By Tom Lauletta, J.D., Contributing Editor, Business Owner's Toolkit

The news from sunny Florida is that yet another major life insurance company--no names, but you would recognize its logo immediately--stands accused by state insurance regulators of having used unethical (and illegal) practices in connection with the sale of thousands of life insurance policies.

Although this latest complaint involves sales to senior citizens, the mechanism allegedly used--called "churning" or "twisting" in the insurance industry has been around for years and will probably outlive all of us. But we figured that if we gave you an idea of what to look out for, at least you could avoid becoming another victim.

First, let's look at the definition. Simply stated, churning is a transaction involving two factors: (1) An agent convinces you to replace a policy that you now own with a new, usually larger, policy, and (2) the policy replacement is not related to your actual needs.

Although there are variations on the scheme, here is an example of how it usually works:

John Morgan owns a $100,000 ordinary life policy, which now has a cash value of $15,000. Guy Smiley, life insurance agent, convinces Morgan to cancel the policy and roll over the cash value into a new $200,000 policy. Smiley sells the replacement policy based on the fact that Morgan's premium payments for the new policy will be no more--and possibly less--than the premiums charged for the much smaller policy. Is this a great deal, or what?

Although there may in fact be legitimate reasons why a policy owner would want to enter such a replacement transaction--we'll discuss them later--you have to look beyond the "how much do I pay in policy premiums" question before you can decide what to do.

The kicker in the above example is that the cash value of the existing $100,000 policy (which Morgan could largely receive outright if he canceled the policy) is used to prepay a portion of the premiums of the $200,000 policy. In this way the remaining periodic premium payments on the new policy are kept artificially low. But if an unscrupulous agent is out to churn your policy, this is not something that he wants you to understand.

So why would an agent want to churn policies? In a word, commissions. By selling a new policy, the agent will earn new commissions. And since most of the commissions that he collects are front-loaded (that is, he gets paid the largest portion of his commission in the early years of the contract), he could even benefit from churning policies that he himself previously sold to the policy owner. (Although insurance companies have "charge-back" rules, which require agents to pay back to the company a portion of their commissions if the policy is canceled within a certain time period, these rules haven't prevented churning.)

The practice of churning is only one type of illegal insurance sales technique that can subject the insurance company, as well as its agent, to serious penalties (including the revocation of the right to sell insurance in the state). You would think that this liability potential would lead insurance companies to set up the internal controls necessary to make sure that their agents don't use such illegal sales techniques.

Some people would argue that at least some companies were made complacent by the fact that the practice of churning generated millions of dollars in added insurance sales. We'll let you be the judge. In any case, from a strictly narrow economic ground--ignoring legal, ethical and long-term business goodwill considerations--both the agent and the company stand to benefit handily when policies are churned.

So When Is Replacement Not Churning?

Certainly not every case where an agent suggests that you replace an existing policy is churning. The key question is whether the new policy, after considering its advantages and costs, will better serve your needs than the one that you already have.

Remember, just because your life insurance needs have grown is no reason to cancel an existing policy and replace it with a larger one. Normally your best course of action here would be merely to leave the first policy in place, and purchase additional coverage. And if your existing policy gives you the right to purchase more coverage under the policy, carefully consider this option first, since it may be the most cost-effective alternative.

When you come right down to it, there are probably two situations when you should consider replacing an existing life insurance policy:

1. When your circumstances have changed so radically that the existing policy is working at cross-purposes to your needs. (Example: After all your children have left home and you have retired, you want to scale back your life insurance coverage. Most companies will not allow you to reduce coverage under an existing policy; you'll have to apply for a new one.)
2. Where the original policy wasn't very good to begin with, or now seems so in comparison with much better policies that have been since developed by the insurance industry. (Example: If you have a traditional whole life policy that gives you only a minimal return on your cash value, you might want to replace it with a more modern policy (such as a universal variable life policy or a term policy coupled with a disciplined investment plan outside of the policy) that gives you the possibility for greater returns, although usually with somewhat greater risks).

How Do You Avoid the Churning Game?

The first and most important step you can take to avoid churning is to deal only with an insurance agent that you have confidence in. This means a person that you know to be trustworthy, knowledgeable and willing to take the time to fully explain why his proposals truly meet your needs. If you don't personally know such a person, ask friends or business associates for a recommendation.

If you are in doubt about any insurance plan recommended by an agent, don't hesitate to ask the agent to give you a few days to study it. Another possibility is to get competitive bids from other agents. Yet another is to seek the independent advice of an insurance professional (such as a financial planner having expertise with life insurance policies) who would not benefit from your decision to buy or not buy. If you choose any of these courses of action, you can expect a certain amount of resistance from your agent, who normally is trained to "close the deal" at the time that he presents it.

But if the agent stubbornly fights your request for more time or information to consider the purchase, this may be a warning sign that the agent has reason to worry that the proposal won't pass the scrutiny of the regulators, or the marketplace.