The ins and outs of life settlements

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“The life settlement world is a murky swamp.”

The market for life settlements — the sale of your life insurance policy to a third party — is expanding rapidly, as many senior citizens find themselves with policies they either don’t need or can’t afford. Consequently, this segment of the population is targeted heavily by salespeople marketing life settlements, and consumers will want to shop carefully to avoid potential drawbacks that include high prices and the inability to obtain a new life insurance policy.

Details of life settlements

Until about 20 years ago, if you had a life insurance policy that you no longer wanted or needed, you had two options:

  1. Surrender the policy back to the insurance company for its cash value.
  2. Let the policy lapse, possibly making all your premium payments worthless.

But now there is a third option: selling the policy to an entity other than the insurance company that issued the policy in a transaction called a life settlement. The life settlement company continues paying the premiums and receives the death benefit when you die.

Life settlements grew out of viatical settlements, which bloomed in the 1980s as a way for AIDS patients and other terminally ill policyholders to tap into some cash before they died.

Viatical settlements are arranged only for people with life expectancies of fewer than two years. But life settlements generally cover people 65 and older who have life expectancies of between two and 10 years.

The big picture

Many insurance salespeople express enthusiasm for life settlements, which can offer 10 percent to 50 percent more cash than surrendering policies back to the insurer, with payment ranging from 10 percent to 80 percent of the policy’s face value.

“My feeling is that life settlements provide older individuals who own life insurance today with an alternative that creates real value for the capital they have invested in their policies,” says Allan Goldstein, president and CEO of Insurance Design Center, a fee-based adviser in Deerfield, Ill.

“The settlement industry breaks a 100-year-plus monopoly that the life insurance industry had for what individuals could retrieve by surrendering their policies,” Goldstein says.

But experts stress that life settlements aren’t for everyone and note that consumers have to be careful not to fall prey to abusive sales practices. Numerous life settlements have ended up in litigation, including one entered into by TV talk-show host Larry King.

“It has to be for the right situation. We’re very concerned that clients be aware of what they’re giving up if they do a settlement. If the life insurance policy is valuable enough for the buyer to buy, maybe it’s valuable enough for the seller to hold,” says Jordon Katz, president of JR Katz, a wholly owned subsidiary of independent insurance broker National Financial Partners in Northbrook, Ill.

Who can benefit

Only when the insured’s original reason for holding the life insurance policy no longer exists should he or she consider selling it, says Jeff Azis, a North Palm Beach, Fla., accountant who has helped engineer life settlements for several clients. “This is only for a policy you are ready, willing and able to give up — one that you longer want or can’t afford.”

Some people can no longer afford the payments as their life insurance premiums become larger. “There are also times when estate plans change,” Azis says. For example, some people buy life insurance to cover estate taxes. But the estate tax exclusion is rising.

A couple can leave $4 million tax free to their heirs this year ($2 million from each spouse) and $7 million next year ($3.5 million each). So families with estates that size or smaller no longer need the insurance.

“Or maybe they bought the insurance to provide money for their kids and grandkids, but their kids are now millionaires themselves, so they don’t need it anymore,” Azis says.

People with unexpected health expenses also may want life settlements to help pay for their care.

Even if you meet those criteria, keep in mind that in only about 10 percent of cases can consumers obtain more money from life settlements than just surrendering their policies, Azis says. And life settlement companies generally are interested only in policies with a value of $250,000 and more.

The risks

Experts offer plenty of reasons for caution when transacting life settlements. As the life settlement industry is new and often targets senior citizens in poor health, “it can be prone to aggressive sales tactics and abuse,” according to an investor alert from the Financial Industry Regulatory Authority, or FINRA, a non-governmental regulator of securities firms.

Your insurance adviser may use a life settlement broker in order to find the best price, which could mean you pay a commission for both the adviser and the broker. Fees will generally take 20 percent to 25 percent off the settlement payment, says Peter Katt, who runs Katt & Co., a life insurance advisory firm in Mattawan, Mich.

“The life settlement world is a murky swamp,” he says. “A lot of people are making a lot of money. They’re the ones doing the deals.”

Additional tips for consumers
  • Many states now regulate life settlement companies and brokers. So check with your state insurance commissioner to see if the life settlement company or broker you are dealing with is properly licensed, and whether either has a record of complaints.
  • Life settlement prices aren’t published for the public, so you’ll want to shop around to find a fair price. You can contact life settlement companies yourself, use a life settlement broker to shop your policy to different suitors or ask your financial/insurance adviser for help.
  • Take steps to guard your privacy. Before accepting any offer from a life settlement company, you should make sure that the company has procedures in place to protect the confidentiality of your information, according to the FINRA alert.
  • If you are still going to want life insurance, be careful about doing a life settlement and then buying a new policy with part of the proceeds. You need to find out if you will be able to get a new policy with equal coverage and how much it will cost.
  • “Your old policy will still be in force and may affect your ability to get additional coverage,” the FINRA alert explains. “Even if you can get a new policy, you may have to pay higher premiums because of your age or changes in your health status.”
  • Consider cheaper alternatives. If you’re looking to dump your life insurance policy to raise cash, remember that you may be able to do that without losing your insurance. For example, you can often borrow against your life insurance. And accelerated death benefits are frequently available for people with long-term or catastrophic illness.

Be careful on taxes. Many of those promoting life settlements maintain you’re eligible for capital gains taxes rather than ordinary income taxes on the amount you receive above the cash value, but usually the proceeds are taxed as ordinary income.