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 cash. The amount received is more than the policy’s cash surrender value, but less than the death benefit. People often pursue life settlements when they need money to pay for retirement, long-term care, or other expenses.
In a life settlement transaction, a seller transfers ownership of their policy to a buyer.
All aspects of ownership transfer, including the premium payments and death benefit, meaning that the original policyholder’s beneficiaries no longer receive anything upon the death of the (formerly) insured.
In exchange, the original policyholder receives a cash payment that is largely tax-free.
This page provides an in-depth look at life settlements, including how they work, how they’re regulated, the history, and much more.
Life Settlement Eligibility
While all circumstances are different, there are a few things that will boost the possibility of selling your life insurance. Here are very basic life settlement eligibility requirements:
- Age/Health: Most people that sell their life insurance are over 65 years old or have a serious medical condition.
- Policy Type: Eligible types include universal, whole, and convertible term policies.
- Policy Size: Most policies have a face value of $100,000 or more.
Reasons to Sell Your Life Insurance
People sell their life insurance for many different reasons. The majority of those reasons are related to the fact that the policyholder needs money during life more than their beneficiary needs money after they are gone.
It is a decision that should be weighed carefully. If you are unsure if a life settlement is right for you, contact your trusted financial advisor to discuss your options.
Some of the most common reasons to pursue a life settlement include:
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. If you let your policy lapse, you might receive a portion of the cash surrender value, but if you sell your policy, you’ll almost always get more.
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. If you don’t have anyone who needs the policy’s benefit, it makes sense to pursue a life settlement and access the cash while you’re still alive.
Your Term Policy Is Approaching Its Expiration Date
Term policies typically expire with no cash value and have expensive replacement costs. You may be able to convert your term policy into permanent life insurance and then sell the new plan for cash.
You Are Looking To Supplement Your Retirement Income
The vast majority of Americans don’t have enough money saved to make life comfortable during retirement. A life insurance settlement allows you to supplement your retirement income so you can stop penny-pinching and enjoy your golden years.
You Are Looking To Cover Unexpected Expenses
Unexpected expenses can have a devastating impact on your finances, especially during retirement. Selling your life insurance can help you pay for any unforeseen obstacles like medical bills or long-term care.
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.
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.
Life Settlement Options
If you are looking to sell your existing life insurance policy, you have several options. The most common life settlements options are traditional, viatical, and retained death benefit settlements.
A traditional life settlement is the most common way to sell your life insurance policy. If you are over 65 years old and have a permanent life insurance policy (or a convertible term policy) that is worth over $100,000, you are potentially eligible for a traditional life settlement.
A viatical settlement is the term used for life settlements when the insured is chronically or terminally ill.
Since the insured person has a shorter life expectancy, the investment by the buyer will have a higher return and will be realized sooner. Therefore, viatical settlements pay more to the policyholder than traditional life settlements.
Viatical settlements work well for policyholders that need money for treatments, improved quality of life, and fighting illness.
Retained Death Benefit
A retained death benefit allows the policyholder to retain a portion of the death benefit after a life settlement. Since they are not selling the full policy, they receive a smaller settlement.
A retained death benefit settlement works well if you have financial needs now, but still need to provide for your loved ones later.
Life Settlement Transaction Process
There are a few standard steps to expect when you sell your life insurance policy. The timeline for this process can vary, but a typical transaction takes 3-4 months, and some providers can expedite the process to as little as a few weeks.
The typical life insurance settlement process looks like this:
- Application: The first step of the process is to fill out an application. The form may be filled out online, by hand, or some combination of the two. The application will ask for basic personal information, including your age and health, along with questions about your life insurance policy. During the application process, you will be asked to sign release forms that allow access to your medical records and insurance policy illustration. These records are needed to determine the cash payout amount.
- Documentation: The settlement company will use the release forms 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 okay 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 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 (such as your broker or insurance agent). 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 vary by state. This process can be tedious and may require several different signing parties. Some of the most common documents in a closing package include a 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 the change of ownership, the payout funds are transferred to the (now former) policy owner. Funds can be released through a single direct deposit or check, or through a serious of payments over a pre-determined period.
How Is The Value Of A Policy Determined?
When calculating a payout amount, life settlement providers attempts to determine how much they will pay into the policy until they receive the death benefit. They want to make sure the investment is worth it.
The most critical factors life settlement companies look at when determining the value of a policy are:
- Life expectancy.
- Cost of keeping the policy in force (expected future premiums).
- The face value amount of the policy (death benefit).
During the application process, the insured signs HIPAA medical release forms. These are used during the medical underwriting process to determine a sellers life expectancy. Life expectancy is critical for estimating a policy’s in-force illustration.
An in-force illustration is information from the insurance provider about what it will cost to keep the policy active moving forward. The policyholder must give the provider permission to obtain this information.
The final part of the valuation process compares the death benefit amount with the projected costs of keeping the policy active. This is easily calculated by looking at the in-force illustration and the seller’s life expectancy.
Life insurance companies then use complex mathematical models to calculate what price they are willing to pay for the policy to get a fair return on the investment.
It’s morbid to think about, but life settlement providers only profit when a policy seller passes away. For this reason, policies are more valuable if the seller has a shorter life expectancy.
How Life Expectancy is Calculated
As we mentioned above, when determining a policy’s value, life settlement companies look very closely at life expectancy.
Basic life expectancy calculators, like this one from the Social Security Administration, only look at age and sex. The models used by life settlement companies are much more complex.
Both life settlement companies and your insurance agency use actuarial tables and medical underwriting when calculating your life expectancy.
Actuarial tables are used to estimate life expectancies based on population averages. Data points can include age, gender, smoking habits, stress-inducing debt, and other lifestyle choices.
Medical underwriting assesses your future health outlook based on your medical records and various statistics to determine the cost of your premiums.
Combining your health assessment with an actuarial table can provide a reasonably accurate estimate of how long you will live.
This whole process used to takes weeks, but new ways of determining life expectancy are emerging. Now that medical records, Medicare data, and insurance claim data are being entered electronically, it is possible to use that data to determine life expectancy quickly using computer simulations.
Life Settlement Taxation
When you sell your policy, you are taxed in three tiers:
- Proceeds (the money you get for your life settlement) 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.
So, the amount of taxable income is usually calculated by subtracting the tax basis (the total amount you’ve paid in premiums) from the amount you receive in the settlement.
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?
State regulations protect over 90% of the nation’s life insurance policyholders.
Each state has a department of insurance, and almost all of them regulate life settlements. Currently, Puerto Rico and 43 of the United States have comprehensive laws and regulations concerning life settlements and viatical settlements.
Most regulations cover:
- The age or length of ownership of a policy before the owner can sell it.
- Disclosure of other offers.
- Disclosure of alternatives to life settlements.
- Disclosure of taxation risks.
- Disclosure of risks to aid and assistance programs.
- Licensing of brokers and agents.
Let’s look at some of these regulations to see exactly how they pertain to life settlements.
Most states require that a policy is owned or in force for a certain length of time before it can be sold. That time period is typically two years. You can check this life settlement regulation map to see the specific rules for your state.
Disclosure And Transparency
States require a high level of transparency in life settlement transactions in order to protect policyholders.
The policyholder must be made aware of all of the risks associated with selling the policy. For instance, some policyholders may find that their Medicare or other government assistance benefits may end as the result of a large payout. This is not usually the case, but it can happen.
Similarly, the life settlement company or broker must fully explain the process of taxation so that the policyholder knows how much of the settlement proceeds they will actually be able to keep untaxed.
Lastly, the policyholder must be apprised of the amount the broker or brokers receive in compensation.
All of these transparency requirements are designed to protect policyholders. If you have questions at any time during the transaction process, be sure to ask, since most states require the purchaser to disclose all of this important information.
Most states require that brokers and life settlement providers are licensed in the state of the policyholder. Insurance agents, who can act in your interest during this process, are usually licensed as well.
Life Insurance Settlement Association (LISA)
In addition to legal regulations, the Life Insurance Settlement Association (LISA) monitors best practices.
LISA is an industry association that acts as a governing body for the most respected life insurance settlement companies in the marketplace.
Each LISA member agrees to its bylaws and best practices before being vetted and approved for membership. They must also maintain full compliance with these regulations and codes of ethics.
Members include life settlement companies, as well as persons and entities associated with the life settlement industry like brokers, financers, medical underwriters, lawyers, and more.
LISA’s influence goes beyond guiding its members in ethical practices and industry norms. They are also active in participating in the creation of laws in states that regulate life settlements by providing language and conceptual information to the writers of those laws.
LISA currently operates from their headquarters in Washington D.C. after moving there from Orlando, FL. You can learn more about their bylaws and codes of ethics here.
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 life settlements was established the 1911 U.S. Supreme Court case, Grigsby v. Russell.
The case revolved around the sale John C. Burchard’s life insurance policy to his physician, Grigsby, for $100 to pay for Burchard’s necessary surgery.
When Burchard passed away, Grigsby attempted to claim the death benefit. However, the executor of Burchard’s estate, R.L. Russell, challenged the claim.
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 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.
For many years, life settlements were uncommon. They became increasingly relevant with the rise of life expectancy and especially in response to the AIDS epidemic.
The first life settlement company was established in the 1980s when AIDS patients began to face extremely short life expectancies. Many found that they no longer needed life insurance as much as they 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.
Risks (And How to Protect Yourself)
As with most financial transactions, there are a few risks you should be aware of while you’re considering a life insurance settlement.
Broker fees and commissions can greatly affect your payout. Protect yourself by asking your settlement provider for a detailed breakdown to ensure there are no surprises. Most states require transparent disclosures regarding fees, so make sure to ask.
As we mentioned above, most of the proceeds from a life settlement are tax-free. But if the money you put into your life insurance grew exponentially due to investments, be prepared to pay taxes.
Leaving Your Beneficiaries With Nothing
It is important to remember that with any life settlement (other than retained death benefit settlements), you are forfeiting any death benefit for your loved ones. For some people, this isn’t a problem since their would-be beneficiaries are financially healthy.
Before you make a decision, consider the effect that decision will have on your loved ones.
Stranger-Originated Life Insurance (STOLI)
STOLI (Stranger-Originated Life Insurance) is illegal in most states. STOLI is essentially a way for unethical investors to benefit from the death of a stranger. That is a very basic definition.
Most states have laws that prevent anyone who does not have an insurable interest in the life of the insured person to take out a life insurance policy on that person. An insurable interest is one in which a policyholder will be affected financially by the death of the insured. An example of a person with insurable interest would be a spouse or a child of the insured person.
A STOLI scenario is one in which a stranger takes out a policy on a person who is expected to die soon and sells the policy to a third party investor without having paid many or any premium payments.
STOLI is one of the main reasons that most states have a two-year waiting policy before a life insurance policy can be sold.
Myths & Misconceptions
Even though life settlements have been around for many years, there are still a lot of misconceptions.
Here are some of the most common myths, and the truth about those myths, so you can be better informed when making your life settlement decision.
Myth #1: Life Settlements Are Unregulated
As we outlined above, most states have state regulations regarding life settlements and over 90% of policyholders are protected by such regulations. Additionally, LISA and other industry associations have requirements, regulations, and industry standards that govern members.
Myth #2: Life Settlements Are Scams
Life settlements should not be associated with illegal or marginally legal practices like STOLI.
A very basic way to think of life settlements is this: You have an asset (a policy), and a buyer wants to purchase that asset. You sell that asset for some money now, and the buyer gets a little bit more money down the road. It’s mutually beneficial for all parties involved.
Life settlements are highly regulated legal transactions. If you are not confident about navigating a life settlement on your own, seek the professional help of a life settlement broker or your insurance agent, both have a legal, fiduciary responsibility to act in your best interest.
Myth #3: Life Settlements Are Only For The Rich
While most life settlements are arranged on policies that are worth $100,000 or more, the lower limit is actually $50,000 face value. Even if your policy is worth less than normal, the amount you receive in a life settlement can still have a huge impact on your financial situation.
Myth #4: Only Permanent Policies Are Eligible
Term life policies can be sold if they are converted into whole or universal life policies.
When you purchased your policy, you may have added what is called a conversion rider. A conversion rider allows you to convert the policy before the expiration of the term.
While a conversion rider makes it easy to convert a policy, most insurance companies allow conversion without it if there is a need to sell the policy for financial reasons, especially in the case of terminal illness.
Myth #5: You Have To Be Sick To Be Eligible For A Life Settlement
You do not have to be sick to pursue a life settlement. Viatical settlements, on the other hand, are designed for policyholders with a relatively short life expectancy. A traditional life settlement has no such requirement.
Myth #6: There Is Too Much Paperwork
Technology and direct policy buyers have made the process of life settlement transactions much, much faster.
The process itself can take some time while applications and underwriting are being reviewed. But the paperwork is now minimal compared to previous industry standards.
Alternatives to Life Settlements
Selling your policy isn’t the only way to get some money out of your life insurance plan. During the life settlement process, the life settlement company will disclose alternatives to life settlements in detail and answer any questions.
Here is a brief overview of some of those alternatives:
Accelerated Death Benefit
An accelerated death benefit allows the policyholder to access a portion of the death benefit while the insured person is still living. The beneficiary still receives the remainder of the death benefit at the end of the insured’s life.
The ADB is a rider that has been added to the policy. It is not a policy loan. The ADB is subtracted from the death benefit and does not have to be repaid.
When the insured person is chronically or terminally ill, a viatical settlement is a higher-paying alternative to a traditional life settlement.
As we mentioned at the beginning of the article, a viatical settlement has a higher cash payout to the policyholder due to the lowered projected costs of the life settlement company keeping the policy in force.
It is possible to borrow against your policy’s cash value.
Like all loans, there are interest fees involved. However, the loan application process is very quick because any underwriting has already been done.
A policy loan can also be less stressful than a traditional loan. If the amount of the loan is not paid back before the insured person expires, the amount of the loan is subtracted from the death benefit.
There is an additional alternative regarding your policy and loans. A secured loan will accept your policy’s cash value as collateral if you decide not to go with a standard policy loan. This alternative would protect your beneficiaries from losing any of the death benefits if you were unable to pay back the loan in full.
Surrendering the Policy
The most lucrative way to get cash for your life insurance is through a life settlement or viatical settlement.
However, if you choose, you can also simply cancel your policy with your insurance company. When you surrender your policy, you receive the cash surrender value of the policy.
The cash surrender value is the cash value minus the fees charged for surrendering the plan.
Life Settlement Statistics
Health and lifestyle statistics in the United States have changed a lot in the past few decades. What was once unthinkable is now the norm, and what was once the norm is unusual and outdated.
To better understand the status of the health and finances of America’s seniors, Mason Finance prepared a report that looks at how seniors are handling changes in health and life insurance.
Here are a few statistical highlights from the report:
- Insurance rates are rising up to 200% per year.
- More than 275,000 people surrender $35 billion of life insurance each year, leaving money on the table.
- $8.8 billion in residual policy value could be returned to policyholders annually via life settlements.
- Settlement values average 7x more than the cash surrender value.
- 70% of people 65 or older will need some form of long-term care support.
- Approximately 40 million households have no retirement savings at all.
These statistics are alarming when you look at how much money seniors are losing or letting go.
In contrast, life settlement payouts average seven times more than the surrender value of most policies.
Download the full report to get a full, clear picture of how a life settlement might be the best option for your financial health.
Life Settlement Trends
New and emerging trends in the life settlement industry are good news for seniors, the terminally ill, and financial advisors. The most exciting trends involve faster processing speeds, increased awareness, and improving best practices.
In the past, it could take months to complete a life settlement transaction. Now, increased data and technology have made the process much faster.
Another trend is that direct to consumer marketing is bringing awareness to policyholders. More people now understand the higher cash benefits of selling their insurance as opposed to surrendering it.
As the industry grows and awareness increases, best practices are being refined to protect both policyholders and investors.
The growing interest in life settlements also gives policyholders and financial advisors more resources to learn about life insurance options.
Investing in Life Settlements
You might be wondering who buys life insurance policies, or how you can invest in other people’s policies.
Warren Buffet, for one. His company, Berkshire Hathaway, invests millions in life settlements annually. But, you don’t have to be a billionaire to invest in life settlements.
Investing in life settlements has advantages over traditional forms of investing like the stock market, mutual funds, or real estate.
As previously noted, life settlement investments are based on actuarial tables and life expectancy. By contrast, other forms of investment fluctuate with market trends.
A life settlement is, therefore, a much more stable investment.
They also benefit the policyholder. If you feel a moral obligation to invest in something that does no harm and does not take advantage of someone somewhere along the line, you can rest easy. A policyholder in need of immediate cash will get a much better payout from a life settlement than a traditional surrender.
There are three ways to invest:
- Direct purchase
- Direct fractional
- Private equity
Direct purchase is not recommended unless you are very experienced in brokering investments. These purchases often require an outlay of over a million dollars.
A direct fractional purchase is one in which the investment is divided out amongst many investors who each pay a portion for the settlement.
A private equity life settlement investment works much like a mutual fund. The investor is joining hundreds of other investors investing in portions of hundreds of policies.
It’s important to note that like any investment, there are risks involved with investing in life settlements.
Mason Finance is dedicated to serving policyholders. If you want to know more about investing, it is best to consult your financial advisor or other trusted professional for more information.
How to Sell Your Policy
The first step in selling your life insurance policy is contacting a potential buyer. You can either get in touch with a life settlement provider directly, or you could work with a broker who can connect you with a variety of buyers.
It never hurts to check with your insurance agent to see if they have any established relationships with purchasers.
Insurance agents and life settlement brokers have a fiduciary duty to work only on your behalf. A life settlement broker is not the same as a life settlement buyer. The broker represents you in the transaction.
Agents and brokers aren’t free. They both receive fees and commissions for their services, which combined can be as much as 30% of your final settlement payout.
You can opt to sell your policy on your own to a life settlement provider. But, the process of handling the complicated portions of the settlement process on your own may not be worth the money you would save.
Mason Finance can help you through that process.
We make it easier by giving you an instant estimate of your policy’s worth and then matching you with a direct policy buyer.
Life Settlement Providers and Brokers
There is a difference between a broker and a provider. A life settlement provider buys your policy, and you may choose to have a broker represent you during that process.
If you are ready to sell your life insurance, your next step is to choose a certified life settlement company or a life settlement broker. The settlement company can help you find a broker and your insurance agency can as well.
Life Settlement Brokers
Like an insurance broker, a life settlement broker has connections with a variety of companies. They are kind of like a life settlement marketplace that can connect you with the highest bidder.
A life settlement broker is your representative during the settlement process. They have a fiduciary responsibility to negotiate according to your best interests. For their services, they receive a commission that averages around 10% of the settlement proceeds.
Brokers are licensed professionals that are highly regulated. Check your broker’s credentials and standing in the industry.
Life Settlement Providers
Life settlement providers also have to be licensed. Buying life insurance policies in a secondary market is regulated in most states.
These companies and their representatives have no fiduciary responsibility concerning your welfare. They are working for their own interests and those of their investors.
Life settlement and viatical providers either buy policies for their own accounts or for groups of investors.
Your Insurance Company
One party that is often overlooked when discussing life insurance settlements is your insurance company. No matter the type of settlement you choose, they are always involved in the life settlement process.
Your insurance company is also required to work in your best interest. They can work directly with the life settlement provider or alongside a life settlement broker.
The Mason Finance Advantage
If you decide that you would like to arrange a life settlement on your own, Mason Finance can help you in that process.
We want to help you get the most out of your policy – that’s why we work with the most well-respected investors. Instead of working with life settlement providers or brokers (who often only play the middlemen between you and the final investor), we can connect you directly with the people purchasing your policy.
When you work with Mason Finance’s network of investors, you’re minimizing transaction fees and maximizing your return on investment (ROI). That means more money in your pocket.
If you are considering selling your life insurance policy in a life settlement transaction, you may want to delve deeper.
These resources can help you: