By J. Brendan Ryan
Enquirer contributor

I sometimes recommend that people in certain circumstances replace their current whole-life or universal-life policies with newer, more profitable or more flexible policies.

When one cancels a policy during his lifetime, tax is usually exacted on the "profit" - that is, the difference between the total amount paid over the years and the total received from the policy. So, typically, such replacements should be done by following certain steps in order to effect a tax-free exchange. This delays and can even totally avoid that taxation.

But the flip side must also be analyzed in each case. Certainly, in many cases the original policy should be retained. Here are some reasons why.

• Contestability. For the first two years of a policy, the insurer can contest and, if successful, void the policy. This could occur if the insurer finds out that the applicant told less than the whole truth on a fact that would have in influenced the insurer's decision to issue the policy. Starting a new policy means starting a new contestability clause.

• Underwriting Class. If your health has changed for the worse since your original policy was issued, or if you have taken up smoking or entered into a risky occupation or recreational pastime, the cost of the insurance may be more than what you are giving up. When it comes to recreation, such as flying a plane or skydiving, you may be asked when applying or a new policy if you prefer to pay more to be covered for death from such activity or if you prefer to have such a manner of death excluded. (If you choose the latter and then die as a result of such recreation, the insurer pays to the beneficiary all premiums paid but no other death benefit.) If none of the risk behaviors existed when you got the first policy, they are covered by it.

• Existing loan. This can be an important consideration for many policies where some cash value in the policy has been borrowed.

Your existing policy may have a "wash loan" provision that kicks in after a certain number of years. This says that the interest credited to your cash value each year will equal the loan interest that you have to pay. In that sense the loan costs you nothing. Your new policy, if it has such a provision, will certainly not make it available for the first 10 or 15 years.

Worse, if you drop a policy after having borrowed part or all of the profit, as defined above, that profit will be taxed as ordinary income.

The tax-free exchange can come to the rescue. But some insurers don't agree that the law allows the rollover of policy loans, so these insurers won't issue the replacement policy under the exchange rules if the original policy has a loan against it. They would have you either first pay off the loan or cancel the old policy and pay the tax on any imputed gain before applying for the new insurance.

Fortunately, some companies believe that the law does allow you to roll over the loan to the new policy. In this situation be sure that the insurer's procedure dictates that no tax notice is sent to the Internal Revenue Service in conjunction with the rollover.

• Minimum interest rate. All non-variable universal-life policies guarantee a minimum interest rate that they will credit to the cash value. Many newer policies have a lower minimum than older ones. For many people this will be important.

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J. Brendan Ryan is a Cincinnati insurance agent. His column appears every other Saturday. Contact him at 2212 Victory Parkway, Cincinnati 45206; 221-1454; fax 221-3447; or e-mail ryanatpineridge@aol.com