RTG Consultants

Life Settlements - Don't surrender your policy

People who need some of the benefits of the life insurance policy before they die, or who have life insurance policies that for whatever reason will otherwise lapse, should consider selling their life insurance policy by way of a “life settlement”. This allows people to get cash out of their life insurance policy, in an amount in excess of the policy’s cash value (if any), while they are still alive.

A life settlement is the sale of an insurance policy, for more than the insurance policy’s cash value, to an investor who keeps the policy alive until the person on whose life the policy is on dies. Often, life settlements involve insurance policies that are failing because they lack sufficient cash value to pay the annual insurance costs, and the policy would have expired anyhow. Sometimes they are term life insurance policies where the policy owner for whatever reason cannot make the necessary premium payments, or desires not to anymore. Essentially, the buyer purchases the policy (giving the selling owner immediate cash) and then resuscitates it or keeps it alive until somebody dies, and then policy finally pays out to the buyer who presumably will get his money back plus some investment yield.

Life settlements can be real saviors for people whose life insurance policies will expire if the status quo is maintained, and who cannot (or are unwilling) to put additional cash into the policy to keep it alive. Instead of the policy eventually becoming worthless, or being limited to the policy’s existing and perhaps low cash value, they instead get a nice, current cash settlement in excess of the policy’s cash value. As we will discuss below, insurance companies hate the life settlement industry because it means fewer policies that lapse before the death benefit it paid, thereby reducing the life insurance companies’ profitability that traditionally anticipates high lapse rates. Insurance companies would instead prefer (greatly prefer) that the policy owners simply surrendered their policies for the cash value of the policies, thus creating a windfall for them since the amounts paid during the life of the policy for “death benefits” turned out to be free money to the insurance companies.

A life settlement means that the current policy owner will receive money for selling their policy, and the policy owner is not required to put up any cash or make any kind of investment. The current policy owner receives, very simply, a large lump sum of cash for selling the policy, and thereafter had no further financial obligations.

Why Policies Fail or Become Unneeded

Life insurance policies can “fail” – or just no longer be needed -- for many reasons, including:

  • The owner has borrowed too much of the cash value of the policy for it to be self-sustaining. This usually happens with retirees who have ended up using the policy as a source of retirement funds, or who have had some unexpected event occur that required them to draw down the cash value of the policy.

  • If the investment performance of a variable policy was very bad in the early years, the policy will not perform as predicted. Those who bought variable policies from 1999 through 2001 can probably relate to this.

  • Too many unscrupulous life insurance agents have put their clients into policies that, in retrospect, were doomed from the start considering the clients’ situation and cash needs.

  • Another type of “failure” is that for whatever reason, the life insurance is no longer needed. The intended beneficiary may have died or been disinherited, or for estate tax planning reasons it no longer makes sense for the policy to pay out as planned, such as that the estate no longer needs insurance for liquidity.

  • A company’s key executive could retire, thus ending the company’s need to maintain insurance on his life.
    · A business could fail, be dissolved, or go public, thus eliminating the need for Buy-Sell Arrangement backed with insurance.

  • An individual policy is being replaced with survivorship insurance.

  • A better insurance or financial product for particular circumstances has become available, but for whatever reason the existing policy cannot efficiently be “rolled” into it.

  • The policy is no longer affordable, or the owners need relief from the monthly premium expenses.

  • The owners need cash now, such as for a medical emergency or to assist a child or grandchild, or they need cash to supplement their retirement income. Also, the owners want a higher cash payout than the cash surrender value.

Not the Same as Viaticals

Although very similar, life settlements are not the same as viatical settlements, which typically involve the sale of a life insurance contract for somebody who is terminally ill, such as a cancer patient or somebody with AIDS. The idea behind a viatical settlement is that, although the insurance policy is well-funded, the person can’t get the benefits of the policy now – when they need it – and so they sell their policy to somebody for an immediate cash payment that they may need for medical care, etc.

Typically, viatical settlements are made when the person on whose life the policy is on has some sort of terminal illness, and a life expectancy of less than two years. If that person’s life expectancy is greater than two years, then a life settlement is made instead. The difference is that the buyer of a viatical settlement has a much, much greater chance of being paid the full policy proceeds in the short term, and thus have greater comfort that their ship will come in soon. For this reason, buyers are willing to pay much more for viatical settlements than for life settlements, since there is no expectations of an immediate payout with the latter and the buyer may be forced to wait some years or decades – and having to additionally fund the policy in the meantime – until the policy pays out.

As investments, viatical settlements have gotten a bad name for two reasons: (1) there have been many scams involving viatical settlements where promoters organized “pools” and raised and embezzled moneys, and never attempted to buy any real policies; and (2) many viatical settlements were made on HIV/AIDS patients who, with the help of new drugs, subsequently recovered and lived for years and decades after their viatical settlement was made (to the deep chagrin of the buyers of those settlements).

Little Risk to Seller

Back to life settlements, there is little risk from the owner’s perspective in selling their insurance policy if the policy would otherwise fail. Usually, these are cash-in-hand transactions, and there is little risk of the persons losing money on such a deal, assuming that the current value of the insurance contract has been calculated fairly.

Types of Qualifying Policies

Nearly all life insurance policies will qualify for life settlements, including term, universal life, variable life, and whole life policies. Sometimes, even group life policies can be settled. Whether it makes sense for a buyer to purchase such a particular policy is a completely different issue. Some of the factors to be taken into account by buyers are:

  • Is the issuing insurance company rated at least B+ or better?

  • Does the policy allow for an absolute assignment or change of ownership?

  • How much cash will be required to resuscitate the policy?

  • Is the policy at least 2 years old?

  • Is the policy non-contestable, and are there unfavorable policy exclusions?

  • What is the face value of the policy? (Policies with a face amount under $100,000 are often not worth the time to most brokers, but you never know).

  • Who is the insured and what is their health and life expectancy?

  • Has there been a change in health (if nothing else, due to aging) since the policy was issued? (Note that good health is not an automatic disqualifier, depending on age).

  • Can copies of medical records on the insured be obtained?

No Medical Exams Required

Except in the rarest of occasions, there is no need for the insured to undergo any additional medical examination. Usually, the buyer can make a determination of the policy’s value based only on the insured’s general health condition and age, then measured against their life expectancy estimates.

Usually, a prospective buyer will ask the insured to sign some medical release forms and an application, so that they can pull all the past medical files and make a determination how long the insured is expected to live based on actuarial tables. The buyer will be required to keep the information confidential, and the buyer will first have to come to the insured for their written release to give the information to anybody.

After the policy has been sold, the buyer will have the right to occasionally check with the insured’s doctor to determine whether you are still alive. Some buyers will set up a system where they send the owner a postcard every six months or so, for the insured to sign and return.

Partial Settlements

In some cases, it is not necessary that the full policy be sold. Instead, you can transfer to a buyer only part of a policy.

Transferring the Policy – Payment – Escrow Agents

Although each buyer is different, most transfers of policy involve the use of an escrow agent. You deposit your policy and the buyer deposits the purchase amount with escrow agent, and then when all the necessary paperwork is completed giving your rights to the policy to the buyer, the escrow agent releases the money.

For this reason, it is important to both parties that a quality escrow agent (often a reputable bank or law firm) be used.

Miscellaneous

Most states have provisions allowing you to rescind the contract and get your policy back within a certain number of days, usually 15 days or so. Of course, you have to give the money back to get the policy back.

Tax Implications

The tax treatment of life settlements and viaticals can be very tricky, and can be some combination of income and capital gains (or, nothing at all in a given case). Often, how the sale is structured can help to dictate what the tax effects will or will not be. For this reason, it is critically important that the existing owner of the policy consult with a financial planner to determine the tax effects.

Potential Downsides

It is critically important to consult with a financial planner about other aspects of life settlements as well, including:

  • Do you need the insurance?

  • Can or should the insurance be replaced, and what will the premiums be?

  • Will you lose any conversion rights or other benefits under your existing policy?

  • Will receiving a large lump sum of cash affect in a negative way your ability to receive supplemental social security income or certain publish health benefits such as Medicaid?

  • Will you lose any asset protection of the cash value if it is currently being protected by creditors under your state’s exemption laws?

Life Settlement Scams

Where there are, unfortunately, scams in this area is that scam artists seek investors for “pools” or “partners” to invest in life settlements. Often, the scam artists will show the investor that they can make big returns investing in life settlements, and obtain the investor’s money, but then they never actually purchase any insurance contracts. Instead, they simply pocket the money, using a portion of it to pay “returns” to previous investors in a pyramid scheme sort of way. A big problem is that the life settlement industry, as is the viaticals contract industry, very loosely regulated and it is difficult if not impossible for a person desiring to invest with a broker of such contracts whether the broker is legitimate or not.

Sometimes, an investor will persuade an older person to buy a life insurance policy specifically for the purpose of selling it into the life settlements market. Such a policy is known as “wet paper” and may not be sellable at a profit for some time, or the insurance company may suspect collusion and cancel the policy.

Sometimes, sellers and the buyer will intentionally misrepresent the insured’s health as poor, in an attempt to drive up the policy value (since a subsequent buyer would think the person is soon to expire and thus the policy will pay off soon). This is known as “cleansheeting” and is basically a scam on subsequent buyers.

Insurance Company Scams

Actually, the greatest scam in this area doesn’t involve insured, owners, or buyers, but involves the insurance companies themselves, since they don’t want these transactions to take place. The reason is that insurance companies typically rely on a certain percentage of policies lapsing for profitability. In other words, insurance companies expect that X% of people will, for whatever reasons, not keep their policies up and therefore they will expire. To the extent that this happens, whatever the insurance company has collected so far is pure and glorious profit to the insurance company.

Insurance companies would instead prefer (greatly prefer) that the policy owners simply allowed their policies to lapse. If that doesn’t happen, the insurance companies want the policies they have issued surrendered back to them for the cash value of the policies, thus creating a windfall for them since the amounts paid during the life of the policy for “death benefits” turned out to be free money to the insurance companies.

For these reasons, many insurance companies are downright hostile to life settlements, and do not allow their agents to promote them to their clients. The insurance companies say something like “getting rid of the policy means that the original insurance goals were not furthered” or something to that effect, totally ignoring, of course, that the insurance company itself relies for profitability on a certain percentage of policies lapsing or being surrendered for cash value. Thus, insurance companies will urge the surrender of the policy even though policy surrender might not yield anywhere near the cash that a life settlement would. And therein lies the very subtle fraud of the insurance companies on their policyholders.

Not all insurance companies are complicit in this fraud, and an increasing number of insurance companies are starting to encourage their policyholders to consider the possible benefits of life settlements in some circumstances, after a very thorough analysis of the consequences in a given case of course.

No Costs to Inquire

Typically, prospective buyers of life insurance policies do not charge fees to review a particular policy to see whether it might qualify for a life settlement. Beware those buyers who do charge significant up-front fees as it might be an advance fee scam.
Source: AP

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