A nonforfeiture clause is a clause in an insurance policy with a cash value (for example, a whole life insurance policy) that stipulates what occurs after a lapse in the policy due to nonpayment. It allows a policyholder to receive partial benefits or a partial refund of the premiums they have paid.
Permanent life insurance, long-term disability and long-term care contracts may have nonforfeiture clauses which are triggered when the holder of an insurance contract voluntarily surrenders the policy or misses a premium payment and the grace period for missed payments elapses.
How a nonforfeiture clause works
When a whole-life insurance policy holder surrenders their policy, the nonforfeiture options stipulated by the contract become available. A policy owner can then decide which way they would like to access the policy’s cash value. If a policy owner does not select their preferred nonforfeiture option, policy terms will stipulate which option will be chosen by default.
An important caveat in exercising a nonforfeiture option is that a policy must have cash value. Some policies have no cash value for the first few years due to administrative expenses, commissions and acquisition costs. Typically permanent life insurance generates low returns in the early years of a policy due to these costs.
Automatic premium loans
Some life insurance contracts will initiate automatic premium loans, which use the cash value of your policy as a premium loan toward missed payments. Your coverage and death benefits will remain in force as long as your cash value is equal to or exceeds your overdue payment. Similar to a conventional loan, you will be charged interest on the loan amount, which will be added to the amount of your loan and will be subject to compounding.
What are the nonforfeiture payout options?
Once a whole-life insurance policy is surrendered, the death benefit no longer exists. Prior to issuing payment to the policy owner, outstanding loan amounts are satisfied with the cash value of the policy. Depending on the contract, the following payout options then become available.
Cash surrender value
If you choose a cash surrender value, you will receive the accumulated portion of a permanent life insurance policy’s cash value. The accumulated portion is the savings portion of a whole life policy that is payable before death. Payments are made within six months of surrendering the policy.
The extended-term option allows you to use the cash value of your life insurance policy to purchase a term insurance policy with a death benefit equal to that of your original whole-life policy. This option allows you to stop paying premiums, but not forfeit the ability to access a death benefit. How long your term policy lasts will be found in your policy’s nonforfeiture table.
For many companies, the extended-term insurance policy is the default option selected when surrendering a whole life insurance policy if you do not select another option.
Reduced paid-up insurance
When you elect for reduced paid-up insurance, your insurer will cancel contract premiums for all future years of your policy. Your death benefit will be adjusted to match the paid-up value of your insurance policy, which is calculated based on age, cash surrender value and the number of premiums paid. This benefit will remain constant without requiring additional premiums. Most insurance companies require policyholders to have at least three years of premiums before they are eligible to elect this option.
Reduced paid-up insurance is the only nonforfeiture option that allows you to keep a portion of your original death benefit and continue to benefit from guaranteed cash value or dividends if these are a part of your policy.
Some insurance companies offer an annuity option where the remaining cash value of an insurance policy may be used to purchase an annuity free of commissions and expenses. An annuity offers regular payments over a time period specified in the annuity contract.
Let’s say you are 40 years-old and have a whole life insurance policy with a cash surrender value of $10,000. Your policy stipulates that if you miss a premium payment, you will receive an automatic premium loan to cover the premium payment. You miss a premium payment of $100 and since your contract has a cash value greater than $100, an automatic premium payment loan is made from the cash value of your contract. Upon payment of the contract death benefit, the amount of this premium payment, plus accrued interest, is deducted from your death benefit.
Alternatively, if you choose to surrender your insurance contract you may choose a cash surrender option. When you choose a cash surrender option, your cash value of $10,000 will be paid to you within six months, less any applicable fees.