Be wary of offers to 'replace' your current policy

By Ginger Applegarth

When it comes to "replacement" life insurance policies, the best advice is: Don't do it.

The concept sounds simple enough, but there's a kicker. Every time a life insurance policy is replaced (or sold by an agent or financial planner who gets a commission on that sale), it comes out of the policyholder's pocket.

A sorry history

Replacement became a huge problem, and a source of embarrassment, in the insurance industry in the 1970s and '80s when interest rates were high.

Several relatively new and aggressive life insurance companies produced payout projections beating anything the traditional stalwarts were offering. But it was all a mirage. Many of the companies were taken over by their state insurance commissions because they were insolvent, leaving the policyholders without insurance or a payout.

Partly out of a reaction to this debacle and to make the insurance industry more professional, most life insurance applications now include a question asking if this new policy is replacing an old one. If so, the agent must provide a detailed explanation.

Additionally, most states now require life insurance agents to file "notifications of replacement" with their state insurance commissions and to comply with various regulations.

The cost of replacing your life insurance

If you think about it, you replace other investments all the time. So why not life insurance? Because those other investments don't have the upfront costs that insurance charges.

There are underwriting expenses, marketing and administrative fees, sales commissions -- the list goes on. Those upfront fees often exceed the premium you've got to pay as well. Replacing term insurance doesn't matter as much, because you're generally just buying the cheapest policy for the time period needed.

The major problem is with permanent insurance, because the agent has the most to gain (the commissions are usually much higher than for term insurance) and the consumer has the most to lose (paying those commissions).

Here's how it works: You meet with your life insurance agent or financial planner who tells you that the policy you bought three years ago just isn't right for you anymore, and there's a new version that's just perfect. You buy the new policy because it looks great on paper. However, for you, it's like going back to the starting line, because you have to pay the same start-up costs as before.

That means it will be that much longer before your cash value equals the premiums you paid. Frankly, unless you're buying a new no-load (commission-free) policy, you're paying two commissions.

Higher commissions for your agent

You may wonder why it matters, if the same agent who sold you the first policy is the one selling you the second. The agent's already getting a commission off the first policy, right? The difference is in the amount of the commission.

The commissions are much higher during the first few years of a policy. A permanent insurance policy might pay 50% of the first year's premium as commission, 20% in the second year and 5% for the next five years. The total paid in commissions often exceeds the cost of the first year of your premium.

If you balk at paying these commissions and go to a fee-only financial planner instead, compare the cost. The planner's fee is still money that you're paying to get the insurance advice.

When it makes sense to replace a policy

The Society of Financial Service Professionals says, "Replacing an existing life insurance policy with a new one generally is not in the policyholder's best interest." But there are circumstances where it makes sense to replace an old policy with a new one.

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