What Happens If I Cancel a Life Insurance Policy?

Cancelling a life insurance policy means formally terminating the agreement between the policyholder and the insurance company. This action ends the coverage provided by the policy, meaning the insurer will no longer be obligated to pay a death benefit to beneficiaries upon the insured’s passing. The implications of this decision vary significantly depending on the type of policy held and how long it has been in force.

Cancellation of Term Life Insurance

Term life insurance provides coverage for a specific period, such as 10, 20, or 30 years. This policy offers a death benefit if the insured passes away within the term, and it does not accumulate cash value. When cancelled, coverage ceases, and no cash value payout is involved.

There are typically no surrender charges or penalties. If premiums were paid in advance, a pro-rata refund for the unused portion might be issued. Otherwise, policyholders generally do not receive money back from premiums paid.

Cancellation of Permanent Life Insurance

Permanent life insurance policies (e.g., whole, universal, variable life) differ from term policies by including a cash value component that grows over time. Cancelling a permanent policy involves financial considerations due to this cash value. Cancellation results in the policyholder receiving the cash surrender value.

Cash Surrender Value

The cash surrender value is the amount a policyholder receives when terminating a permanent life insurance policy before maturity or death. This value derives from the policy’s cash value component, accumulating from premiums paid. The cash value grows over time, often through interest or dividends, representing the policyholder’s equity.

Surrender Charges

Insurers often impose surrender charges when a permanent policy is cancelled, particularly in early years. These fees help insurers recover costs associated with issuing and maintaining the policy. Surrender charges are typically higher in initial years (sometimes 100% in the first year) and gradually decrease over 10 to 15 years. This charge reduces the cash surrender value received.

Tax Implications

When cash surrender value is received, a portion may be subject to taxation. If the amount received exceeds total premiums paid (the cost basis), the difference is a taxable gain. This gain is typically taxed as ordinary income, not capital gains, increasing the policyholder’s tax liability. For example, if $20,000 in premiums were paid and the surrender value is $30,000, the $10,000 gain would be taxable.

Outstanding Policy Loans

Outstanding policy loans taken against the cash value will be deducted from the cash surrender value before payout. If an outstanding loan exceeds the policy’s cost basis, the excess may also be subject to income tax. This means that even if the net cash surrender value is lower due to a loan, there could still be a taxable event if the original cash value growth was substantial.

Non-Financial Considerations

Cancelling any type of life insurance policy carries significant non-financial consequences that extend beyond monetary outcomes. The most immediate and impactful result is the complete loss of the death benefit. Once a policy is terminated, beneficiaries will no longer receive financial protection upon the insured’s death, which can leave loved ones without crucial support for expenses like funeral costs, debts, or living expenses.

Cancelling a policy can also affect future insurability. If a policyholder later decides they need new coverage, they will likely need to undergo new medical exams and underwriting processes. As individuals age, or if their health status changes, new premiums will almost certainly be higher than those of the original policy. Additionally, waiting periods for certain policy benefits, which may have been satisfied on the old policy, could reset with a new one.

Exploring Alternatives to Cancellation

Before deciding to cancel a life insurance policy, especially a permanent one, several alternatives can help address changing financial needs without complete termination. These options allow policyholders to retain some form of coverage or access policy value differently. Exploring these possibilities can prevent the complete loss of a death benefit or incurring significant surrender charges.

• Reduced Paid-Up Option: Use accumulated cash value to purchase a smaller, fully paid-up whole life policy. No further premiums are required, and a reduced death benefit remains in force.
• Extended Term Option: Use cash value to purchase a term policy for a specific duration, maintaining the original death benefit. The term length depends on the policy’s cash value and the insured’s age.
• Policy Loans: Borrow against the cash value, using the policy as collateral. These loans have flexible repayment schedules and often lower interest rates than other borrowing, though unpaid interest can reduce the death benefit.
• Reduce Face Amount: Lower the death benefit to reduce premium payments, making the policy more affordable.
• Life Settlement: Sell a permanent policy to a third party for a lump sum, typically more than the cash surrender value but less than the death benefit. Generally for policyholders over 65.
• Viatical Settlement: For policyholders with a terminal or chronic illness (life expectancy two years or less). Offers a higher percentage of the death benefit than life settlements and is often tax-free.

The Cancellation Process

Initiating the cancellation of a life insurance policy requires direct communication with the insurance provider. Policyholders typically need to contact their insurer by phone, through an online portal, or by sending a written request. It is necessary to provide specific information, such as the policy number, and often a formal written request or a signed cancellation form is required.

Some policies include a “free look period,” usually 10 to 30 days after policy delivery, during which cancellation results in a full refund of premiums paid without penalty. If cancelling outside this period, policyholders should confirm any outstanding premiums, loans, or fees that may need to be settled. After submitting the request and any necessary documentation, the insurer will typically provide confirmation of the cancellation, and any eligible cash surrender value payout generally occurs within 30 days.