Life Settlements
Sometimes It’s Alright To Settle
There’s a Viable Secondary Market for Life

Our clients often ask us to explore various estate- and business-planning options. One unique option for seniors is the sale of their of their life insurance policy, a life settlement. For the right situation, a life settlement has a significant advantage over traditional alternatives and should be considered. To understand what a life settlement is, you must understand what it is not and how the transaction has evolved.

In 1911, the Supreme Court decided that life insurance policies are freely assignable for value. The court found that a life insurance policy is a form of property and that policy owners are free to sell and transfer ownership to other parties.

The court stated the following in the case of Grigsby vs. Russell (1911): “Life insurance has become, in our days, one of the best recognized forms of investment and self-compelled saving. So far as reasonable safety permits, it is desirable to give to life policies the ordinary characteristics of property. This is recognized by the bankruptcy law (70,1), which provides that, unless the cash-surrender value of a policy (like the one before us) is secured to the trustee within 30 days after it has been stated, the policy shall pass to the trustee as assets. Of course, the trustee may have no interest in the bankrupt’s life. To deny the right to sell except to persons having such an interest is to diminish appreciably the value of the contract in the owner’s hands.”

Since then, there has been a dramatic increase in the value and volume of the life settlement industry. The market for life insurance has helped consumers manage their life insurance assets more effectively, providing an alternative to lapse or surrender. In 2004 alone, life settlements provided seniors with $1 billion in purchasing power -- $660 million in excess of cash surrender value, according to the Life Insurance Settlement Association (LISA).

There is now a mature and viable secondary market for life insurance policies. As the market matured, recognized financial leaders began providing significant capital funding. Warren Buffet said, in his February 25th letter to shareholders, “Berkshire purchases life insurance policies from individuals and corporations who would otherwise surrender them for cash. As the new holder of the policies, we pay any premiums that become due and, when the original holder dies, collect the face value of the policies. The original policyholder is usually in good health when we purchase the policy. Still, the price we pay for it is always well above its cash-surrender value (CSV). Sometimes, the original policyholder has borrowed against the CSV to make premium payments. In that case, the remaining CSV will be tiny and our purchase price will be a large multiple of what the original policyholder would have received, had he cashed out by surrendering it.”

What A Life Settlement Is Not

It is important to understand the fundamental difference among the life settlement business, investor owned life insurance (IOLI), stranger owned life insurance (STOLI) and other similar structures. Industry associations, such as the American Council of Life Insurers (ACLI), the Association for Advanced Life Underwriters (AALU), and others have done a great job at confusing the differences. Settlements are legal, ethical, honest, and good for the industry while the others are not.
Investor-owned life insurance and the many other varieties involve a third-party investor approaching a senior about purchasing premium-financed life insurance (lender paid premium). This often involves the investor advancing money to the insured as an enticement to purchase a policy.

What a Life Settlement Is

Life settlements offer consumers an alternative to lapsing or surrendering policies. Policyholders have a choice that will help them realize full market value if they decide to abandon their policies.
A life settlement is an option for seniors (typically age 70 or older) who want to maximize the disposition of unwanted life insurance policies. The life settlement transaction involves selling a life insurance policy to an institutional investor in exchange for a lump sum payment. The payment is larger than the cash-surrender value, but smaller than the death benefit. The institutional buyer becomes the new owner of the policy, paying premiums, going forward, and collecting the death benefit upon the insured’s death.

Sometimes, an insurance policy is no longer needed to meet its original purpose of protecting a breadwinner’s stream of income, compensating for the loss of a business’ key employee, or funding a buy/sell agreement. The most popular policies that are settled are low cash value universal life policies. Our clients are often surprised that their term insurance policies have value as well, allowing them to recover a portion of all of the premiums they have funded throughout the years. There is also a market for joint survivorship and group policies (if convertible and portable).

Approximately $15 billion worth of life insurance policies were sold on the secondary market in 2006. Partly fueling the growth is a more knowledgeable marketplace and a maturation of the industry. This emerging industry is becoming a mainstream option for seniors and their advisors due to increased regulatory oversight and the infusion of institutional capital from investment banks, such as Credit Suisse, Goldman Sachs and Deutsche Bank as well as foreign and domestic hedge funds.
Furthermore, the recent volatility and underperformance of the stock and bond markets has shaken investors to the core. Global investors have lost confidence. They are looking for alternatives that can provide safe, secure, predictable rates of return. These institutional investments should provide long-term, consistent cash flow and positive returns. We are seeing a surge in these investments outside the traditional investment channels and a backlash against traditional investment vehicles. However, this industry is not insulated from the credit and capital markets. As the availability of money has contracted, so has the number of available policy buyers. This has created an excess supply of policies and we’ve seen a reduction in value of offers to our clients as of late. As the credit and capital markets recover, we fully expect the same in the life settlement marketplace.

Case Studies

An estate attorney introduced us to an 81-year man who had a $1.25 million life insurance policy that he acquired almost 20 years ago to pay estate taxes. Initially, he was diligent about funding the policy, but decided to stop paying premiums over the past decade. We discovered that the policy was projected to lapse over the next 12 months without new premium payments under the insurance company’s guaranteed interest rates. Although the client valued the insurance, he didn’t want to continue funding premiums. If the policy lapsed, there would be no cash-surrender value and he would get nothing.

We explored the secondary market with a myriad of institutional investors. The client accepted the best offer of $257,000. Along with our work in finding the best value for the policy, we had underwritten the client with a stable of reputable life insurance carriers. The client was in good health and was very active. We were able to secure a very good offer from a carrier and recommended that the client and his advisor acquire the new insurance using some of the proceeds from the sale of their existing policy. The new policy was funded with a single premium payment. The $1.5 million policy significantly extended the coverage period for the client and his family. This strategy resulted in the continuity of additional life insurance protection, which was the family’s goal, without any out-of-pocket expense from the client.

Another client asked us to double the coverage on a 65-year old key executive employee of his business. There was term insurance in the amount of $5 million. Term insurance rates have been decreasing steadily due to the improvement in general mortality trends. So, one good option is to replace the existing coverage with a $10 million policy. A few years ago, we would simply lapse the policy after the new one was in force. We suggested that we explore the settlement of the convertible term policy instead of simply surrendering the policy. The client received over $150,000 from the settlement of the term policy instead of giving it up for nothing.

Generally speaking, if the life settlement proceeds do not exceed cost basis or the premiums paid for the policy, the payment will not be subject to income tax. You must consult with your tax advisor regarding the tax treatment.

These are very specific circumstances and we explored many other options. However, it is evident that the emergence of the life settlement industry provides a viable option that was not previously available. Make no mistake; this is a sophisticated financial transaction that has pitfalls. It requires the coordinated due diligence of knowledgeable advisors. Nevertheless, monetizing an asset normally seen as having little or no current worth, allows the client can leverage it into significant value.
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R. Wesley Sierk, III is the president and lead strategist for Risk Management Advisors, Inc. He’s an expert on the insurance marketplace, asset protection, executive compensation, corporate benefit planning, alternative risk transfer and captive insurance formation. He is a frequent speaker to industry and trade associations, and business organizations. He’s a member of the American Society of Pension Professional & Actuaries, Associations for Advanced Life Underwriters, the Wealth Counsel, and the International Forum He’s the author of “Taken Captive: The Secret to Capturing Your Piece of America’s Multi-Billion Dollar Insurance Industry.” He is also the author of You Can Make It, But Can You Keep It?”