Life Insurance Lapse: Understanding Why Policies Lapse

Rebecca Parson
Rebecca Parson

Rebecca Parson

Author

Rebecca Parson is a financial and tech writer with 10 years of experience writing about topics such as life insurance, commodities investing, and the SaaS industry. She has a master’s degree from Johns Hopkins University and a bachelor’s degree from the University of Mary Washington. Her writing has appeared at money.com, sacbee.com, cart.com, herodevs.com, blanchardgold.com, and more.

Brian OConnel
Brian OConnel

Brian O'Connel

Contributor

Brian O’Connell has been a contributing writer for U.S News & World Report since 2016. A former Wall Street bond trader and the author of two best-selling books; “The 401k Millionaire” and “CNBC’s Creating Wealth”, he has 20 years experience covering business news and trends, particularly in the business and financial sectors. He believes education is the best gift a financial consumer can receive – and brings that philosophy to every story he writes. His byline has appeared in dozens of top-tier national business publications, including CBS News, Bloomberg, Time, MSN Money, The Wall Street Journal, CNBC, TheStreet.com, Yahoo Finance, CBS Marketwatch, and many more.

By Rebecca Parson, Brian O'Connel
Author, Contributor, Life Insurance
life insurance lapse

Life insurance is a critical financial safety net for families, individuals, and businesses.

However, when a life insurance lapses, it poses a significant risk to policyholders’ financial health and their beneficiaries’ financial security.

In this article we will explore why policyholders allow their policies to lapse, alternatives to letting a policy lapse, and essential strategies to prevent lapses.

What is a Life Insurance Policy Lapse?

If you stop paying your life insurance premium and let the grace period slip by, your policy will lapse, meaning your coverage stops dead in its tracks. But, don’t lose hope just yet – depending on what your policy says, you might be able to bring it back to life by jumping through a few hoops.

Common Contributing Factors for Life Insurance Lapsing

Several factors can contribute to life insurance lapse rates, including socioeconomic status, policy type, and age of the policyholder. 

Policyholders with lower incomes are at a higher risk of allowing their policies to lapse due to financial strain. When the budget is tight, they may view life insurance as an unnecessary expense, especially if they struggle to see the value or are unsure how it works.

Policy type can also play a significant role in lapse rates. Term life insurance policies often have higher lapse rates than permanent life insurance due to their lower initial costs, set amount of years the initial term covers, and lack of cash value.

Age also plays a crucial role. As policyholders age, their need for insurance may decrease while the premiums needed to keep the policy in good standing increase. These two factors are the primary contributors of policies lapsing. Additionally, the cost of premiums increases with age, making it more challenging to maintain coverage for those on fixed incomes

Why Do People Let Their Life Insurance Policies Lapse?

Three variables primarily drive the reasons life insurance policies lapse. Let’s unpack these:

  • Premium Affordability: One of the most common reasons for lapses is the inability to sustain level premiums or increasing premiums as the insured ages. Ensuring that the premium amounts align with the policyholder’s financial situation is critical for long-term policy sustainability.
  • Financial Obligations: As the wheel of life turns, many policyholders have fewer or no beneficiaries as their children become financially independent. The lack of an insurable interest may reduce the need for life insurance and make the increasing premium burden a wholly unnecessary expense. This can cause policyholders to look at their annual statements and opt for a cash surrender value. This surrender value may be similar to what they would receive if they let the policy lapse but is preferable to burdensome monthly premiums. 
  • Economic Downturn: Economic downturns often result in households cutting discretionary spending. This discretionary cut can include life insurance premiums, making policies more susceptible to lapses during financial hardship. Families should plan accordingly and understand how long the policy’s cash value will cover the cost of insurance (COI) and when more premiums are necessary to keep the policy in good standing. 

What Happens When a Life Insurance Policy Lapses?

When a life insurance policy lapses, the coverage ends. The beneficiaries will not receive any death benefit upon the insured’s passing unless they reinstate or revive their policies before that happens. Policyholders have a grace period during which they can make up missed payments and reinstate their policies. However, the length of the grace period is not guaranteed and may vary depending on the insurance company’s policies.

What Strategies Can Help Prevent Life Insurance Policies from Lapsing?

There are several crucial strategies policyholders and financial advisors can adopt to avoid policy lapses. These include:

  • Reviewing the policy: As circumstances change, so do insurance needs. Periodically reviewing the policy can ensure that it remains suitable and meets the policyholder’s current and future needs.
  • Premium Planning: Understanding when premiums will increase is essential in avoiding unpleasant surprises and preparing accordingly.
  • Life Settlement: Exploring options before surrendering a policy: Before surrendering a policy or allowing it to lapse, seek alternatives such as borrowing against the cash value or selling the policy in a life settlement transaction. 
  • Education: Many lapses are due to a need to understand the policy’s benefits and financial implications. Educating policyholders on all available options can help them make truly informed decisions about their life insurance.

Alternatives To Lapsing A Life Insurance Policy

Life insurance policyholders should understand the alternatives to lapsing, and financial advisors should offer informed guidance. These options can include:

  • Life Settlement: A life settlement is a financial transaction in which a policyholder sells their life insurance policy to a third party for more than its cash surrender value but less than the face value. This option is becoming increasingly popular among seniors who no longer need coverage or cannot afford the increasing premiums as they age.
  • Policy Loans: Some types of life insurance policies allow policyholders to borrow against the cash value of their policies. While loans must be repaid with interest, this option can provide access to much-needed funds without surrendering the policy or reducing coverage.
  • Reduced Coverage. In some cases, reducing coverage or benefit amounts may be possible rather than surrendering a policy entirely. This can help policyholders save on premiums while maintaining some level of coverage.

Managing Life Insurance Policies for Financial Security

Policy lapse rates aren’t just numbers on an actuarial table; they represent the potential collapse of financial safety nets. For policyholders, staying informed and taking an active role in understanding and managing their insurance is crucial. Financial advisors ensure that the financial products they recommend are perfectly tailored and continue to serve their intended purpose with time.

This exploration of life insurance lapse rates should underscore the need for an informed approach to managing life insurance policies. By understanding the factors contributing to lapses and the severe consequences that can follow, individuals and advisors can work together to navigate life insurance more effectively.

As we’ve seen, to guard against these risks, continual vigilance and a willingness to adapt policies are essential. Remember, your life insurance is only as good as it is active, so take the reins on managing your coverage with the insight and care it deserves.

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