When a permanent life insurance policy lapses due to non-payment, or when the policyholder chooses to surrender the coverage, the nonforfeiture clause helps protect the accumulated cash value. Nonforfeiture clauses stipulate how a policyholder can receive their policy’s cash value, allowing them to receive a lump-sum payment or apply the funds to continuing coverage.
A nonforfeiture clause determines how an insurance policyholder can receive their policy’s accumulated cash value in the event of a lapse due to non-payment, or when the policyholder chooses to surrender the coverage. The terms and conditions of a life insurance policy require you to make premium payments.
In addition to a death benefit, permanent life insurance policies also build a cash value over time. A nonforfeiture clause, which stipulates that a policyholder will not forfeit their accumulated cash value if they stop paying premiums, is part of many permanent life insurance policies.
Let’s say you have a $120,000 whole life policy that has accumulated a cash value of $30,000. Six months ago, you lost your job and now can’t afford the premium payments. If your policy lapses due to non-payment, you are still entitled to the accumulated cash value if your policy contains a nonforfeiture clause.
After a policyholder has paid premium payments for a sufficient period, the policy’s nonforfeiture clause may apply if the policy lapses due to non-payment. The nonforfeiture clause may also kick in if the policyholder surrenders the policy. The amount of money an insurer will return to the policyholder depends on the policy’s surrender value. This is the amount the policyholder can borrow or withdraw from the accumulated cash value.
Surrender value and cash value are two different things. The cash value is the amount a policy is worth as it grows over time. If you take an early withdrawal from the policy, you will most likely have to pay a steep fee, which will affect the remaining value—the surrender value.
When a policyholder chooses to surrender their life insurance policy or if it lapses due to non-payment, they may have several payout options.
Automatic premium loan: When a policy lapses due to non-payment, some insurance companies allow the policyholder to borrow the amount of lapsed payments from their policy’s accumulated cash value. This option is only available when the lapsed premiums amount is less than or equal to a policy’s cash value.
Cash surrender value: With this option, the insurance company cancels the policy and pays its cash surrender value in one lump-sum payment. Most state insurance codes enable insurers to take up to six months to make the payment. And once the carrier cancels the policy, it cannot reinstate the coverage.
Extended term: The extended-term option enables the policyholder to use the cash value from the original policy to purchase term life insurance coverage. The length of the term will depend on the amount of cash value accumulated in the original permanent life policy. Nonforfeiture clauses stipulate a default payout, which is often the extended term option.
Reduced paid-up: This option allows the policyholder to use the cash surrender value to purchase another permanent life policy of the same type with a single lump-sum payment. The new policy will have a reduced face value but will accumulate a cash value without paying further premiums.
Single-premium annuity: Some carriers enable a policyholder to use the cash surrender value to purchase an annuity. The amount of the lump sum payment will depend on the amount of the original policy’s accumulated cash value and will pay the policyholder for the remainder of their life.
Retains accumulated cash value: A nonforfeiture clause safeguards a policy’s investment by allowing the policyholder to cash out the accumulated cash value.
Option to continue life insurance coverage: The cash value of a policy protected by a nonforfeiture clause may also be used to purchase another policy or annuity.
Reduced death benefit: When the policyholder chooses the extended term or reduced paid-up options, they can retain life insurance coverage, but with a reduced death benefit.
Loss of coverage: Choosing the cash surrender value option enables the policyholder to keep their accumulated cash value, but it also cancels the life insurance coverage.
A nonforfeiture clause ensures that a permanent life insurance policy owner will not lose their accumulated cash value. While it’s an important financial safeguard, it requires the policyholder to make wise choices when selecting a payout option.
Sometimes, a policyholder may no longer need the life insurance coverage. In such cases, receiving a lump-sum payout can prove beneficial. But when a policy lapses due to non-payment and the policyholder still needs life insurance coverage, nonforfeiture options, which often reduce coverage, can leave them with insufficient protection.
When opposed to term life insurance, permanent life insurance offers various advantages, including lifelong coverage and cash value.
One the other hand, permanent life insurance is more expensive than term life. Furthermore, you may be required to pay the premiums for the rest of your life (or at least until age 100).
What if, a decade or two of making payments, you decide you no longer want to continue? Is cancelling the coverage and collecting the cash surrender value your only option?
Not at all. If you fail to pay your permanent life insurance premiums, the insurance company will most likely offer you some non-forfeiture options.
Reduced paid-up insurance is an alternative to canceling your policy. It allows you to use the cash value from your existing policy to purchase a smaller whole life insurance policy with a one-time payment.
Continue reading to find out more about reduced paid-up insurance, how it works, and when it can be a smart option.
What is a non-forfeiture clause?
In addition to the death benefit, permanent life insurance policies accumulate cash value overtime. The non-forfeiture clause (or provision) ensures that the policyholder will not lose their accumulated cash value if the policy lapses due to non-payment of premiums or the policyholder cancelling their coverage.
A non-forfeiture clause is included in most permanent life insurance policies and gives the policyholder three options to access their cash value.
If the policyholder chooses this payout option, the insurance provider will pay the cash value minus surrender charges. At that point, the coverage will end and the policy cannot be reinstated.
With this option, the policyholder can use the cash value to buy a replacement term life insurance policy. The death benefit of the new policy will be same as that of the original policy. How long the new policy will last depends on the following factors:
The extended-term is one of two non-forfeiture options available to policyholders who don't want to continue paying premiums, but would like to keep some life insurance protection.
Reduced paid-up insurance is the other option that allows you to keep some life insurance coverage. Just like the extended-term option, it provides peace of mind knowing that your family will receive financial assistance in the event of your death.
When you sign up for permanent life insurance, you will be asked to select a non-forfeiture option. If you do not select one, the insurer will use the default option, which is mentioned in your policy document. Usually, the extended term is the default non-forfeiture option.
Apart from the three options listed above, some insurance companies also offer the following two options:
This allows you to convert your permanent life insurance policy into an annuity. An annuity provides you with a consistent source of income for the rest of your life. The amount of income you receive is determined by the cash value of your insurance and your present age.
If the policyholder fails to pay a scheduled monthly premium, the automatic premium loan provision allows the insurance carrier to withdraw money from the policy’s cash value and use it as a loan to pay the missed premium. This may be a win-win situation for both the insurer and the policyholder. The insurer can collect the owed premium while the policyholder is able to keep their policy active instead of having it lapse due to the non-payment.
The automatic loan does not reduce the death benefit, but it accrues interest. If you die before you can pay off the loan in full, the outstanding balance will be deducted from the death benefit.
What is reduced paid-up insurance?
So you have a permanent life insurance policy. You no longer want to pay the monthly premiums, but want your coverage to continue. You can opt for a paid-up option in which the death benefit is reduced and no future premium payments are required.
This is referred to as "reduced paid-up insurance"; “reduced” because your new death benefit is less than the original and “paid-up” because future premiums are not payable.
Basically, with reduced paid-up insurance, you use your policy’s cash value to purchase a new permanent life insurance plan with a single premium payment. The new policy will have a smaller death benefit, but the coverage will be guaranteed for life. Also, you will no longer have to make premium payments every month.
How much coverage you buy depends on two things:
The new policy will have the same terms and conditions as the original policy. However, all riders included in your original will be dropped.
The new life insurance plan will also accumulate cash value, which you can access by making a withdrawal or taking out a policy loan. You do not really need to repay the withdrawn or borrowed amount since it is your money after all. However, in that case, the death benefit will be reduced in proportion to the cash value accessed.
The reduced paid-up option is available only for permanent life insurance. Since term life insurance policies have no cash value, they do not offer this option.
How does reduced paid-up insurance work?
Let's say you purchased a whole life insurance policy at age 40 and have been paying premiums for the last two decades.
You are approaching retirement age, and no longer want to pay monthly premiums, but would like to maintain some life insurance coverage. Given this, surrendering your policy for its cash value may not be an ideal solution, since a new policy at age 60 can be expensive, especially if your health is not what it used to be. Instead, the reduced paid-up option would suit your situation.
Once you have informed the insurer about your intention, they will determine your policy’s cash value, which let us say is $21,000. After factoring in your current age, the insurer decides that the maximum death benefit it can offer you in exchange for a one-time payment of $21,000 is $42,190. You feel the new death benefit is sufficient for your needs and fill out the required application to purchase reduced paid-up insurance.
Your new policy will continue to accumulate cash value, which you can access at any time while you are still alive. Your beneficiaries will receive the death benefit upon your death.
What is the difference between the reduced paid up option and a paid up addition?
A paid-up addition is a miniature whole life insurance policy that you can add to your original whole life policy. Because the additional coverage is paid in full upfront, you will not have to pay any future premiums. The add-on policy builds cash value and can earn dividends.
A paid-up addition is an option available on whole life insurance plans offered by mutual life insurance companies. Mutual insurance companies issue dividends to policyholders, depending on the company’s annual performance. Policyholders can use the dividend payments to buy additional whole life insurance without having to undergo any medical underwriting.
The reduced paid-up option, in contrast, is a nonforfeiture option available with many whole life insurance policies, including those issued by non-mutual life insurance companies. It allows the policyholder to purchase a smaller whole life insurance policy by making a single premium payment using the existing policy’s cash value. This way, the policyholder can avoid paying any more premiums and continue enjoying life insurance protection.
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What is the difference between the reduced paid up-option and the extended term insurance nonforfeiture option?
Both the reduced paid-up and extended term insurance options allow you to use the cash value to pay for new life insurance coverage in full.
However, there are key differences between the two.
To sum it up, reduced paid-up insurance may be a better option if your priority is to continue enjoying whole life insurance coverage, even if it is reduced.
On the other hand, extended term insurance makes sense if you want to keep the original death benefit intact and do not mind losing lifelong coverage and the cash value feature.
Who is reduced paid up insurance best for?
Reduced paid-up insurance is a good choice for policyholders who are struggling to make whole life insurance premium payments, but want to keep death benefit protection in place, and do not mind reducing the coverage amount in order to keep all the whole life insurance features intact.
Some of the main advantages of reduced paid up insurance are:
Permanent life insurance policies usually come with a non-forfeiture clause that ensures policyholders do not lose their accumulated cash value if they stop paying premiums. Insurance providers generally offer several non-forfeiture options, one of which is reduced paid-up insurance.
Reduced paid-up insurance option lets you purchase a new permanent life policy with a single premium payment using your existing plan’s cash value. The new policy will have a lower death benefit, but it will accumulate cash value and last your entire lifetime.
Reduced paid-up insurance is a viable option for those who want to stop paying insurance premiums but would like their beneficiaries to receive some death benefit when they die. For more information on this, reach out to a Dundas Life insurance expert today.