Viatical and life settlements explained: Opportunities, risks and key differences

A viatical settlement and a life settlement are both financial transactions involving the sale of a life insurance policy, but they cater to different circumstances and policyholder demographics.

A viatical settlement is a type of financial arrangement where a person with a terminal illness sells their life insurance policy to a third party for an immediate cash payment. The key characteristic of a viatical settlement is that it is specifically designed for individuals who are diagnosed with a life expectancy of usually less than two years due to a terminal illness.

In a viatical settlement, the amount paid to the policyholder is less than the death benefit of the policy but typically more than its cash surrender value. The third party, which could be a person or an entity specializing in these transactions, becomes the new owner of the policy, takes over the payment of premiums and eventually receives the full death benefit when the original policyholder passes away.

The primary purpose of a viatical settlement is to provide financial relief during a difficult time, allowing individuals facing a terminal illness to access the value of their life insurance policies to cover medical bills, living expenses or other immediate financial needs.

A life settlement, on the other hand, is a similar financial transaction but is aimed at a broader demographic, primarily older adults, typically those age 65 and over. Unlike viatical settlements, the policyholders in life settlements are not necessarily terminally ill. They might choose to sell their life insurance policy for various reasons such as changes in their financial needs, the policy becoming too expensive to maintain or the policy no longer being needed for its original purpose.

In a life settlement, the policyholder sells their policy for an amount that, again, is less than the death benefit but more than the cash surrender value. The buyer, similar to a viatical settlement, takes over premium payments and receives the death benefit upon the policyholder's death.

The financial incentive for the policyholder in a life settlement is to gain access to cash from an asset that would otherwise remain untapped until death. The transaction provides a way to reallocate resources for current living expenses, debts or investments for retirement or other purposes.

The fundamental difference between the two lies in the health status and life expectancy of the policyholder. Viatical settlements are specific to terminally ill individuals with a limited life expectancy, providing them with financial support in their remaining time. Life settlements cater to older individuals who are not necessarily facing a life-threatening illness but are looking to liquidate a life insurance asset for immediate financial benefits.

The genesis of viatical settlements can be traced back to the devastating impact of the AIDS epidemic. This period saw a significant shift in how life insurance policies were perceived and utilized, especially by those facing terminal illnesses.

In the 1980s, the world witnessed the rapid spread of the AIDS epidemic, a health crisis that brought about not only medical challenges but also financial distress for those affected. At the time, the medical community was grappling with understanding and treating this new and fatal disease, leaving many patients with a dire prognosis. As a result, individuals diagnosed with AIDS faced not only a health crisis but also an economic one, as the cost of treatment and care was often exorbitant and not fully covered by insurance.

It was under these trying circumstances that viatical settlements emerged as a financial solution. The term "viatical" comes from the Latin "viaticum," which historically referred to the provision made for a journey, typically in the context of a pilgrimage. In the modern financial sense, viatical settlements offered a journey of another kind — a journey through one's final days with financial peace of mind.

Viatical settlements were designed to allow individuals with a terminal illness, like AIDS, to sell their life insurance policies to a third party before death. The seller would receive a lump sum payment that was less than the death benefit of the policy but more than the surrender value. This transaction provided the policyholder with immediate cash that could be used to cover medical expenses, pay for care or simply improve their quality of life during their remaining time.

For the buyers of these policies, typically investors or companies specializing in life settlements, this was seen as a calculated investment. The buyers would pay the ongoing premiums and eventually receive the death benefit upon the passing of the insured. For the sellers, it meant a chance to access the value of their life insurance policies without having to wait until death, thus turning a non-liquid asset into a vital source of liquidity.

The emergence of viatical settlements also opened up discussions around the emotional and ethical aspects of monetizing one's life insurance policy during a health crisis. For many, the decision to enter into a viatical settlement was not just financial but deeply personal, often fraught with emotional considerations and a sobering acknowledgment of one's mortality.

As viatical settlements grew in popularity, they caught the attention of lawmakers and regulators. Initially, the industry was largely unregulated, leading to concerns about exploitation and fair practices. This necessitated the development of regulatory frameworks to protect the interests of the terminally ill policyholders. Various states in the U.S. began to enact legislation governing viatical settlements, focusing on issues such as licensing of viatical settlement companies, disclosure requirements and protections against fraud.

While viatical settlements were specifically tailored for those with a limited life expectancy, the concept eventually broadened, giving rise to life settlements. Life settlements extended the idea to older adults who, although not necessarily facing a terminal illness, were interested in liquidating their life insurance policies for immediate financial needs.

The historical context of viatical settlements is a testament to the adaptability of financial instruments in response to societal needs. Originating as a compassionate response to a health crisis, these settlements evolved into a structured financial solution, offering a new perspective on life insurance and its potential uses. This evolution also paved the way for the life settlement industry, expanding the scope and applicability of this financial concept to a broader demographic.

Life settlements, on the other hand, evolved from viatical settlements but cater to a different demographic — typically older individuals who are not necessarily facing a life-threatening illness but seek to liquidate their life insurance policy for reasons such as retirement planning or financial emergencies.

The payout amount in both viatical and life settlements is influenced by an array of factors. First and foremost is the size of the policy itself. Naturally, larger policies with higher death benefits can command greater settlement amounts. However, the health status and life expectancy of the policyholder play an equally pivotal role. In viatical settlements, where policyholders have a limited life expectancy due to terminal illness, the payout is typically higher. This is because the investor purchasing the policy anticipates a shorter waiting period before the death benefit is payable, thereby assuming a higher risk which is offset by a larger payout.

Life settlements, catering to individuals who are typically older but not necessarily facing a terminal illness, tend to have lower payouts. The determining factor here is the longer life expectancy, which means a longer wait for the death benefit and consequently more premium payments, reducing the settlement offer.

The tax implications of viatical and life settlements add another layer of complexity to these financial decisions. Viatical settlements can be tax-free under certain conditions. If the policyholder is chronically or terminally ill, the Internal Revenue Service (IRS) may not tax the proceeds from the settlement. This exemption is in recognition of the financial hardship often faced by individuals in such health conditions.

In contrast, life settlements may be subject to more intricate tax rules. The amount received over the premiums paid into the policy can be taxed as income. Additionally, if the policy was purchased as an investment, there could be capital gains tax implications. These tax considerations require careful planning and consultation with a tax professional to understand the full scope of potential tax liabilities.

Both viatical and life settlements can have profound effects on future financial planning, inheritance and eligibility for certain government benefits. By opting for a settlement, policyholders forego the death benefit originally intended for their beneficiaries. This decision can significantly alter the landscape of estate planning and inheritance. Moreover, the influx of funds from a settlement might impact eligibility for means-tested government benefits like Medicaid, necessitating a reevaluation of financial strategies and potential needs for long-term care.

One of the most compelling reasons for considering a viatical settlement is the need to cover high medical costs. For individuals battling a terminal illness, the costs of treatments, medications and hospice care can be astronomical, often exceeding what insurance will cover. Viatical settlements provide a lifeline, offering immediate financial resources to manage these expenses.

Viatical settlements also play a crucial role in enabling access to quality end-of-life care. The funds can be used to ensure comfort during a policyholder’s final days, whether through better medical care, access to palliative treatments or the ability to remain at home surrounded by loved ones. This aspect of viatical settlements underscores their value not just in financial terms but also in enhancing the quality of life during a profoundly difficult period.

The decision to pursue a viatical or life settlement is laden with considerations that span beyond immediate financial gain. It requires a thoughtful analysis of payouts, an understanding of complex tax implications and a careful assessment of long-term financial impacts, especially regarding medical costs and quality of life considerations.

By settling their life insurance, individuals also can ensure their families are not left with overwhelming medical or funeral expenses.

There are several key reasons why individuals might choose to avoid viatical and life settlements, primarily related to financial implications, emotional and ethical considerations, and long-term consequences. They include:

• Reduced payout compared to policy value. One of the most significant drawbacks of both viatical and life settlements is that the payout amount is generally much lower than the death benefit of the policy. Policyholders receive only a percentage of the policy's face value, which means losing out on the full potential benefit that could have been passed on to beneficiaries.
• Complex and potentially unfavorable tax implications. While viatical settlements may be tax-exempt under certain conditions, life settlements can incur complex tax liabilities. The proceeds from a life settlement can be taxed as income, and there might be additional capital gains tax if the policy's sale price exceeds the sum of the premiums paid. Navigating these tax implications can be complex and potentially reduce the financial benefit of the settlement.
• Emotional and ethical considerations. Selling a life insurance policy, especially in the case of a viatical settlement, can be an emotionally charged decision. It often requires coming to terms with one's mortality or illness in a very concrete way. Additionally, there are ethical considerations surrounding the idea of benefiting financially from one’s impending death, which can be discomforting for some individuals and their families.
• Potential for scams and exploitation. The industry of viatical and life settlements, although regulated, can still be prone to scams or exploitative practices. Vulnerable policyholders, especially those who are terminally ill or elderly, might be at risk of receiving unfair offers or falling victim to fraudulent companies.
• Long-term financial implications for beneficiaries. By choosing to sell their life insurance policy, policyholders are giving up the death benefit that would have otherwise gone to their beneficiaries. This decision can have significant long-term financial implications for those who were counting on the death benefit as part of their financial planning or inheritance.
• Psychological impact. The process of selling a life insurance policy, particularly under circumstances of ill health or financial distress, can have a psychological impact. It might bring feelings of guilt, sadness or a sense of loss, not just for the individual selling the policy but also for family members and loved ones.
• Loss of control over policy. Once a viatical or life settlement is completed, the policyholder loses all control over the policy. This includes the inability to change beneficiaries or negotiate terms, which can be an uncomfortable loss of control over a significant financial asset.

In summary, while viatical and life settlements can provide immediate financial relief in certain situations, they also come with a range of potential downsides. These include financial losses, tax complications, impact on benefit eligibility, emotional challenges, risk of exploitation and long-term effects on beneficiaries. It is essential for individuals to carefully weigh these factors and consider all alternatives before opting for a settlement.