Life Settlements Explained
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What is a life settlement?
A life settlement is the sale of a life insurance policy to an investor for an amount more than the policy’s cash surrender value, but less than the death benefit, or payout value to the beneficiary.
In a life insurance settlement transaction the policyholder transfers ownership to a life settlement provider. The former policy holder is no longer responsible for the policy premiums and receives a cash payment that’s larger than the surrender value of the policy. The life settlement provider is now responsible for all expenses related to the policy.
Read on to learn more about life settlements.
Am I eligible for a life settlement?
The easiest way to check your eligibility is using our life settlement calculator.
Age/Health: Most people that ultimately sell their life insurance are 65+ years old or have a serious medical condition.
Policy Type: Universal, whole, and convertible term policies are all great candidates for a life insurance settlement.
Policy Size: The existing policy should have at least $100,000 of face value.
Should I sell my life insurance?
Common reasons you might consider a life settlement:
- You can no longer afford the premiums. A life settlement is a great way to avoid letting your policy lapse if you can no longer afford the premiums. Letting your policy lapse can lead to little or no payout depending on the policy type.
- You no longer need the policy. Another reason to sell your life insurance is that you no longer have a spouse or children that would be dependent on the claim in the case of your death.
- Your term policy is approaching it’s expiration date. Term policies typically expire with no cash value and expensive replacement costs. You may be able to convert your policy into permanent life insurance and then sell the new policy for cash.
- You are looking to supplement your retirement income. A life insurance settlement allows you to supplement your retirement income so that you can stop penny pinching and really enjoy yourself.
- You are looking to cover unexpected expenses. Selling your life insurance can help you pay for any unexpected expenses you are facing which may include medical bills or long term care.
Pros of a Life Settlement
You get an immediate lump sum payment larger than the surrender value
You no longer have to make premium payments on your policy
You can cover medical and long-term care costs
You will have more money to enjoy your retirement
Cons of a Life Settlement
Your beneficiaries will not receive anything upon your death
You may become ineligible for Medicaid
Unlike a death benefit, life settlement proceeds may be taxed
The payout might not be enough to cover your needs
How to get started with a life settlement
Today, utilizing your life insurance agent and a life settlement company is the most common approach to selling a life insurance policy.
Your life insurance agent may select a life settlement broker to solicit bids for your policy. Both parties have a duty to you and work on your behalf. However, there is a cost for this representation and you will find fees and commissions for the life insurance agent and broker together can be up to 30% of the value of your payout.
Another option is to sell your policy directly to a life settlement provider. While this option can be more cost effective, in that you are not paying brokerage commissions, you will be managing the all of the paperwork and the entire settlement process on your own.
At Mason Finance, we make selling your life insurance simple. We give you an instant estimate of what your policy is worth and match you with a direct policy buyer.
Life insurance settlement transaction process
If you have decided that you want to sell your life insurance policy and gotten started with either an agent, broker, or provider there a few key steps that you should expect. The typical transaction timeline is between 3 and 4 months. It is possible to move faster and some providers can turn around a firm offer in as little as 1 week.
Depending on who you are working with each of the following steps can be more or less involved from the consumer perspective.
- Application: The application may be filled out by hand, online, or some combination of the two. You will need to provide some basic personal information and then sign release forms allowing the company you are working with you to access your medical records and insurance policy illustration.
- Documentation: During the documentation step the company you are working with will take the release forms you signed in your application and attempt to gather your medical records and policy illustration. You may need to follow-up with your doctor’s office or insurance provider to confirm that it is ok to release this information.
- Review: At this point there is enough information to determine the value of your life insurance policy. The life settlement provider(s) will decide whether or not they want to purchase your policy and what they are willing to pay. It is possible that during the review process a settlement provider will determine that it doesn’t make sense to purchase your policy.
- Offer: The life settlement provider will communicate the payout offer either directly to you or your advisor. This offer may be negotiable and you always have the right to walk away from the transaction if you are not satisfied.
- Closing package: The exact contents of a life settlement closing package varies by state. This process can be tedious and may require a number of different signing parties. Some of the most common documents in a closing package include; Letter of competency (LOC), Verification of coverage (VOC), Life settlement contract, Life expectancy reports, Change of ownership form (COO), and Change of beneficiary form (COB).
- Funds Transfer: Once the insurance company has verified change of ownership the payout funds are transferred to the now former policy owner.
How is the value of a policy determined?
There are many factors that determine exactly what a policy is worth in the secondary market. The most important of these are the insured’s life expectancy, the cost to keep the policy in force (expected future premiums), and the face value amount of the policy which is also known as the death benefit.
When a life settlement provider is pricing a policy they are trying to figure out what the expected cash outlay will be until they receive the policy benefit. In order to do this they need to estimate how long the policyholder will live for and how much it will cost to keep the policy active over that period of time.
In an effort to better estimate life expectancy, life settlement providers often collect medical records through HIPAA release forms. With the medical records they can perform a medical underwriting to estimate the life expectancy of the policy owner.
To better understand what it will cost to keep the policy active while the insured is still alive the life settlement provider will look at the policyholder’s “in-force illustration” which is the technical way of saying, information from the insurance provider about what it will cost to keep the policy active moving forward. Again, the policy owner must have given the provider the right to obtain this information.
Once the life settlement provider has an estimate of what it will cost to keep the policy active while the insured remains alive they can compare that cost with the policy’s benefit. At this point, providers use a mathematical model to help them figure out the amount they can pay the policyholder today and still achieve a sufficient return from purchasing the policy.
How are life settlements taxed?
When you sell your policy you will be taxed in three tiers:
- Proceeds received up to the tax basis are free of income tax.
- Proceeds received that are greater than the tax basis up to the amount of the cash surrender value are taxed at ordinary income rates.
- Proceeds received that are in excess of the cash value get taxed as capital gains.
Thanks to the recently passed Tax Cuts and Jobs Act of 2017 (TCJA) your tax basis has now become much easier to calculate. It is simply the cumulative investment you have made in your line insurance contract up until the life settlement transaction.
For more information on how the tax basis was calculated before TCJA check out our blog post on life settlement taxation.
And please keep in mind that Mason Finance does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
How are life settlements regulated?
Life settlements are regulated by each state through their respective departments of insurance.
Today, 43 states and Puerto Rico have comprehensive life settlement laws and regulations. This means that approximately 90% of the US population is protected by state regulations.
One of the key things that life settlement regulation covers is how long a policy owner must have owned their policy before they are eligible to sell. Most of the regulated states have a two year waiting period but if you want to know the specifics for your state you can check out this life settlement regulation map.
Another major part of life settlement regulation is transparency. States that have comprehensive regulation require that policy owners receive substantial disclosure- including the disclosure of compensation paid to brokers.
In addition to disclosure of broker compensation, most states also require that policyholders receive all offers and counteroffers, information on the alternatives to a life settlement, and are told about the risk pertaining to taxation and government assistance programs.
Lastly, states with comprehensive regulation require the licensing of both life settlement brokers and providers. For more information about regulation and industry practices, check out the Life Insurance Settlement Association (LISA).
History of life settlements
Life insurance has been a major part of personal financial planning since its advent in the 1800s.
The legal basis for the secondary market sale of a life insurance policy was established in 1911 in a case, Grigsby v. Russell, that ultimately reached the US Supreme Court.
The case revolved around a life insurance policy taken out by John C. Burchard. In need of a surgical procedure, Burchard sold his policy to his physician, Grigsby, for $100.
A year later Burchard passed away and Grigsby attempted to claim the death benefit. He was challenged by the executor of Burchard’s estate, Russell.
Ultimately the Supreme Court ruling, delivered by Oliver Wendell Holmes, stated:
“So far as reasonable safety permits, it is desirable to give the life policies the ordinary characteristics of property. To deny the right to sell except to persons having such an interest is to diminish appreciably the value of the contract in the owner’s hands.”
This decision, handed down over a century ago, gave legal precedent for the mature and regulated life settlement industry that exists today. This precedent has been reinforced over the years, most recently with the Health Insurance Portability and Accountability Act (HIPAA) in 1996.
The modern life settlement industry began to take form in the 1980s with the establishment of the first life settlement company. With the onset of the AIDS epidemic, many victims faced extremely short life expectancies. Many of those that owned life insurance policies found that they no longer needed the protection but needed cash to pay for experimental treatments. It was under these circumstances that the first “viatical” settlements were created.
Today, viatical settlements are explicitly different from standard life settlements, but it was these early transactions that were the foundation for the life settlement industry as we know it.