Using Life Settlements
A life settlement may be an ideal way to free up extra cash to help the elderly remain in the home, to pay for medical and long term care expenses or to pay bills. Here is a description of what a life settlement is and how it works.
What is a life settlement?
Do you know the fair market value of your life insurance? In a recent case, a 77-year-old man had a $3.9 million policy that was not performing up to expectations. His advisor recommended that the policy be appraised. A life settlement provider determined that the market value of his policy was $740,000 – four times its cash surrender value. The client decided to sell the policy and use the proceeds for current needs instead of benefiting his estate.
These early viatical settlements, defined now in many states as transactions involving a terminally ill insured, often involved AIDS patients in extremely reduced economic circumstances. Offers were often from non-institutional funders. Competitive bids were uncommon in this underdeveloped marketplace. There was little or no confidentiality regarding the identity of the insureds whose policies were sold.
The unacceptable conditions and environment of the formative life settlement market has, understandably, left a bad impression in the minds of many within the life insurance planning industry. However, this dappled history of viatical sales should not predispose a person to avoid a thorough examination and understanding of the current, rapidly expanding market for life insurance contracts. Today’s life settlement transactions bear little or no resemblance to the viatical sales of yore.
Two Ways to Benefit from Coverage
If the health of the insured had not declined since the time the policy was issued, or if there had been no significant increase in how the industry priced comparable risks, then the surrender value would represent the reasonable market value of the contract. However, if the insured had experienced a moderate decline in health (or if industry pricing had increased) then the premiums established at the time of purchase were less than what was actuarially required to support the risk element of the death benefit. Consequently, the policy was a better “deal”. Viewed as an investment with the death benefit representing a return, the policy was worth more than its surrender value. Certainly a policyholder who wanted to sell the contract would prefer a sales price that more accurately reflected the true worth of the policy in light of the insured’s change in life expectancy. Such a sales price was impossible to determine or attain as long as the only potential buyer was the issuing carrier whose offer was the surrender value.
In most other markets, such a situation would not be tolerated. Imagine if a homeowner, after living in the home for many years, was told that instead of being permitted to sell the home to any willing buyer, he or she could only sell it back to the original builder at the price determined by the builder. Clearly no one would tolerate such a situation for homeowners, but that situation is exactly what has existed in the life insurance market. The advent of a secondary market has lessened this monopsony power of life insurers and created a free market for policy owners to value their life insurance.
A market that generates fair and reasonable offers for existing policies is advantageous for owners who intend to lapse or surrender policies because coverage is no longer needed, or because the product no longer serves current planning goals, or because coverage has become unaffordable. Outliving a need for coverage is a common occurrence. By definition, “term” insurance is designed to address those situations where protection is required for a defined period of time. Some examples would include coverage against buy-sell obligations at death, key-person coverage on an employee until retirement, or security on an existing debt. The previous disposition of policies in these situations that resulted in little or no cash may now command significant funds that can be used to fund a lifetime buyout, pay nonqualified benefits to a retiring employee, or liquidate loan obligations sooner than expected.
A lapse due to a change in product suitability may occur when a product with improved features or guarantees is needed. A common situation involves the surrender of a single life contract when a second-to-die policy is purchased to more economically fund against anticipated estate tax liability. Funds from the sale of the original policy can be used to jump-start the new contract. This is especially advantageous when there are no tax advantages to exchanging the policy under IRC 1035.
The most difficult situation involving the surrender of a policy is when the cost of coverage becomes prohibitive. The circumstances are usually problematic because the decline in health that makes a life settlement attractive may be severe enough that the need for coverage is now more urgent. In such cases the industry has proven self-correcting in extreme cases where death is imminent and the need for cash desperate. With increasing frequency, carriers are providing policyholders with accelerated death benefits (ADB) that allow for prepayment of the death benefit upon evidence of the likelihood of death or the existence of certain medical conditions. The requirements vary with carrier or policy. The proliferation of the availability of ADBs may ultimately eliminate the need for a secondary market for true viatical sales.
The most analysis is needed in situations where mortality is measurable but not imminent (usually cases involving life expectancy between 3-15 years) and the insured either needs the money or simply cannot afford future premiums. A life settlement may be advisable in those situations where the policyholder either has no heirs to benefit from coverage or where he or she believes they can make better investment use of the life insurance settlement amount over the time remaining than would result if a death benefit were paid.
New Territory in the Financial Landscape
A potential seller can assure getting the highest bid for a life settlement by working through a broker who shops and negotiates the most valuable contract among the various providers available. Going directly to a provider results only in getting that provider’s bid and removes the competitive aspect from the process. In addition, a broker is aware which providers have particular needs based on the policy criteria received from particular funders. It is not uncommon for a broker to agree to shop a case only under some condition of exclusivity. First, this protects the time and expense involved in finding a buyer. The average life settlement case requires approximately 30-60 days to close. Second, and more important to the client, it serves notice to providers that they must make their best offer to the exclusive broker because they will not have an opportunity to bid through another source.
A properly advised life settlement, rather than bringing an end to the insurance plan, can be valuable to the continuation and improvement of the plan. In most cases a life settlement represents the proper and profitable disposition of an unneeded asset that provides funds for a need or another financial vehicle that better suits the current position of the client. Studies show that in the majority of the life settlements involving policies over $1 million in death benefit, the funds are used to buy another financial planning product.
Indeed, life insurance policies can help address a wide range of financial goals from paying estate taxes to protecting against various business risks to covering survivor needs. Over time circumstances can change and policies may become outdated, inefficient or unneeded. Rather than surrendering a policy for its cash value or letting it lapse, first consider a life settlement.
JE McGowan Consulting estimates the potential secondary market for life insurance policies exceeds $18 billion annually. The growth in the secondary market for life insurance has soared over the last decade.
A study published by Conning and Company, an insurance investment and research firm, found that more than 20% of the policies on insureds age 65 and older have a fair market value in excess of their cash surrender values.
In the past few years, the secondary market for life insurance has exploded onto the financial planning scene. Clearly, the market’s basic premise – the consumer’s right to sell unwanted or unneeded life insurance – has been validated by the U.S. market’s spectacular growth, which is expected to exceed $45 billion in face value by 2007.
Consider the estate planning community. A recent article titled “The Benefit of a Secondary Market for Life Insurance”, in the Real Property, Probate & Trust Journal of the American Bar Association concludes that the secondary market for life insurance is both pro-competitive and pro-consumer. By allowing companies to compete for unwanted or unneeded policies, the secondary market has generated greater consumer choice, a wider range of products and favorable valuation for consumers. But the implications don’t end there. The article goes on to suggest that the market will enhance the perceived value of life insurance, leading to an expansion of the industry as a whole. It concludes by suggesting that lawmakers design regulations to “encourage participation and investment in this secondary market.”
Such regulation is indeed happening. A number of states are in the process of passing provisions that protect the consumer’s right to know about the opportunities available in the secondary market. These moves are sending a clear message to financial advisors that the secondary market offerings are now within the limits of their fiduciary responsibility.
Another factor is the sheer magnitude of the opportunity. In the U.S. alone, there is more than $100 billion of life insurance in effect where the market value exceeds surrender value. Not surprisingly, the situation has attracted the attention of the capital markets. High quality institutional capital is pouring into the secondary market. Not only does institutional backing provide a secure funding source for secondary market transactions, it also provides the highest degree of consumer protection with regard to privacy and confidentiality, as well as a solid foundation on which the industry can grow.
Does all this mean that life settlements and other secondary market transactions will be popping up on every street corner? Of course not. For the majority of policy owners, maintaining their current policy will continue to be the best course. But the mere presence of the market gives them the means to evaluate what the policy is worth in empirical terms. This is likely the most important implication of the secondary market. Life insurance is now more than a tool for risk-management. It has become an asset with significant value that should be appraised and considered alongside one’s real estate, businesses or equities.
This expanding secondary market is providing new options for policyholders – options that are bringing long-term benefits to every sector of the life insurance industry. Life insurance is now more flexible, more powerful and more valuable for consumers and the professionals who serve them. Insurance is indeed being redefined. And things may never be the same.
How to Identify the Right Circumstances
Lifetime settlements are for people without a terminal illness who have a life expectancy of 3 years or more but usually less than 15 years. As a general rule, anyone over the age of 65 could be a good candidate, though those age 70 or 75 will generally get a higher price due to a shorter life expectancy. Sometimes the insured has simply outlived his or her family or beneficiaries. Insureds should also consider selling an unneeded life insurance policy for any of the following reasons:
Businesses may also benefit from selling a policy in the secondary market to
Candidates for Life Settlement – Buyer’s Criteria
Transaction Mechanics of a Life Settlement Transaction