiquitous use of Code Section 1035 of the Internal Revenue Code. This provision allows for a tax-free exchange of like-kind property — but only if you follow the rules. Some agents and advisors don’t know that if there’s a higher gross cash value in the policy than the net cumulative premiums paid — and there’s a loan outstanding on the policy at the time of the exchange — there will be taxable income. This as an intended '1035' exchange which becomes an actual '1099' exchange! The exchange items in the questionnaire help clarify and remind the agent of issues that need attention.
There are three more issues to consider before recommending a replacement. The first of these are the incontestable provisions. Few clients understand the rules under which a death claim can be held up pending investigation of misstatements or misrepresentations on the application if death occurs within the first two years of the policy. Similarly, most readers of Agatha Christie mysteries are misinformed about the payment of a death claim due to suicide. It’s critical to provide a full explanation of incontestable rights already attained in an existing policy that’s more than two years old, together with the explanation that such rights don’t exist for the first two years of the new policy. I’d recommend a signed acknowledgment from the client that they understand these issues. It might also be prudent to have all current beneficiaries acknowledge their understanding when the policyowner is buying a new policy to replace one that’s more than two years old.
The second key issue involves the contestable provisions within the policy: those extra-contractual tax laws or other changes that have been preserved for policies issued before a particular date. The RQ lists seven possible 'grandfathering' issues:
• Policies issued before 08/06/63 don’t have to meet the 'four out of seven' rule for tax deductibility of loan interest. However, the 1986 Tax Act effectively makes this advantage moot for interest deemed to be personal loan interest.
• Policies issued before 06/20/86 and owned for certain business purposes have no ceiling on deductible loan interest. Policies issued after this date have a $50,000 loan amount limitation on the amount of deductible interest.
• Policies issued before 06/21/88 won’t be subject to the Modified Endowment restrictions imposed on policies issued after this date. Although it appears that some 'grandfathering' follow along with a bona fide exchange, I’d recommend that the client’s legal and tax counsel review this provision.
• Life insurance isn’t the only type of policy subject to replacement concerns. Variable Annuities purchased before 10/21/79 are eligible for a step-up in basis if the owner dies before the annuity start date.
• Annuities issued before 08/14/82 are subject to the more favorable basis-out-first cost recovery rules for withdrawals. Also, these policies aren’t subject to the 10% penalty for withdrawals that generally occur before age 59 1/2.
• Annuities purchased by non-natural persons before 05/12/86 will generally continue to receive tax-deferred accumulation. However, subsequent contributions made to annuities before this date will not be entitled to tax treatment as an annuity.
• Finally, and back to one last Life insurance item, a survivorship policy issued prior to 09/14/89 isn’t subject to the seven pay MEC test if there’s a reduction in benefits.
I’ve noted these technical tax items for educational purposes only. Seek competent legal counsel before applying this information to any specific situation.
My final key issue concerns financial strength ratings. Much has been made of ratings in the past few years. Although financial strength is important, it’s not the sole determining factor in selecting a Life company. Ratings agencies generally have been downgrading carriers as part of an apparent overall strategy to bring the Life insurance industry into alignment with the ratings of companies in the financial services/products sector of the economy. A drop in ratings per se generally isn’t a sufficient reason to replace a policy.
It’s also important to know that there can be differences of opinion among rating agencies. Both agent and policyholder should review the different ratings (available from libraries and the insurance company) if the rating will be a significant factor in the policy replacement decision. I’d suggest inviting the Chief Financial Officer of each company to comment on the replacement recommendation when it focuses on financial strength.
CONCLUSION
The Society of Financial Service Professional’s Replacement Questionnaire (RQ) might be yet another educational breakthrough in helping the Society’s members — and other interested agents — do the right thing in the midst of the debate about this highly charged issue.