All About Life Insurance Settlement
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UPDATED: Mar 13, 2020
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You’ve probably seen a TV advertisement about selling your existing life insurance policy for cash and wondered if this is the right move for you and your family. You may be wondering what type of plans are eligible for this settlement or how much money you can get.
These transactions, called life settlements or senior settlements, involve selling your life insurance to a third-party person or entity, who doesn’t have insurable interest, for one lump-sum payment.
Typically, the payment you receive will be more than the policy’s cash surrender value but less than the death benefit amount. It seems like no-brainer, right? You will get more money than what the insurer would pay you.
Let’s go over essential details before you pull the plug.
A Little History About Life Settlement
The life insurance settlement market is relatively new. It started over 100 years ago from a ruling of a Supreme Court case. Grigsby v. Russell, 222 U.S. 149 (1911) established a life insurance policy as a private asset, such as home, stocks or other investment types, and therefore may be liquidated at the owner’s discretion.
This is a compelling case which involved a patient of Dr. Grigsby who needed surgery but didn’t have the funds to pay for it. Instead, he offered to sell his policy to Dr. Grigsby for $100 in exchange for the surgery.
Dr. Grigsby agreed to the terms and, consequently, became the policy’s owner who was responsible for making the payments but would also receive the death benefit when the insured dies. The patient died a year later, and when Dr. Grigsby attempted to obtain the death benefit, the insurer declined to pay.
They reasoned that he had no insurable interest since he wasn’t related to the patient and life insurance policies could only be used to cover debts, and anything over that is deemed a wager, which isn’t allowed. This case eventually went to the Supreme Court which distinguished Dr. Grigsby as the policy owner.
What Is a Life Settlement?
If you own a life insurance policy that you no longer want, it serves no purpose, or you can’t afford to keep, you generally have two choices: surrender it to the carrier for cash (provided it’s a permanent policy) or let it lapse.
Life settlement allows a third unique alternative: selling your policy to a third party, other than the insurer who issued your policy, for one lump-sum above the policy’s surrender value but less than its death benefit amount. This transaction is called a life settlement.
The life settlement market arose as a result of the viatical industry that developed in the 1980s as a source of liquidity for AIDS patients or other terminally ill individuals who had a life expectancy of two years or less and saw no advantage in owning a life policy. He/she sold the policy to a third party for cash in exchange for the death benefit payment when they pass away.
Side note: I can’t see the morality or humanity of such an act because your primary intent as an investor is the recoup your investment earlier, which means an early death is a reason for a celebration while others are mourning.
How Do Life Settlements Work?
The typical candidates for life settlements are 65 or older and own a policy with $100,000 or more of face value.
The life transaction is only possible when the policy’s market value is higher than the surrender value (the money you get from the insurer if you cancel or surrender your policy).
Some of the critical factors in evaluating a policy’s worth are the type of policy, the amount, your age and life expectancy. In other words, the lower your life expectancy and premiums are, the larger the market value is.
When you sell your life policy, you collect one-time payment while the buyer or institution becomes the policy’s owner while you remain the insured. The new owner is responsible for ongoing premium payments for as long as you live and also has a financial stake in your death.
The sooner you die, the faster he collects. Once you pass away, the insurer pays the death benefit to the buyer.
Life Settlement Pros
- You can’t afford the premiums: For instance, if you own a universal life policy for which your cash value decreased and the cost of insurance increased, you may find out that the flexible premiums you used to pay aren’t appealing anymore and you can’t afford it.
- Your need for life insurance no longer exists: The mortgage is paid up and/or the children are out of the house and no longer depend on your income. Buying protection 30 years ago was not only a great idea but a responsible one, too. However, now, the policy has become a liability.
- Your policy is about to lapse: Whatever the reason is, you may want to check if you could sell your policy and get more money than the carrier offers.
- Change in financial or life circumstances: Life rarely goes as planned. Events such as divorce or the death of beneficiary could be a reason to get rid of your current life insurance policy.
Life Settlement Cons
- Don’t think that you are the winner here: If you are a candidate for a life settlement, you likely have 2–10 years left to live. Remember, the investor or institution who has an interest in your policy will only recover his purchase once you’re dead. Unlike the insurance carrier, who underwrote your application with the notion of how long you’ll live, a life settlement is estimating how fast you’ll pass away.
- The life settlement market isn’t highly regulated in all states: Scams and frauds are a common practice along with aggressive sales tactics and abusers who target seniors who aren’t in the best of health or terminally ill. Moreover, life settlements involve commission rates as high as 30 percent which, for some, is worth selling their soul and mother for a quick buck. Be aware!
- Tax consequences: You may have to pay taxes on your life insurance settlement. If you received a settlement larger than your total initial investment (what you paid in premiums), you would pay taxes.
- Medical information: Are you ready to share your medical records with a third-party entity? You’ll have to. Investors and entities who wish to purchase your existing policy will use life expectancy providers (LEPs), much like a life insurance underwriter, which specialize in estimating your life expectancy based on your current and past health, age, gender, and smoking among others. Doing so would require access to your medical records.
- You may no longer be eligible for a new policy: If you thought to get rid of your current policy and just buy a new one, think again. The reason your life settlement went through is that your life expectancy is ten years at best. You will be hard pressed to find a policy with that going against you, unless, of course, you opt for the guaranteed issue—for a much lower face amount and waiting period.
- Your survivors may still need protection: The reason you first bought the policy is to provide financial security to your heirs. If you sell the policy, that assurance is gone, and your beneficiaries may have to pay for burial expense or other expenses.
- The settlement process is about four to six months: If you thought this would be an immediate fix and therefore can avoid paying premiums, think again.
- High transaction costs: Other than the top commission rates brokers earn by pairing you with buyers, there is no way to determine if you’re getting a reasonable price for your policy.
Other Options to Consider
- If you are thinking about switching a new policy instead of the one you have, consider 1035 exchange. The IRS allows you to avoid paying tax on investment gains of the original policy if the same person is insured and transferred into a new policy.
- If you need quick cash and this is your reasoning for a settlement, then contemplate taking a loan from your policy’s cash value, provided there is some. Yes, you may pay a little interest, but you’ll keep your policy in force instead of getting rid of it.
- If you were diagnosed with a terminal illness, call your insurer or broker who sold you the policy and find out if you have an accelerated death benefit rider. Most plans come with this rider which allows the policy owner to tap into the death benefit, usually up to 75% if he/she has less than two years to live.
You might have watched the ad on TV with the lovely old couple who just found out that their life insurance is an asset. They chose to sell it, and they’re now living joyfully with their grandchildren in the background.
You thought, “I could have this life, too. I have a policy.”
First, your life insurance policy isn’t an asset or investment and shouldn’t be treated as such. Second, licensed life insurance agents who sell policies as an investment, instead of what it is—insurance—could get into a lot of trouble with the department of insurance’s ethics department.
If you believed that you could just get rid of your policy and someone will pay cash for it, then you’ll go and resume living another 50 years, you are mistaken.
The only time a buyer would buy your policy is if they can make money, and the only way to do so is if you perish soon after the life settlement. Hence, if you are selling your policy, chances are the investor can make money pretty fast.
Make sure you do your due diligence about the company you’re dealing with and make sure you weigh all the options before taking a life settlement. We at Effortless Insurance don’t deal with life settlement but see prominent value in educating our seniors who may contemplate such thing.