Reinstatement, policy loans, and nonforfeiture options

When a premium goes unpaid

A permanent life insurance policy builds cash value, and that cash value belongs to the policyowner in a real sense. Three groups of provisions decide what happens to it when premiums stop, and how the owner can use it while the policy is in force: policy loans, nonforfeiture options and reinstatement.

The sequence starts with a missed premium. The policy stays in full force through the grace period. If the premium is still unpaid when the grace period ends, the policy does not simply vanish. Depending on its provisions and the owner's choices, one of three things happens:

1. An automatic premium loan pays the premium, if the owner elected that provision and there is enough cash value.
2. Otherwise the policy lapses and the cash value is applied under a nonforfeiture option.
3. Later, the owner may apply to reinstate the lapsed policy.

Policy loans

Any policy with a cash value lets the owner borrow from the insurer, using the cash value as collateral. Term insurance has no cash value, so it has no loan provision.

• Amount: up to the policy's loan value, which is essentially the cash value minus the interest that will accrue to the next premium due date.
• No qualification: no credit check and no explanation of how the money will be used. The owner is borrowing against an asset they already own.
• Interest: the policy states the loan interest rate, which may be fixed or variable. Interest the owner does not pay is added to the loan balance.
• No required repayment: the owner can repay on any schedule, or never. Any loan balance plus accrued interest still outstanding is subtracted from the death benefit or from the cash surrender value.
• Termination risk: if the loan plus unpaid interest grows to equal or exceed the cash value, the policy can terminate. The insurer must first give the owner advance written notice, commonly 30 days.
• Deferral: the insurer may delay a loan for up to six months, but not a loan to pay premiums on the policy itself.

A loan is different from a partial withdrawal (available on universal life). A withdrawal permanently removes cash value and is never repaid. A loan leaves the cash value in place as collateral and can be paid back.

The automatic premium loan

The automatic premium loan provision is optional, usually free, and must be elected by the owner. If a premium is still unpaid at the end of the grace period, the insurer automatically lends that premium from the cash value. The policy stays in force at its full face amount, with no lapse. It works only as long as there is enough cash value, and each loan adds to the debt that will reduce the death benefit.

Nonforfeiture options

Nonforfeiture means the owner cannot forfeit the policy's cash value just because premiums stop. The standard nonforfeiture law requires permanent policies to promise it. After premiums have been paid for at least three full years, the owner who surrenders the policy is entitled to a cash surrender value. The owner chooses a paid-up benefit or the cash by making a request within 60 days after the due date of the premium in default. The policy must also show a table of its cash values and other options for each of its first 20 years.

The owner has three choices:

• Cash surrender value: take the cash, minus any loan, and the coverage ends. Any amount received above the premiums paid is generally taxable income.
• Reduced paid-up insurance: the net cash value is used as a single premium to buy a smaller amount of the same type of permanent insurance. It is paid up for life, needs no further premiums, and keeps building cash value.
• Extended term insurance: the net cash value buys term insurance for the same face amount (minus any loan), lasting as long as the cash value will pay for it. When that period ends, so does the coverage.

If the owner makes no choice, the policy applies the option it names automatically. That is most often extended term. Insurers commonly make reduced paid-up the automatic option on policies issued at substandard (rated) premiums, because those insureds would otherwise get expensive term coverage.

Memory aid: reduced paid-up reduces the amount but keeps the coverage for life. Extended term keeps the amount but limits how long it lasts.

Level term policies with no cash value have no nonforfeiture benefits, and the nonforfeiture law excludes them.

Reinstatement

A lapsed policy can usually be reinstated, restored to force as the original contract, instead of the owner buying a new one. The usual requirements:

• Apply within the reinstatement period, commonly 3 years after the lapse (some policies allow 5).
• Provide satisfactory evidence of insurability.
• Pay all overdue premiums, with interest.
• Repay or reinstate any outstanding policy loan, with interest.

Reinstatement is not available if the owner surrendered the policy for cash, or if an extended term period has already run out.

Reinstatement is often better than buying a new policy. The premium stays at the rate for the original issue age, and the accumulated cash values come back. In exchange, a new contestable period usually begins, but it applies only to statements in the reinstatement application. The suicide exclusion period generally does not restart.