How to handle the life settlement transition

A life settlement is the sale of an existing life insurance policy for immediate funds that represents a percentage of its net death benefit. This is a great option for anyone that no longer needs, wants, or can afford their policies.

The policy owner can actually turn insurance premiums (liability) into cash (asset) representing a percentage of the death benefit of the policy. In the past, these transactions, commonly known as viatical settlement agreements, were almost exclusively used with terminally ill policyholders. However, in recent years they have been utilized as a new financial tool in the estate planning and business arenas.

The overall concept of a life settlement is relatively simple: a policy owner agrees to sell a policy for an agreed upon sum of money to a third-party funding company, who then becomes the new owner and beneficiary of the policy and assumes all future premium obligations. Several factors play into the determination of the fair market value of a policy. These are the net death benefit of the policy; the age and health condition of the insured; the amount of the policy premiums; and the rating of the insurance carrier.

Actual case example: A 68-year-old could no longer afford to pay the premiums on a $3.3 million variable life policy with no cash value. He was going to allow the policy to lapse before his tax adviser suggested that he consider a life settlement. The result was that the insured received $1.1 million for a policy he thought was worthless.

Generally, policyholders over the age of 70 will be considered for life settlement transactions. Individuals as young as 65, may also be considered when they have significant health concerns. Life insurance policies of many types will be appropriate for a life settlement including term, universal, whole, variable, group, and survivorship life. An individual, a trust or a business may own these policies.

There are many circumstances in which the sale of an existing life insurance policy would be of interest to the policy owner, the most common reason being that the policy is no longer wanted, needed, or affordable. For example, someone may want to sell an existing insurance policy that is no longer needed because the insured may have outlived the beneficiary of the policy or the insured may have changed their mind for one reason or another about leaving a policy for that beneficiary. In a situation like this, it may make more sense to extract some present value from the policy rather than continuing to pay premiums.

Many other situations exist in which a life settlement transaction may be desirable. The insured may be in serious need of funds and the availability of a life settlement allows the insured to derive some personal value from the policy in a time of great need. A policyholder may also have a need for long-term care, long-term care insurance, or health insurance, and an existing policy may be sold to help fund these current needs.

Under some circumstances, a life settlement may be the only means by which an insurance policy may be removed from an individual's estate without the total loss of the value of the policy. A life settlement can be a means of avoiding the IRS three-year look back rule relating to the transfer of life insurance policies, thereby maximizing the proceeds to be transferred to the insured's family or other beneficiaries and reducing estate taxes by removing the death benefit from the estate. Because a life settlement is a "sale for value," the three-year rule does not apply. Of course, proceeds from the sale of the policy will still be included in the estate of the policyholder, however, this amount will be greatly discounted from the amount of the death benefit.

Many individuals find it advantageous to donate highly appreciated assets to charity because they receive a current income tax deduction equal to the fair market value of the asset, rather than their basis in the asset. Often, however, such appreciated assets are income producing -- stocks, oil and gas properties, real estate -- and the donor may not be willing, or able, to give up the income. As an alternative, proceeds obtained from a life settlement may make up some of the lost income of the highly appreciated, income-producing assets. The appreciated assets can then be gifted to charity to satisfy the individual donor's charitable goal of making a substantial lifetime gift.

Furthermore, a life settlement transaction may be appropriate in certain business situations. In a family-owned business, the proceeds from the sale of a key-person policy may be gifted to the benefactors to be used for the purchase of the family-owned business at a pre- death discount. Or, a policy that was purchased to finance a buy- sell agreement may no longer be needed after the business has been sold to a third party, the key person has retired, or because the business may have matured to the point that its fortunes no longer depend on one individual. In these situations, there may be little utility in continued payment of insurance premiums. Value received from a life settlement, although discounted, still represents some value for the insurance premium dollars spent.

Actual case example: An 80-year-old business founder sold his business and retired, making a key man policy of $1 million, with $150,000 cash value, no longer needed. A life settlement transaction was arranged resulting in funds being received representing a net gain of $110,000 over the cash value. The life settlement proceeds were used to supplement the business founder's retirement income and to buy his wife long-term care coverage.

Tax consequences from a life settlement transaction will vary, but generally all life settlement funds up to the basis are received tax- free and funds received in excess of basis are treated as either ordinary income or capital gain unless the policyholder is terminally ill, in which case the proceeds may be tax free. Of course, as with any financial transaction it is advisable to consult with the appropriate attorneys, tax and financial advisers and estate planning professionals regarding the legal and tax implications involved.

In summary, there are many cases where a life settlement involving the sale of an existing life insurance policy may be a means of deriving some current economic benefit from a life policy that is no longer of use to the policyholder. Use of life settlements as an option in financial and estate planning provides some individuals, such as seniors or family business owners, previously unavailable flexibility with life insurance policies.

Jack V. Sinclair is a principal with The Heritage Group and has been in the financial services business since graduating from the University of Oklahoma in 1970.

Jennifer K. Golden is an attorney with the law firm of Phillips McFall McCaffrey McVay & Murrah, where her primary areas of practice are federal and state taxation, estate planning and probate.

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