Don’t Take Term Convertibility for Granted
By Greg Freeman, JD, ChFC, CLU, RICP, CLTC
For almost all of my time in the industry, term policies have been convertible to permanent coverage. The right was automatic, just a part of the contract that everyone bought. Today, the privilege has been modified to being something less than it used to be or even optional. The question is whether advisors should take the option by way of higher price or selection of a carrier that offers it. Of course, as with many other elements of insurance design, the answer comes down to client needs and objectives. It can also come down to whether it is a good deal or not.
Sure, we all see term insurance as the cheapest way to obtain some mortality protection, so long as we are working with a need that may only impact our clients prior to a later age, say age 70. So, since we are trying to cover a need at the lowest cost, haven’t we nailed it with the most basic of stripped-down term insurance policies? Why even bother with some additional feature that will likely be abandoned along with the policy in some later year?
This is where it can get interesting. What are the chances that a term policy will end up paying out a death benefit? Industry articles tend to report the claims rate at somewhere around 1-2%, probably closer to 1%. But if you ask your client whether the chances are greater that the client could end up losing his or her insurability during the term coverage period, you are likely to hear that the insurability risk is greater than the mortality risk. So, if the loss of insurability is more likely to occur, why are we focusing only on the mortality risk? Of course, the way we cover insurability risk is with a conversion option. If your client were to become uninsurable or insurable at higher pricing due to poor health, that conversion privilege could be quite valuable.
Few people ever purchase term insurance with the plan to later convert to permanent. Yes, there might be someone who understands present values or has done serious math to conclude that rather than buying permanent coverage now, they should start with term. In my experience, the decision to convert has been an unplanned situation, where insurability has been lost. We have worked with clients who have been in car accidents, faced newly diagnosed cardiovascular issues, and even found an early onset long term cognitive decline. In each case, the ability to convert their term insurance made a huge difference for their families.
I need to mention two other areas where convertibility can be very important. First, you may have clients who are likely to be facing estate taxes in the future. If they own term insurance now, they might want to make sure it is convertible for that future time when the current need is less, but the permanent estate tax need has emerged. We expect that the estate tax exemptions in the future will be much less forgiving, leaving many more families in need of coverage to protect them from the impact of estate taxes. And that coverage will only be available to so those who are insurable or have other term coverage that is convertible.
The second group of people we want to highlight are those who are considered key persons in their company. They may be covered either to protect the company from losing them or as a fringe benefit that makes employment with their company more attractive. The convertibility option can give the employer important flexibility if the key employee’s health takes a turn for the worse. And the coverage that is given to the employee as part of his or her compensation will take on much more value if it remains convertible in the event of an adverse health event.
So, while there is little reason to give up convertibility, advisors still need to make a decision about the cost. As mentioned earlier, some term policies with no conversion can be cheaper, and some carriers may offer you a choice of taking conversion or not. There is likely to be a cost difference. Also, you might encounter a list of choices that are priced substantially the same, some with good conversion privileges and others with poor or no conversion. In those cases, convertibility should easily break the tie.
We recommend that your review of pricing have two key components, a qualitative analysis and a simple cost consideration. On the qualitative side, you need to ask: 1) convertible for how long? and 2) convertible to what? Some carriers limit the time when they will allow conversion. We used to think of the option as lasting for the length of the term’s guaranteed premium period, but carriers are now limiting the option to an age, such as 65, or a shorter period of time, such as 5-7 years. While still valuable, these limitations can be far less valuable than we may have assumed in the past.
The “convertible to what” question is also one you never want to miss. On the good end of the spectrum, there are carriers who allow conversion to any permanent product they offer at the time of conversion. This makes sure your client can access the best products available. At the other end of the spectrum are those carriers who have only one permanent product built for conversion, and it is quite often a stinker. That specific conversion product could have premiums that are higher than the market prices by 50% or more. Sure, if your client is uninsurable, the high -priced conversion product is still the best deal he or she could ever secure at that time, but there will be some regret over which term product they started with in the first place. Related to this is the very expensive term sold by our friends at Acme Mutual. They say you are paying more for their term because you can convert to their whole life product of which they are very proud. Someone needs to let them know that their whole life product is also not so hot, and their customers will be paying more before and after the conversion.
Finally, there is the question of cost. Sure, the conversion privilege is of value, but at what cost? I already noted that where conversion products are priced at virtually the same premium as nonconvertible products, the choice is easy. Not only that, but term insurance is so cheap to begin with, the extra pricing for convertible policies is hardly worth the analysis. The safe bet is to just pay the slight difference. However, we do have an opportunity to see a price difference that is quite quantifiable. This shows up in the two term policies offered by Penn Mutual. They offer term insurance with and without the conversion. While there is a difference in rates among the various ages and duration of coverage, one example we have seen is that the term conversion costs around 7-8%. If you want to check this out for yourself, just go to AdvisorServe.com and run a term quote. For a male, age 40, preferred, looking for $1,000,000 of 20 year non-convertible term, the monthly premium at Penn Mutual is $71.47 per month. If you then scroll down the list to the Penn Mutual quote for convertible term, the monthly rate will be slightly higher, at $77.37. The cost of protecting insurability would be a mere $5.90 per month.
By the way, don’t just think about clients who are considering whether to have convertibility added to their new coverage. What about your clients who own term right now and may have suffered a decline in health? They might be the very people who should activate a conversion right now. Having set them up with convertibility, don’t forget it when the time is right to convert. You don’t want to be “that guy (or gal)” who failed to take advantage of a very valuable financial option because it remained hidden in an old policy.
At the end of the day, your advice regarding convertibility can become incredibly valuable. While many clients may opt for cheaper non-convertible policies, we believe that more clients should be considering the conversion option rather than chasing down the absolute cheapest policies. It is a discussion you can have with your client that shows you are thoughtful and valuable to them. It should become a choice that is made with eyes wide open. And when those tragic situations occur where a client later becomes uninsurable, you will be an absolute hero.