In a life settlement, a third-party purchaser buys an in-force life insurance policy for its fair market value. That value is typically more than the policy's cash surrender value but less than the death benefit. The policy's seller -- who is generally 70 or older and has a life expectancy of two to 12 more years -- is not restricted in how they use the proceeds from the sale of the policy. The third-party buyer becomes liable for all further payments and premiums on the policy, and they receive the full amount of the death benefit upon the death of the former policyholder.
The emergence of the secondary life insurance market creates several estate planning opportunities for individuals and businesses that are seeking to dispose of a life insurance policy prior to its payout. It also provides an attractive alternative to two options policyholders had before the life settlement market began flourishing.
Lesser of two evils
First, before the life settlement market began to come of age, an individual who wanted to dispose of their life insurance policy had only two options. For one, he or she could simply stop making premium payments and let the policy lapse. This option has a major drawback: Once the policy lapses, the beneficiaries no longer have the right to receive the death benefit when the insured dies.
The policy owner could also return the policy to the insurance company for its cash surrender value. If there was any cash surrender value, this is a more attractive option than allowing the policy to lapse, since the policyholder will receive at least some financial benefit. However, the cash surrender value on a life insurance policy is rarely, if ever, equal to or higher than the fair market value that can be had in the life settlement market.
Estate planning applications
Life settlements might be effectively used as an estate planning tool when a policyholder's circumstances change because of health, financial difficulties, or some other issue that places a greater financial burden on the policyholder. With a life settlement, that financial burden can be alleviated with the proceeds received from the policy's sale. Moreover, one of the most attractive benefits of a life settlement is that there are no limitations on the use of the settlement proceeds for the insured. There are, however, income tax implications that must be considered.
A somewhat different scenario allows for the utilization of a life settlement as an estate planning tool when a client is underinsured. This scenario is based on the concept that every individual has a certain level of insurability and that many people (especially wealthy people) fail to insure themselves up to their personal "limit" of insurability. The life settlement market allows the client to purchase a new policy to insure themselves up to their insurable limit and sell the policy for its "fair market value" at some future time. Upon the sale, the client will receive the settlement proceeds and will be relieved of all future payments and premiums on the policy. Moreover, the settlement amount will typically exceed the amount of premiums paid over the holding period.
Under any of these circumstances, the estate planning advisor and client should carefully weigh the financial, tax, and other consequences of selling the policy. Although the client will receive settlement proceeds, the policyholder is sacrificing the future death benefit.
Accordingly, the advisor and client may consider the impact on the insured's beneficiaries, the impact on the insured's long-term financial health, and the effect, if any, on the insured's estate's ability to pay estate taxes, among others. Such issues can significantly reduce the viability of a life settlement as an estate planning tool for the client. If necessary, the insured can use the policy as leverage to borrow funds, rather than sell the policy in a life settlement. But despite these questions, life settlements are now a legitimate estate planning tool and can provide substantial benefits to policyholders in various situations.
Geoffrey A. Weg is with the firm of Valensi Rose PLC. He can be reached at 310-277-8011 or gaw@vrmlaw.com.
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