What is a life settlement?

A life settlement is the sale of a life insurance policy by the policy owner (who is not terminally or chronically ill) to a third party (typically an entity in the business of buying life insurance policies or a settlement company), in exchange for a lump sum greater than the policy’s cash surrender value but less than the death benefit. The company that buys the policy will continue the premium payments necessary to maintain the policy, name a new beneficiary, and eventually collect the death benefit upon the insured’s death.

How are viatical settlements different?

Viatical settlements are available only to terminally ill or chronically ill individuals. To be considered terminally ill for purposes of a viatical settlement, an individual must be certified by a physician as having a life expectancy of 24 months or less. A chronically ill individual is an individual who has been certified by a health-care professional as unable to perform at least two activities of daily living for a period of at least 90 days due to a loss of functional capacity, or if the individual needs substantial supervision for that individual’s own protection due to cognitive impairment. Terminally or chronically ill individuals who enter into viatical settlements with properly licensed viatical settlement providers are not subject to federal income tax on proceeds that result from the viatical settlement. In contrast, life settlements are not restricted to terminally or chronically ill individuals, and proceeds are not free from federal income tax.

A word on insurable interest

Typically, in order to own a life insurance policy, one must have an insurable interest in the life of the insured at the time the policy is issued. An insurable interest means, very generally, that the policyowner has an interest (e.g., financial, emotional) in the insured person remaining alive. This requirement prevents people from buying life insurance policies on others’ lives and having a reason to desire, cause, or hasten their deaths. Employers, spouses, and, in some cases, even ex-spouses (as required by a divorce decree) have been determined to have insurable interests. How then can a third party such as a settlement company purchase a life insurance policy?

In the case of life and viatical settlements, the insurable interest requirement is satisfied by the original policyowner (typically the named insured). Simply put, the law requires that an insurable interest need only exist at the inception of the life insurance contract, and that insurable interest is not a condition necessary to satisfy the terms of the contract (i.e., the payment of the death benefit).

Who is eligible for a life settlement?

While many states have yet to regulate eligibility requirements, most life settlement companies use the following underwriting criteria in determining who is eligible for a life settlement:

• People typically age 65 or older (with a minimum age of 55),
• Who have a life expectancy greater than 2 years
• Are not considered terminally or chronically ill, and
• Have a significant amount of life insurance (e.g., $250,000 or more)
• The policy is past the contestability period (generally 2 years from policy inception)

Policies less than two years old

Most life settlement providers require that a life insurance policy be in effect for more than two years. That is because an incontestability clause is standard in most life insurance policies. This clause typically provides that the insurer has two years in which to contest the veracity of the information provided by the insured. The insurer uses this time to discover any misinformation (which may be intentional or not) that the applicant may have provided. After the period is up, the insurer isn’t able to rescind the contract by claiming a material misstatement or fraud in the application. The significance of the clause is, of course, that a life settlement provider wants to make sure that the insurer isn’t able to rescind the contract once the life settlement provider has purchased it.

• Caution: There is an exception to this rule. If the applicant misstates his or her age, the insurer can act on this information whenever the information is discovered by requiring the policyowner to pay a higher premium, or by reducing the death benefit to that which would have been purchased by the lower premium.
• Example(s): Jenna fills out an application for life insurance. One question on the application asks about her smoking habits. Jenna believes that she could be faced with higher premiums if she admits to having been a smoker, so she lies and answers that she never smoked. In truth, she smoked for 15 years, but gave up the habit 10 years ago.
• Example(s): The life insurance company has two years to discover the truth about Jenna’s history. This is the contestability period. If the information is uncovered before the end of the period, the insurer can cancel Jenna’s policy (though it may have to return some of the premium paid), or it can offer her the option of a higher premium to compensate for the new information. After two years, the insurer likely has no recourse and must continue to provide the life insurance coverage agreed to in the contract.

Advantages of life settlements

Often a better payout than surrendering for cash value

Life settlements allow policyowners more flexibility in managing the cash value of their life insurance policies. If a policyowner wants to forfeit a policy’s death benefit and “cash out” of the policy, he or she would normally surrender the policy to the insurance company for the existing cash surrender value. A life settlement, however, may provide the policyowner with significantly more proceeds. An individual may use the proceeds for any purpose he or she wishes–including making lifetime gifts to loved ones.

• Caution: Individual gifts in excess of the annual gift tax exclusion made from proceeds of a life settlement may be subject to gift tax.

Life insurance dollars can be applied to other needs

Individuals purchase life insurance for many reasons (e.g., to provide income to their families in case of their death, to pay for children’s college education). When children become independent and couples reach retirement age, however, the need for life insurance often dissipates. Many find themselves paying premiums on policies they may no longer need. These individuals may feel that insurance dollars could be better spent elsewhere. The money might be used to take the vacation of a lifetime, to make needed home improvements, or simply to meet current expenses.

Alternatively, individuals may see a need to reallocate dollars to other insurance needs. For example, long-term care insurance, while typically not a consideration for young, healthy people just starting their careers, is often an important part of financial plans for older individuals. However, premiums can be costly, and cash may not be readily available. A life settlement may be a source of funds to purchase such long-term care insurance.

Disadvantages of life settlements

• Currently, there is little regulation of life settlements, so there is some potential for confusion and misunderstanding. This is expected to change over time, however.
• A life settlement will generally result in taxable income to the individual who sells the policy, and therefore should be considered carefully. However, if an individual is determined to surrender a policy and is able to obtain more through a life settlement than by surrendering the policy, there is little downside to exploring the life settlement option.
• Still, the obvious disadvantage of both life settlements and surrendering a life insurance policy is that an individual gives up all rights in the policy, most notably the death benefit.

What alternative options are available?

Surrender the policy

When a life insurance policy is surrendered, the policyowner turns in the policy for a predetermined sum of money. This is the surrender value, and it is typically much less than the amount one can expect from a life settlement. Surrender value is calculated by adding the accumulated dividends and unearned premiums to the current cash value amount and subtracting any outstanding loans (or interest), and the surrender charges. If there is any gain (difference between premiums paid and surrender value), that amount will be taxed as ordinary income.

Obtain a policy loan

Unless otherwise stated in the policy, a policyowner has the right to borrow against the accumulated cash value in his or her life insurance policy. A policy loan may yield a better interest rate than what is currently being offered by area banking institutions. This is not a typical loan, however, because it need never be repaid. The loan balance will be subtracted from the death benefit or future surrender value. However, though a policy loan gives policyowners immediate access to cash, these loans are limited to the cash value that has built up in the policy.

• Tip: Interest on life insurance policy loans is not tax deductible to individuals, although it may, in some instances, be tax deductible to businesses.

Let policy lapse

If the policyowner ceases premium payments, the policy will eventually lapse (after the stated grace period expires), unless the cash value is great enough to generate dividends or interest sufficient to sustain the policy. Should the policy lapse, the accumulated cash value will be forfeited. However, no income tax liability will be incurred, and no surrender charges will be due.

How are life settlements regulated?

Currently, more than half of the states have statutes regulating life settlements. Most states that have enacted such legislation protect consumers by requiring life settlement agents and brokers to register and be licensed.

What are the tax implications of a life settlement?

• Since life settlements by definition don’t meet the rigid criteria of viatical settlements, the proceeds will generally be taxable. Because the life settlement practice is still unfolding, it is important to discuss these matters with a qualified estate and/or tax planning professional.
• The tax treatment of life settlements generally leads to a two-tier taxation of the proceeds paid to the policy owner, where a portion may be taxed as ordinary income and a portion as long-term capital gain:
• The basis is the sum of the premiums paid by the policyowner reduced by any amounts withdrawn. Proceeds resulting from a life settlement are taxable only to the extent that the amount received exceeds basis.
• To the extent that the amount received in the life settlement exceeds basis but is less than or equal to the cash surrender value of the policy, the gain is taxed as ordinary income.
• To the extent that the amount received in the life settlement exceeds the cash surrender value of the policy, gain is generally treated as long-term capital gain.

• The 2018 Tax Reform Act changed and simplified how life settlements are taxed. Under this Act, a surrender or a sale of a life insurance policy are treated the same for tax purposes, with the possibility of some ordinary income and some long-term capital gain, per the example below.

  • Example: Lou owns a cash value life insurance policy with a death benefit of $500,000. He is 68 years old and has recently been diagnosed with emphysema. Lou needs money to pay for medical treatments and is considering using his life insurance policy for that purpose. He is thinking about either surrendering the policy for its cash value or selling it to a life settlement company. Part of his decision will be based on the income tax consequences of each option. Lou has owned the policy for 10 years and has paid $60,000 in premiums. The cash surrender value is $85,000 and he has been offered $100,000 if he sells the policy to a life settlement company.

    In this situation, Lou will have ordinary income on the $25,000 amount by which the cash surrender value of the $85,000 exceeds his $60,000 basis. He will then have long-term capital gain on the $15,000 by which the offer of $100,000 exceeds the cash surrender value of $85,000