Things to Know About Life Insurance Settlements
A life insurance policy is an asset similar to real estate, stocks, bonds or personal property like an automobile. As a result, a life insurance policy can be sold like any other asset. The sale of a life insurance policy is called a life insurance settlement.
In 1911, the U.S. Supreme Court ruled in the case of Grigsby v. Russell that a life insurance policy is a personal asset and as such could be assigned or sold by the policyholder to a third party for cash.
In the 1980s – largely as a result of the HIV/AIDs epidemic – many terminally ill patients in need of money to pay for medical care helped establish the secondary market for the sale and purchase of life insurance policies based on viatical settlements.
A viatical settlement is different from a life settlement. In order to qualify for a viatical settlement, a policyholder needs to show that they are terminally ill or suffer from a permanent chronic illness. Although the process is different, viatical settlements helped identify and solidify the option to sell policies in financial markets.
The evolution of life settlements became more popular through the late 1990s and into the next century. Seniors in America increasingly discovered life insurance settlements as an option to sell unneeded or unwanted policies. Life insurance settlements became a preferred option to a policyholder other than letting a policy lapse or taking a cash surrender.
In 2008 and 2009, as a result of the financial crisis and corresponding recession, policyholders settled approximately $8 billion worth of U.S. life insurance. A survey at the time showed that about 80% of seniors owned some type of life insurance but more half were unaware of their ability to sell their policies for cash.
In the current day, life insurance settlements continue to be attractive investment opportunities for institutional investors, private equity groups and other large portfolio managers. A life insurance settlement is essentially treated like a zero coupon bond for investment purposes.
When is a life settlement right for you?
As a result, your life insurance policy has value and a market where investors are willing to pay several multiples of what a policyholder would receive from a simple cash surrender. Life insurance settlements can provide cash relief for individuals that no longer need, want or can’t afford their existing life insurance. A life settlement can be a great alternative for the insured in the following circumstances:
(1) Retired and no longer needs income replacement at death or his/her children are grown and no longer need protecting.
(2) Sold his/her business and the key person policy is no longer needed.
(3) Purchased the policy as part of an estate tax planning strategy which is no longer necessary.
(4) Retired and has encountered unexpected long-term healthcare expenses.
(5) Wants to obtain significant cash from a settlement to reinvest in something else or spend it.
Unfortunately, Americans let their existing policies lapse at the rate of 4-5% per year. Two-hundred billion a year of life insurance goes uncollected resulting from those policy lapses. Ninety percent of seniors who lapse or surrender their policies say they would have considered selling their policy through a life settlement if they were made aware of the possibility.
Determining life settlement value
The basic qualifications for a life settlement is policyholders are 65 or older, the face amount of the death benefit is $250,000 or more and an insured’s life expectancy is considered to be 20 years or less.
The lower the premiums and the shorter the life expectancy, the higher the selling price. The greater the amount of premiums that need to be paid and the longer the investor must wait for the death benefit, the lower the policy value.
There are basically four elements to determining the value of a policy:
- Amount of the death benefit to be paid pursuant to the policy.
- The remaining expected life of the insured.
- The amount of premiums to be paid until the death benefit is paid.
- The discount rate or required rate of return on the purchaser/investors investment.
While every case is different, the death benefit is known in each case. In most cases, the amount of the annual premium payments can be calculated with a reasonable amount of certainty. The one variable that is the most difficult to predict is the remaining life expectancy of the insured. Trying to determine how long an insured will live is at best uncertain based on an insured’s age, gender, health and lifestyle.
Finally, the selling price of a policy will always be greater than the cash surrender value but less than the death benefit.
Tax consequences of a life settlement
When a policy-owner sells a life insurance policy, he/she is taxed on the sale proceeds in three tiers. First, sale proceeds received up to the tax basis (total premiums paid) are free of any tax. Second, proceeds received that are greater than the tax basis up to the amount of the cash surrender value on the policy are taxed at ordinary income tax rates. Third, proceeds received in excess of the amount from tier two get taxed as capital gains.
For those individuals 65 or older with in-force life insurance or with life insurance policies owned by a previously created trust should consider determining whether a life insurance settlement may provide a replacement dollars for proceeds lost in other investments.
If you have an insurance policy that you may no longer need, can no longer afford or you simply want cash now to reinvest or spend, a life insurance settlement may be right for you.
Dan A. Penning is the principal advisor with the Penning Group-Strategic Advisors. Dan practiced law for over 30 years prior to forming the Penning Group in the areas of business and family asset succession planning and estate planning.