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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Selling your life insurance: pros and cons

Cue the commercial: two kids gambol across the green toward Grandma and Grandpa, who are living their dream retirement since they sold their life insurance policy. The concept is not exactly new but has gained acceptance thanks to growing interest from investors seeking uncorrelated returns.

Selling a life insurance policy that is no longer needed or for which the premiums are unaffordable can be a viable option for some holders in specific circumstances, but the decision must be considered carefully in consultation with a trusted advisor and the transaction handled by a reputable agent or firm.

A “life settlement” is the broad term used to describe the transfer of a current life insurance contract from the owner to a third party for some specified consideration. Once the transaction is complete, the original owner receives the cash consideration and remains insured, while the buyer continues to pay the premiums and receives the death benefit when the insured individual passes.

A well-structured life settlement can benefit both the seller and the buyer of the policy. A typical payout would be more than the current surrender value of the policy but less than the ultimate death benefit. The investor is wagering on the life expectancy of the insured. If the seller dies earlier than his actuarial expectancy the investor profits, but a long and happy life for the insured means investment losses for the new policy owner. Obviously, the age and health condition of the applicant are major factors in determining eligibility and compensation.

Life insurance is at least as old as the Roman empire, but the ability to sell a policy for cash is a relatively recent development.

A Supreme Court opinion in 1911 held that an insurance contract was considered personal property and therefore possessed the same rights of transferability as any other asset. However, it was the result of a tragic health crisis 70 years later that resulted in the emergence of a secondary market.

Over 100,000 Americans succumbed to the AIDS epidemic in the 1980s, and those who received the diagnosis had a considerably shortened life expectancy. Given the critical need for cash to be used for treatment and living expenses, a new arrangement known as a “viatical settlement” arose to allow terminally ill patients to effectively cash out their life insurance policies to provide for their immediate needs.

A viatical settlement is the sale of a life insurance policy wherein the policyholder (called the “viator”) is terminally ill or suffers from a life-threatening health condition. The term is from the Latin “viaticum”, originally referring to preparations for a journey and later adopted as an ecclesial term for the Eucharist offered to the dying. Viatical settlements are subject to specific conditions which if met render the proceeds tax free.

The early days of viatical settlements were an unregulated frontier during which fraud was rampant and recourse limited. Since then, most states have assumed responsibility for regulating the industry and require licensing of personnel and firms engaged in the purchase of insurance contracts. Most states also require that the policy be in force for at least 2 years (5 years in a few states).

With the advent of effective treatment regiments for HIV/AIDS the demand for viatical contacts diminished, but the idea remained. An expanding population over age 65 found they either no longer required life insurance or could no longer afford the premiums. Today a growing market segment is providing liquidity to relatively healthy seniors. In general, prospective sellers are age 75 or above without a critical or terminal diagnosis who want to convert their policies into cash. Here the trick is in the underwriting: applicants must submit health and prescription information, and investors are very selective. Again, the average cash payout is between the cash value and the death benefit. In some cases, even term policies may qualify if they contain a conversion provision.

A well-researched life settlement can be an effective way to tap into an asset you may not have considered. But there are other considerations you should weigh. You should consult your tax professional to understand the potential liability if any. Also know that the proceeds from a settlement are available for creditors to attach in litigation. If you are a recipient of public assistance like Medicaid or SNAP, your settlement may impact or curtail your benefits. And there is no guarantee that your private medical and personal information remains secure or who may access it.

You should also contact your current agent or carrier to investigate other options. For example, your policy may have an accelerated death benefit which provides early access to the funds. You might also consider surrendering the policy for the current cash value if you are not a good candidate for a life settlement. It may also be possible to exchange the policy for a different one that provides more appropriate benefits like long term care or borrow against any current cash value of the contract. Your insurance professional or advisor can assist in evaluating options.

If you are considering a life settlement, chances are your coverage has already served a useful purpose in providing security and peace of mind. Good to know there might still be an option to wring more value out while you can enjoy it.

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