Life insurance holders are opting to trade in their old policies for new, better designed or more conservative policies issued by companies in solid financial health these days. But they’re holding on to their variable annuity contracts, as buying new ones in the midst of a big equity market decline might result in a decline in principal. Plus issuers are raising fees and cutting back on benefits. Indeed, tax-free 1035 exchanges of life insurance policies are rising, while the pace of 1035 exchanges for variable annuities has slowed.

Data is hard to come by, but industry experts estimate that over 15 percent of all life insurance sales are due to exchanges, up from 12 percent ten years ago. The 1035 exchanges are particularly popular for universal life insurance with death benefit guarantees, says Howard Drescher, spokesperson for LIMRA. Meanwhile, 40 percent of variable annuity sales were triggered by 1035 exchanges in 2008, down from 50 percent in 2005, says Frank O’Connor, manager of Morningstar’s Variable Annuity Research and Data Service, in Chicago.

To initiate a tax-free 1035 exchange, named for Section 1035 of The Internal Revenue Code, appropriate 1035 exchange forms must be completed by the agent and client. (The new policy is not tax-free if the policyholder cashes out his insurance policy or annuity and then purchases a new one.) Under the IRS rule, tax-free exchanges are permitted when a policy holder wants to switch one life insurance policy for another life insurance policy or an annuity, or when the holder wants to exchange one annuity for another. Annuities cannot be exchanged for life insurance tax-free.

Get a Life
Life insurance holders seem to think now is a good time to get a better deal, says Howard Drescher, spokesperson for LIMRA, Windsor, Conn. For starters, many policyholders and their advisors are worried about the financial health of the life insurance companies issuing their policies. A.M. Best, Standard & Poor’s Moody’s and Fitch have downgraded the ratings on many insurance companies in the past year.

Some life insurance policy holders are also opting for policies with no-lapse guarantees, says Drescher, whose research and consulting company is compiling data on 1035 life insurance policy exchanges. With universal life insurance, policyholders can vary premium payments. They earn a variable interest rate, typically re-set annually by the insurance company, on the cash value portion of their policy. A no-lapse policy prevents the policy from terminating if the cash value build-up fails to cover the cost of the insurance.
“People who are still in good health but are in a poorly designed policy may benefit from a 1035 exchange," says Scott Witt, president of Witt Actuarial Services, New Berlin, Wisc. “The older policy may be too expensive while there is not enough cash value build-up.”

Whitt adds that exchanges often involve poor performing Universal Life Insurance and Universal Variable Life Insurance Polices purchased in the 1980s and 1990s. In the 1980s, for example, people purchased universal policies based on illustrations using high interest rates. Now that interest rates are dramatically lower, cash values are minimal, and premiums may not cover the insurance cost.

Variable universal life policyholders have also been hit by stock market declines this year and are turning to conservative whole life insurance or term insurance, says Whitt.

Others are switching from older whole life insurance policies with high premiums into lower premium universal coverage for extra savings. A 65 year-old policyholder who needs extra income could save nearly $200 monthly on $300,000 of coverage by exchanging a whole life policy for a new universal policy.

But Whitt cites the following drawbacks to 1035 life insurance policy exchanges:
· There may be back-end surrender charges on the older policy.
· The cash value of the older policy will be reduced by commissions on the new policy. Depending on the insurance company, commissions can be as high as 120 percent during the first two years.
· Those who are not in good health may pay higher premiums for a new policy.
· New policies have a two-year contestability period. As a result, the insurer could challenge a death claim due to a misstatement of information in the contract.

Sticking With VAs

On the variable annuity side, severe stock market losses have resulted in a decline in the value of most variable annuities—some have fallen below the value of their principal guarantees. In these cases, conducting a 1035 tax-free exchange would lead to a decline in the benefit base of a holder’s guaranteed lifetime withdrawal benefits or annual income stream in retirement.

“In the future inflows are going to come from new sales, not 1035 exchanges,” said O’Connor. “Existing policyholders don’t want to give up their living benefits.” Plus, carriers are re-tooling benefits for new products, and charging more for them, he says.

Say, for example, a policyholder invested $100,000 in a variable annuity with a 5 percent annual guaranteed lifetime withdrawal benefit. No matter how the underlying investment performed, the policyholder would be guaranteed to get $5,000 in annual income from the annuity when he or she retires, based on that benefit base of $100,000.

But if the policyholder conducted a 1035 tax-free exchange after the account value had dropped to $70,000, he or she would be stuck with a lower benefit base of $70,000. So the new policy, paying the same 5 percent annual guaranteed lifetime withdrawal benefit, would only produce $3,500 in annual income when the policyholder retires.

Registered reps very wisely prefer not to subject their clients to such a scenario.

“Most exchanges are the planned obsolescence variety, not unlike the auto industry, where perfectly good VA products are traded in for new products with the latest flavor of guarantee,” O’Connor continues.

There’s another reason: tighter regulations. FINRA Rule 2821, which covers sales suitability, mandates strict 1035 exchange compliance rules, says Kevin Loffredi, senior vice president of Annuity Intelligence, an Oakbrook Terrace, Il- based report. Under the new rule, limited to variable annuities, registered reps must justify a 1035 exchange. On a new product, your client must either have a step-up in living benefits value and/or higher withdrawal percentage on guaranteed lifetime withdraw benefits, he says. “Moving to a product with more sub accounts doesn’t fly anymore.”

Others stress that a 1035 annuity exchange is a red flag to regulators.
“The rule underscores the importance of good record keeping,” warns William D. Nelson an attorney with the Denver law firm of Rothgerber Johnson & Lyons LLP. “The regulators have a hot button regarding age (of the policyholder) and (1035) exchanges. They will be cautiously scrutinizing sales. The trend is toward disapproving a number of transactions that don’t feel right on a reasonable basis.”

One exception to the downward trend in variable annuity tax-free exchanges involves low-load or no-load variable annuities. Insurance company executives at Ameritas Life, Vanguard and Jefferson National report about 50 percent of their sales are triggered by 1035 exchanges. These companies offer low-cost mutual funds and mortality expense charges that are some 100 basis points less than broker-sold products. The companies say fee-only advisors are exchanging older high-cost variable annuity policies that are past their surrender periods.

Last year, Chris Cordaro, chief investment officer of RegentAtlantic Capital LLC, Chatham, N.J., routed $20 million in 1035 exchanges into no-load variable annuities.

“I’ve had clients with $300,000 to $600,000 in variable annuities with annual expenses of 3 percent,” he says. “They (annuities) were past their surrender period, so I moved them into a no-load annuity with a flat fee of $20 a month and low-cost fund management fees.”