The most common reason to buy life insurance is to provide income replacement for loved ones in the event of the death of a breadwinner. But as life goes on, children grow up and family needs may change. The once-valued protection can become a financial burden for an aging policy holder.
Or perhaps a client’s financial goals have changed. An irrevocable life insurance trust, or ILIT, set up years ago to transfer wealth and avoid estate taxes, may no longer make sense as current low interest rates require policyholders to pay ever higher premiums to maintain a universal life policy.
Older policyholders who don’t want to keep their life insurance, or who can no longer afford to pay the premiums, have three options. They can stop paying the premiums and allow the policy to lapse. They can surrender the policy and collect any accumulated cash value, minus any loans or surrender fees. Or they can sell their policy to a third party.
In a life settlement, an insured person sells a life insurance policy to a third party in exchange for an upfront cash settlement that is worth less than the death benefit, but more than the policy’s surrender value. The life settlement investor takes over the policy premiums and collects the death benefit when the insured dies.
A 2013 report from the London Business School estimated that life settlement proceeds are, on average, about four times more than cash surrender values. Unfortunately, many Americans don’t know about the life settlement option.
An estimated $200 billion worth of life insurance is expected to lapse or be surrendered each year through 2027, according to a 2018 study by Conning, an investment management firm. The projected $200 billion in lapsed or surrendered policies each year is potentially worth $50 billion on the life settlement market, assuming a payout rate of 25%.
The life settlement industry has evolved and expanded over the past 20 years. It started in response to the AIDS epidemic, allowing terminally ill individuals to sell life insurance policies for cash, often needed to pay medical bills, while the investor would collect the death benefits. The rather ghoulish image that clung to what were known as viatical settlements has given way to a reinvention as a modern financial planning tool.
“What started as a simple transaction to fulfill the need for immediate cash has evolved into a complement to the overall financial planning process,” said Peter Hershon, senior vice president of Coventry, the country’s largest provider of life settlements. “Many advisers now include life insurance in their overall annual review process, asking clients about the original purpose of the policy, whether their goals have changed and how the policy fits into those goals.”
To be eligible for a life settlement, a policyholder generally must be 65 or older and own a life insurance policy worth $100,000 or more. Younger policyholders may qualify for a life settlement if they have experienced a decline in health since they first purchased the policy.
Most types of insurance qualify for life settlements, including universal life, whole life, variable life and even term life policies that are convertible to permanent insurance. Proceeds from a life settlement can be used for any purpose, including to pay for current medical expenses or long-term care needs or to add to an investment account or supplement retirement income. There is also an option to retain a portion of the policy death benefit while eliminating future premium payments.
The life settlement industry is expected to grow substantially in coming years, reflecting the aging population, increased longevity, and the fact that retirement savings are often insufficient to replace working income. The roughly half of American seniors who own life insurance can liquidate those polices to create retirement income.
There is also a growing demand on the investor side for life settlements, as institutional investors search for higher yields in the current low-interest-rate environment and look for diversification. Life settlements are a non-correlated asset that can complement a portfolio of real estate, equities and fixed-income investments. Because of that increased demand, life settlement payouts are generally higher than they have been in the past.
“Because so much capital is coming in, it allows us to pay more for policies than we did just a few years ago,” Hershon said.
“It is critical for financial advisers to have a policy appraised to understand the market value of an unneeded life insurance policy,” he added. “It is found money.”
The Tax Cut and Jobs Act of 2017 simplified the tax consequences of selling a life insurance policy. Proceeds up to the total amount of premiums paid over time are tax-free. Proceeds in excess of the tax basis up to the amount of the policy’s surrender value are taxed as ordinary income, and any remaining proceeds are taxed as capital gains.
(Questions about Social Security rules? Find the answers in Mary Beth Franklin’s 2021 ebook at MaximizingSocialSecurityBenefits.com.)
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