When opposed to term life insurance, permanent insurance offers various advantages, including lifelong coverage and cash value.
One the other hand, permanent life is more expensive than term life. Furthermore, you may be required to make premium payments 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 make your permanent life insurance premium payments, the life 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 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 guaranteed 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 policies and gives the policyholder three options to access their cash value.
1. Cash Surrender 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.
2. Extended-Term Option
With this option, the policyholder can use the cash value to buy a replacement term life insurance policy. The guaranteed death benefit of the new policy will be same as the death benefit of the original policy. How long the new policy will last depends on the following factors:
- the amount of cash value available
- the face value of your original policy
- your current age
The extended-term is one of two non-forfeiture options available to policyholders who don't want continue to pay premiums, but would like to keep some life insurance protection.
3. Reduced Paid-Up Insurance
Reduced paid up life 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 policy, 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:
- Single-Premium, Immediate Annuity
This allows you to convert your permanent life 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.
- Automatic Premium Loan
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 guaranteed death benefit.
What is reduced paid up insurance?
So you have a permanent life 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 guaranteed 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 life insurance, you use your policy’s cash value to purchase a new permanent life 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 cash surrender value of your original policy (cash surrender value = the policy’s cash value minus surrender charges).
- Your present age
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 policy. 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 policy at age 40 and have been pay 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 policy 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 life 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 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 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 policy, in contrast, is a nonforfeiture option available with many whole life 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.
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 policy may be a better option if your priority is to continue enjoying whole life 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 life 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 features intact.
Some of the main advantages of reduced paid up life insurance are:
No monthly premium payment
Since you are buying the new policy with a lump-sum payment, you will not have to pay monthly premiums.
Your family will receive a death benefit
The payout may be lower, but you can still rest easy knowing your loved ones will receive death benefit when you pass away.
You will continue to accumulate cash value
With reduced paid up life insurance, the new policy retains all the features of whole life policy. That means it will build cash value, which you can use while you are still alive.
Permanent life 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 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.