Nonforfeiture Options
When a permanent life insurance policy has accumulated cash value and the policy owner stops paying premiums, nonforfeiture options determine what happens to that value. These options are required by state law to protect policy owners from losing their accumulated equity.
What Are Nonforfeiture Options?
Nonforfeiture options (also called nonforfeiture values) are the choices available to a policy owner who stops paying premiums on a permanent life insurance policy that has cash value.
Why They Exist
| Purpose | Benefit |
|---|---|
| Protect equity | Policy owner doesn't lose accumulated value |
| Required by law | Standard nonforfeiture law in all states |
| Provide choices | Multiple options to fit different needs |
When They Apply
Nonforfeiture options apply when:
- Premiums are no longer being paid
- Policy has accumulated cash value
- Grace period has expired
Cash Surrender Value
The cash surrender value option allows the policy owner to terminate the policy and receive the accumulated cash value in a lump sum.
How It Works
| Step | Action |
|---|---|
| 1 | Policy owner requests surrender |
| 2 | Insurer calculates cash value |
| 3 | Surrender charges (if any) deducted |
| 4 | Outstanding loans deducted |
| 5 | Net cash surrender value paid |
Cash Surrender Value Calculation
| Component | Effect |
|---|---|
| Cash value | Starting point |
| Minus surrender charges | Early surrender fees (may apply in first 10-15 years) |
| Minus outstanding loans | Any policy loans with interest |
| Equals | Net cash surrender value |
Tax Implications
| Situation | Tax Treatment |
|---|---|
| CSV > premiums paid | Gain is taxable as ordinary income |
| CSV ≤ premiums paid | No taxable gain |
When to Consider
- Policy is no longer needed
- Cash is needed for other purposes
- Better options available for the money
- Policy performance is disappointing
Reduced Paid-Up Insurance
Reduced paid-up insurance uses the cash value to purchase a smaller amount of permanent life insurance that requires no further premium payments.
How It Works
| Feature | Description |
|---|---|
| Death benefit | Lower than original face amount |
| Premiums | None required—policy is paid up |
| Coverage type | Same type as original (whole life) |
| Duration | Lifetime coverage |
| Cash value | Continues to grow |
Calculation
The cash surrender value is used as a single premium to purchase whatever amount of paid-up whole life insurance that amount will buy at the insured's attained age.
Example
| Item | Amount |
|---|---|
| Original face amount | $500,000 |
| Cash surrender value | $75,000 |
| Reduced paid-up amount | $175,000 |
Advantages
| Advantage | Explanation |
|---|---|
| Lifetime coverage | Protection continues for life |
| No more premiums | Policy is fully paid |
| Cash value grows | Continues to accumulate |
| No tax on switch | Not a taxable event |
Disadvantages
| Disadvantage | Explanation |
|---|---|
| Lower death benefit | Significantly less than original |
| Cannot be undone | Generally irreversible |
| May not meet needs | Reduced coverage may be inadequate |
Extended Term Insurance
Extended term insurance uses the cash value to purchase term insurance for the original face amount for as long as the cash value will fund.
How It Works
| Feature | Description |
|---|---|
| Death benefit | Same as original face amount |
| Premiums | None required |
| Coverage type | Term insurance |
| Duration | Limited—based on cash value |
| Cash value | None (term policy) |
Calculation
The cash surrender value is used as a single premium to purchase as much term insurance at the original face amount as possible, given the insured's attained age.
Example
| Item | Amount |
|---|---|
| Original face amount | $500,000 |
| Cash surrender value | $75,000 |
| Extended term period | 12 years, 6 months |
Advantages
| Advantage | Explanation |
|---|---|
| Full death benefit | Original face amount maintained |
| No more premiums | No payments required |
| Maximum protection | Highest benefit for the cash available |
Disadvantages
| Disadvantage | Explanation |
|---|---|
| Coverage ends | Terminates after the extended period |
| No cash value | Term insurance has no savings |
| No flexibility | Cannot extend beyond calculated period |
Comparison of Nonforfeiture Options
| Feature | Cash Surrender | Reduced Paid-Up | Extended Term |
|---|---|---|---|
| Cash received | Yes, immediately | No | No |
| Coverage continues | No | Yes | Yes (limited time) |
| Death benefit | None | Lower | Same as original |
| Premiums required | None (policy ends) | None | None |
| Duration | Policy ends | Lifetime | Limited period |
| Cash value | Paid out | Continues growing | None |
Automatic Nonforfeiture Provision
If the policy owner does not select a nonforfeiture option, the policy will automatically apply a default option.
Common Defaults
| Default Option | Description |
|---|---|
| Extended term | Most common automatic default |
| Automatic premium loan | If selected, loans cover premiums |
| Reduced paid-up | Some policies default to this |
Automatic Premium Loan (APL)
If the APL provision is elected, when a premium is due and not paid:
- The insurer automatically borrows from cash value
- Loan pays the premium
- Policy remains in full force
- Interest is charged on the loan
Exam Tip: The automatic nonforfeiture option is usually extended term insurance unless the policy owner has previously selected automatic premium loan.
Key Takeaways
- Nonforfeiture options protect policy owners from losing cash value when premiums stop
- Cash surrender provides immediate cash but ends coverage
- Reduced paid-up provides lifetime coverage at a lower death benefit
- Extended term provides the original death benefit for a limited time
- Most policies default to extended term if no selection is made
- APL can prevent lapse by automatically borrowing to pay premiums
- Nonforfeiture options are required by state law
The nonforfeiture option that provides the original face amount of coverage for a limited period of time is:
Reduced paid-up insurance differs from extended term insurance in that reduced paid-up:
If a policy owner stops paying premiums and does not select a nonforfeiture option, the policy will typically:
11.2 Dividend Options (Participating Policies)
Continue learning