In my past article published in the Winter 2019 Philadelphia Estate Planning Council Newsletter “Term Insurance, Beyond the Pricing”, I explored the various reasons why selecting term insurance is more than commodity shopping. Because of the seemingly non-differentiated characteristics of the policy, it seems that the best way to appears an amount of death benefit is to pay the lowest price.
This view of term insurance ignores (at least) one critical component – term conversions.
What is a Term Conversion?
Simply put, the conversion privilege allows the policy owner to recharacterize all or a portion of term insurance to permanent insurance without the need for medical qualification. In this sense, I like to think of term conversions as “insurance for your insurability.”
For insureds that have experienced an adverse change in health since their term insurance policy was issued, conversion provides an avenue to acquire new permanent insurance at their previous more favorable risk class.
Not all term conversion privileges are the same. At inception, different carriers will have specific contractual language that determines a) how long the policy is convertible and b) to what the policy can be converted.
And since this is life insurance – and by definition life insurance can’t be easy – there’s also variations in the strength of that policy language. A policy can be guaranteed convertible to “to any products available” or only to “a permanent policy.” Further (again reference that life insurance can’t be easy), with weak contractual language some carriers may (and have) significantly limit the permanent products that can be used in conversion post issue.
This may be a recurring theme, but the past 12 months have really changed things. From a consumer standpoint, the pandemic has catalyzed many families to review their financial goals and objectives and revisit their estate and protection plans. For the life insurance providers, the combination of mortality uncertainty and underlying economic pressure from a low interest rate environment (Shameless Self Advertisement #2: “The Impact of COVID-19 on the Life Insurance Industry”) has resulted in a shift in the availability of products, but more importantly to this discussion, underwriting restrictions on high risk cases.
At the time of writing, the majority of highly rated insurance carriers in the marketplace have limited issuing policies to underwriting class of at least “Table 4” or “Table D”. This rate class is generally equal to the “Standard” rating plus and an additional 100% premium. For those doing the math at home, it’s double.
For risks that fall further down the table acquiring coverage at this point, whether it is term or permanent, is extremely difficult, if at all possible. A conversion of term insurance is most likely the only way for an individual with impaired health to extend coverage since new underwriting (and the restrictions therein) are not a factor.
During the first few months of the pandemic, the ability to convert term insurance without a medical exam – and potential exposure to the administering nurse – led to a notable increase in term conversions for healthy individuals. Going forward, conversions will continue to be popular because of the ease: no medical exam, no 23-page application, no waiting 4-6 weeks for underwriting to be completed.
When evaluating the options for term insurance, it is critical to understand the term conversion provision of the policy. Recently, several providers have made available different product versions of term insurance that are either fully convertible or non-convertible; other carriers have gone the route of offering a rider (at an increased cost) to extend the duration of the conversion beyond the base product.
It is important to review inforce term insurance regularly to track the conversion deadline, especially if the conversion period is shorter than the guaranteed level period. Additionally, as we’ve seen several times over the past few years, insurers will issue notices that they are making significant changes to their permanent portfolio or creating conversion only products (generally not favorable to the consumer). That is a signal to consider conversion prior to the changes taking place.
Conversion provides an efficient way to change the purpose of coverage. Generally, term insurance is used as the baseline for protection; it is the most cost-efficient way to secure death benefit in the event of a premature death. While term insurance was used to provide income protection or to cover a liability 20 years ago, that may no longer be necessary.
The death benefit can be restructured as a permanent policy meant for legacy planning. The frequency of mortality is still 100%. A permanent policy, specifically one that includes secondary guarantees, can be a valuable addition to a portfolio in the tax-efficient transfer of wealth, while also reducing overall risk.
Permanent insurance can also be designed with a focus on asset accumulation. The cash value within the policy grows tax-free, and when properly constructed, can be accessed income and capital gains tax-free during life. This strategy is effective when the insured is moving from the protection to retirement planning phase of their life cycle.
For young, healthy individuals, term insurance is extremely cost efficient. Logically, after going through the medical qualification process, actuaries are confident that through the law of large numbers the vast majority of term insurance won’t result in a claim. A planning technique is to purchase high quality, convertible term insurance in situations where pure income protection may not be need as an “option” to convert to permanent insurance at a later date for estate planning purposes. Should health deteriorate when the need for permanent insurance is required, this option can be executed and favorable insurance is still attainable.
A Personal Note
My wife was diagnosed with breast cancer in 2017 at the age of 29. A wellness and diet conscious former athlete, her medical profile was that of a healthy young woman. Her family history, however, indicated breast cancer was a significant concern.
Fortunately, her very handsome and smart insurance advisor made sure that she maintained a convertible term policy from a provider that was more expensive than other options, but provided the most robust conversion language.
We were able to convert a portion of her term insurance to a permanent policy at Standard rates. (The Standard rate was because of family history. Again, actuaries are smart people.) As a self-employed acupuncturist, we are able to use the permanent policy as death benefit protection that would be difficult to obtain in the coming years, but also to create a private retirement vehicle in a tax favored manner.
Knowing her family history made the decision to buy convertible term insurance a much easier one. Even without that prior knowledge, clients and their families can’t anticipate a sudden change in health or circumstance. Convertible term insurance not only provides protection against a premature death, but also provides insurance against losing insurability in the future.