Familiarize yourself with the option of a life settlement
By Erez Rotem
Integrity Life Solutions
Estate planning & elder law
Familiarize yourself with the option of a life settlement.
What is a life settlement? A simple definition is “the sale of a life insurance policy on the life of a senior into a secondary market for more than the cash surrender value.”
As a part of your fiduciary responsibility, you should be familiar with the option of a life settlement for any client with a life insurance policy, be it an individual, a trust or a business. In fact, several states have statutes on the books that make it mandatory for an insurance company to notify an owner about this option if he is surrendering or lapsing a policy. You should be aware that there exists a secondary market for life insurance policies; an institutional market which buys policies purely for financial gain — that is, the death benefit. There are enough of these institutional buyers such that a rather organized market has evolved over the past 20 years.
While policy values in today’s market are somewhat depressed due to global financial conditions, for any market to work, sellers must also benefit . Here is how it typically works. Life settlement brokers, who represent the seller, solicit bids from possible buyers (institutional funds) with the intent of creating an informal auction in which buyers are bidding against one another, driving up the price.
It is important to understand that a life settlement broker can tap into the entire market at one time. Naturally, there can be a huge difference in the selling price between simply contacting one life settlement buyer as compared to getting multiple bids through a broker. Beware, therefore, of the distinction between buyers and brokers. Bottom line: A life settlement broker works for your client to maximize the sale price of a policy by leveraging potential buyers against one another. The broker’s commission, being a percentage of the gross sales price, will increase as well, so the broker has an incentive to perform well for his client. Why would an individual or trust want to sell a life insurance policy? For the same reasons that an individual would cash in or lapse a policy. They may no longer want or need the policy — their beneficiaries died before them, their children are grown and independent, their estate has diminished and their potential estate tax has decreased or disappeared, or their company has been sold and a buy-sell agreement is no longer applicable. They may no longer be able to afford the premiums — their retirement assets have diminished and are no longer producing enough income to cover the premium payments, or they need the money they were using for premiums to pay for other expenses like long term care or nursing home expenses. Or, they simply may need cash.
Often, their goals have changed and rather than leaving money to their beneficiaries, they want more cash to supplement their own living expenses. Sometimes, older individuals live longer than they had planned. But, in fact, they could need the cash for innumerable other reasons.
Consider this example closely. An owner of a 20-year term policy may never have had the intention of converting it to a permanent policy — a feature that exists on most term policies — and is now letting it lapse. But your client may instead have the ability to sell the policy to an investment company, which will then convert the policy for their own benefit after the sale. Your client could be walking away from thousands of dollars because of his ignorance, and of course, the carrier will be “laughing all the way to the bank” now that its obligation to pay any death benefit has ceased.
Alternatively, the client may still want to have insurance, and need insurance, but the current policy may not fill his needs. A new policy may offer more bells and whistles, such as a death benefit guarantee or a longer death benefit guarantee. Internal costs of insurance have decreased in newer policies, so the client is considering exchanging the current policy for a new one in the context of a 1035 exchange of the cash value.
However, even after consideration of the tax advantages under section 1035, it may be more lucrative to sell his current policy (likely a taxable event) if the sale price is much greater than cash surrender value of the existing policy. Many life settlements, in fact, result in cash payments to sellers of amounts in excess of four or five times the cash surrender value. What kind of policies sell? All kinds of policies — including term policies — as long as they are convertible to a permanent policy.
Some policies, however, are more marketable than others. The sale price is dependent upon at least these five variables:
1. The face of the policy — the amount of the death benefit
2. The life expectancy (LE) of the insured
3. The cash surrender value (if any)
4. The insurance company’s rating or credit worthiness
5. The cost to keep the policy in force — projected premium payments
As for premiums, buyers require up-to-date illustrations from the carriers indicating how much they should expect to pay over the coming years, through expected maturity (or the LE year). Buyers will always want to pay the minimum premium to keep the policy in force — that is the cost of insurance only.
Potential buyers evaluate how much they might be willing to bid on a policy based upon their own projected internal rates of return (IRR) in light of these and other parameters. Although somewhat anecdotal, my understanding is that offers will be made on the basis of IRRs from 12 percent to 20 percent and higher, after consideration of the fund’s total investment (initial purchase price, plus future premiums). And these figures may be net of other transactional costs not within the scope of this discussion.
How does the process work? The client signs an application which includes a questionnaire, disclosures, as well as release forms for the clients’ medical records and new carrier illustrations. Medical records are obtained and are sent to approved medical underwriters that calculate life expectancies (LEs), stated in months. New illustrations are requested from the carrier, along with proof that the policy is still in force.
The policy is then listed for sale (generally on a secure MLS type internet based service) with accompanying information such as LE reports, illustrations, etc. Potential buyers are contacted for solicitation of initial and continuing bids. Simply put, when bidding has peaked, the owner is notified of the highest offer, which he may either accept or decline. The owner is under no obligation to accept any offers throughout the valuation process. If the client indeed accepts the offer, a purchase-sale contract, escrow contract, and ancillary documents are signed, including forms from the carrier that instruct it to change ownership and beneficiary status. The client will not actually receive the cash settlement until such closing documents are signed and the issuing insurance carrier makes the necessary changes and has confirmed this with the parties. In most states, the seller has another 15 days from the receipt of the cash (known as the “rescission period”) to change his mind, repay what has been paid to him and reverse the sale. Or, worst case scenario, if the insured dies within this period, the sale is automatically rescinded. But beware of differences in state laws and/or funders’ contractual forms.
The insured must understand that someone will own a policy on his life, and that policy will most likely stay in force until his death. He also gives rights to future medical records. The insured also must designate a person for the new owner to contact regularly (every six months, e.g.) to attest to the health or death of the insured.
The tax ramifications of a life settlement are covered in IRS Revenue ruling 2009-13, effective as of August 2009. This ruling suggests that the sale of a policy is like the sale of other assets, and will result in taxable income to the extent there is a gain over basis. Gains may be classified as either ordinary or capital, depending upon a simple analysis: ordinary income to the extent income would have resulted had there been a surrender of the policy; otherwise, capital gains.
This Revenue Ruling also suggests that, going forward, the cost of insurance must be considered in the computation of basis. Tax impacts should be an integral part of the conversation and should be done in consultation with the client’s tax advisors.
One other important issue is that Medicaid eligibility, and/or similar benefits, may be compromised by the sale of a life insurance policy. Although the policy may not have much of a cash surrender value, selling the policy may result in a large cash settlement to the owner.
Be aware that if an insured has a life expectancy of less than two years, the policy will be sold as a “viatical settlement”. Generally speaking, in such cases the code provides that this is a non-taxable event to the seller.