Life settlements: Unlocking value from your life insurance policy

In today’s economic climate where investors are on a quest for yield, selling a life insurance policy is a strategic option that can unlock the value of an asset that might otherwise be underutilized.

How life settlements work

Life settlements involve a policy owner selling a life insurance policy to an unrelated third party for more than its cash surrender value and less than its death benefit. The new owner then pays any remaining premiums and the new beneficiary eventually receives the death benefit.

The value of the policy is determined by considering how long the insured is expected to live, the annual premium, the death benefit, and various other policy features. Some people confuse this with the term “viatical settlement,” which actually is a life settlement, but the insured is someone with a terminal disease with a life expectancy of less than two years.

Before life settlements became popular, people who no longer needed or wanted to pay premiums on their life insurance policies had two undesirable alternatives: surrender it for the cash value of the policy (which may be well below the policy’s fair market value) or allow it to lapse. A life settlement provides an attractive alternative, allowing policyholders to sell their in-force life insurance policies for an amount greater than the current cash value of their policy.

When to consider a life settlement

So, when does a life settlement make sense? Here are a few possible scenarios:

• A person age 65 or older experiences a decline in health after the original policy issue. This policy owner needs or desires cash today more than a death benefit for his or her heirs.
• A healthy individual age 65 or older has a term policy that’s going to terminate or lose its ability to convert to a longer-lasting policy without underwriting. The temporary need for the term insurance no longer exists.
• A healthy individual age 70 or older has a policy that’s guaranteed to be in place at his or her passing as long as premiums are paid on time. The policy owner decides to explore the economics of a sale.
• Estate planning needs have changed, such as estate taxes are no longer a concern and the policy owner doesn’t have a desire or need to keep the policy.
• A term policy is nearing the end of a term period but is still able to be converted.
• An owner’s business is being sold or changes are made that result in insurance no longer being needed; for example, in situations involving the sale of a business, where revising a buy/sell agreement or accumulating enough wealth over time eliminates the need for the coverage.
• An executive retires and receives life insurance through deferred compensation but does not need or want it.
• Family situations that require changes in insurance, such as divorce.
• The policy economics have changed, perhaps because the premiums are no longer affordable and the policy has been performing poorly.

Examples of life settlement cases

Here are some real-world examples of how life settlements benefited policy holders:

• A client age 75 had two $2,000,000 policies owned by a business. The business was sold and the life insurance policies were no longer needed. The cash value of each policy was less than $35,000. The first policy was sold in a life settlement for $409,000, and two years later the second policy was sold for $984,000.
• A client age 92 had a trust with six policies, each with $1,500,000 death benefit. Each year the trustee had the difficult task of deciding whether it was worth paying the premium for all of the policies. The client sold three policies for over $1,000,000 each and the trust had money to pay the premiums for the rest of the policies.
• A client age 65 had a $5,000,000 10-year term policy. During estate planning it was determined that a joint policy was best and once it was put into place, the term policy was no longer needed. It was sold for $20,750 — about the same amount that had been paid into the term policy.

Tax treatment of a life settlement

A life settlement involves three key tax considerations. 

• Not taxable: The amount you’ve already paid in premiums on the policy, also known as the cost basis, is not taxable in a life settlement sale. For example, if your cost basis is $30,000 and your policy sells for $75,000, $30,000 of the proceeds are not taxable. The cost basis in life settlements refers to the total amount of premiums that have been paid into the life insurance policy by the policyholder minus any previous withdrawals. It represents the total investment made by the policyholder over the life of the policy.
• Taxed as ordinary income: If the policy’s cash surrender value is greater than the cost basis, the difference between the amounts is taxable as ordinary income. So, if you paid $30,000 on a policy with a cash value of $35,000, the difference of $5,000 would be taxed as ordinary income.
• Taxed as capital gains: To determine how much of your life settlement is taxed as capital gain, subtract the amount subject to ordinary income tax from the total amount subject to tax. In the previous example, that would be $45,000 minus $5,000. So, $40,000 of your life settlement profits would be subject to capital gain taxes.

Potential drawbacks of life settlements

What are some of the drawbacks of a life settlement? Key issues include ensuring the policy owner understands how much will be received, how long the process can take, and how to weigh that information against the benefits of keeping the policy. Additional concerns include:

• Finding the right buyer: Some companies may initially offer substantially lower purchase prices than they’d provide in a competitive environment. This is especially important since life settlements tend to occur within an older population when issues such as mental capacity can be involved.
• Determining policy value: The process for determining the value of the life insurance policy can involve gathering medical records on the insured(s) and obtaining projections showing how long the policy could last in various scenarios. Discussing realistic expectations upfront and maintaining the policy appropriately during this process will ensure the owner has information to make good decisions.
• Emotional considerations: Undertaking an honest assessment of the insured’s life expectancy and how paying insurance premiums on that life can affect emotions and family dynamics.

Food for thought

Historically, if you had a policy that you didn’t want, need, or couldn’t afford as premiums increased over time, your choices could be limited to surrendering the policy for cash value, letting it terminate, or making changes to the coverage. In the current environment with investors searching everywhere for yield and tax law changes, making life settlements potentially more attractive, selling a policy should be seriously considered as a valid option. 

In a life settlement agreement, the current life insurance policy owner transfers the ownership and beneficiary designations to a third party, who receives the death proceeds at the passing of the insured. As a result, this buyer has a financial interest in the seller’s death. A policy owner should consider the continued need for coverage, and, if the policy owner plans to replace the existing policy with another policy, the policy owner should consider the availability, adequacy, and cost of comparable coverage. Policy owners considering the need for cash should consider other less costly alternatives to a life settlement. When an individual decides to sell their policy, they must provide complete access to their medical history, and other personal information, that may affect their life expectancy. This information is requested during the initial application for a life settlement. After the completion of the sale, there may be an ongoing obligation to disclose similar and additional information to the buyer or servicing agent at a subsequent date.

A life settlement may affect the insured’s ability to obtain insurance in the future and the seller’s eligibility for certain public assistance programs, such as Medicaid, and there may be tax consequences. Individuals should discuss the taxation of the proceeds received from a life settlement with their tax advisor. A life settlement transaction may require an extended period of time to complete. Due to complexity of the transaction, fees and costs incurred with the life settlement transaction may be substantially higher than other securities. Once the policy is transferred, the policy owner has no control over subsequent transfers. Valmark and its registered representatives act as brokers on the transaction and may receive a fee from the purchaser. The gross offer will be reduced by commissions and expenses related to the sale. Each client’s experience varies, and there is no guarantee that a life settlement will generate an offer greater than the current cash surrender value. In such cases, the client can always surrender their policy to the carrier if the coverage is no longer needed. Securities are offered through Valmark Securities, Inc. member FINRA and SIPC. Plante Moran Insurance Agency Services, LLC are unaffiliated with Valmark Securities, Inc.