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If you are in or nearing retirement, you may have been contacted by one or more companies asking to purchase your “unwanted” or “unneeded” life insurance policy. These life insurance policy buyers may highlight the benefits of selling your coverage, such as no more premium payments and an instant cash payment that can be used now.
But before you sign on the dotted line and hand over your survivors’ future financial protection, it is absolutely essential that you have a good understanding of how life insurance settlement transactions work, and why they may – or may not – be in your best interest.
Life insurance is purchased for any number of different needs. These typically include one or more of the following:
One of the most common reasons for purchasing life insurance is income replacement. When an income-earner in a household passes away, it can oftentimes be difficult for survivors to continue living their current lifestyle.
This is the case for those who are young and have families to support, as well as for older individuals and couples who may lose some (or possibly even all) of their spouse’s pension and/or Social Security income benefits.
Debt payoff is another top reason for having life insurance. As an example, the ability to pay off a mortgage, auto loan and credit card balances when a breadwinner dies could make the difference between survivors remaining in their current home or having to completely change their living arrangements.
Life insurance may also be used for paying the high cost of a funeral and other “final expenses,” as well as college funding for a child or grandchild, the cost of settling the estate (which could wipe away 40% or more of your estate’s value) or even making donations to a favorite charity.
In some cases, life insurance could provide other benefits, such as providing “accelerated” benefits. In this case, a portion of the death benefit may be accessed for qualifying expenses while the insured is still alive.
For example, if the insured is diagnosed with a terminal or chronic illness, or if they must reside in a skilled nursing home, penalty-free money may be taken from the life insurance policy’s death benefit. Then, at the time of the insured’s death, the amount of the funds that were accessed are simply deducted from the death benefit payout. (Not all policies provide this feature.)
Because life insurance death benefit proceeds are received by the beneficiary (or beneficiaries) free of income taxation, 100% of the amount that is received can be used by the survivors, without having to give a portion to Uncle Sam. This tax-advantaged nature is another of the many benefits of owning a life insurance policy.
In addition, if the policy is permanent (versus term), there is both death benefit protection and a cash value component, where the funds grow on a tax-deferred basis. This can allow the value to grow exponentially – especially over a long period of time.
A life settlement transaction occurs when an individual (or in some cases, a couple) sells their life insurance policy to a third party, typically for an amount that is less than the death benefit but more than the cash surrender value.
With this situation, the purchaser becomes the new owner of the life insurance policy, as well as the beneficiary. The new owner takes over the payment of premiums, and also receives the death benefit when the insured dies (provided that the policy is still in force).
In this case, the sooner the insured dies, the faster the purchaser of the policy is “paid” – and the higher their return on investment. For instance, using a hypothetical example of a life insurance policy with a death benefit of $250,000 and an annual premium of $3,000, here is how the purchaser could earn a significant return, given a purchase price of $30,000 in a life settlement transaction.
It is easy to see how the investor/life settlement company profits less – and incurs more in expenses – when the insured lives longer. In many cases, even given the immediate lump sum of cash that the policy owner receives, life settlements are oftentimes not favorable for the policy seller, but very profitable to the organization that buys the life insurance contract.
Life settlements are often touted as a way for terminally ill individuals to pay for health care and other expenses while they are still alive. Unfortunately, these transactions are oftentimes mis-sold, using fear tactics to scare seniors into selling their policy – even when it is in the owner’s best interest to hang on to the coverage.
So, while the receipt of cash might be enticing, assigning ownership of your life insurance policy to another individual or company could end up robbing your survivors of funds that are needed in the future.
| If insured dies in year: | Investor costs: | Amount investor recieves |
|---|---|---|
| If insured dies in year:1 | Investor costs:$33,000 (Purchase price + one year of premium payment) |
Amount investor recieves$217,000 ($250,000 death benefit minus $33,000 costs) |
| If insured dies in year:2 | Investor costs:$36,000 (Purchase price + two years of premium payments) |
Amount investor recieves$214,000 ($250,000 death benefit minus $36,000 costs) |
| If insured dies in year:3 | Investor costs:$39,000 (Purchase price + three years of premium payments) |
Amount investor recieves$211,000 ($250,000 death benefit minus $39,000 costs) |
| If insured dies in year:5 | Investor costs:$45,000 (Purchase price + five years of premium payments) |
Amount investor recieves$205,000 ($250,000 death benefit minus $45,000 costs) |
| If insured dies in year:10 | Investor costs:$60,000 (Purchase price + ten years of premium payments) |
Amount investor recieves$217,000 ($190,000 death benefit minus $60,000 costs) |
Just like other types of investments and financial vehicles, life insurance settlements may not be right for you – even if they are a good solution for others. Typically, though, good candidates for life insurance settlement transactions include those who:
Certainly, as we age, our life expectancy becomes shorter. That’s why life insurance policies where the insured is age 65 or over are more attractive to life settlement investors. Otherwise, the investor could end up having to pay the premium for a long period of time.
In the past, the most favorable life insurance policies to purchase were those in which the insured had been diagnosed with a terminal illness. That is because the life expectancy of the insured was usually quite short.
Today, however, more life settlement companies are considering policies of healthy individuals, and the “sweet spot” is usually on those where the insured has a three- to 15-year life expectancy.
Permanent life insurance policies are generally favored by life settlement investors. That is because with a permanent policy, the coverage will remain in force for the remainder of the insured’s life – regardless of whether he or she contracts a serious health condition (as long as the premium is paid).
This differs from term life insurance where there is a time limit, or “term” of coverage, such as 10, 15, 20 or 30 years. In this case, even if the term policy’s premium remains level for the entire time frame, if the insured is still alive when the policy expires, the cost could be significantly higher if the coverage is renewed. That is because the cost of the insurance will be based on the insured’s then-current age and health condition.
As an example, Jack owned a 20-year term life insurance policy with a $150,000 death benefit. When he purchased the coverage at age 62, his premium cost was $1,100 per quarter. However, as he approached age 82, he received a notice from his insurance company telling him that the new premium would jump to more than $11,000 per quarter – roughly 10 times more than he was currently paying.
In checking with several life settlement companies, Jack found that none of them were interested in purchasing his policy, as the buyer would have to pay $44,000 per year just to keep it in force.
Plus, given Jack’s good health report on his annual physical, it is possible that the investor would have to continue paying the premium for many years. With the policy’s death benefit of $150,000, the high premium would not warrant a large return on investment for a life settlement company.
In some cases, if an insured has more than one life insurance policy, they will often become an even more enticing candidate for life settlement investors because they may want to sell more than one of these plans.
Although receiving a lump sum of cash can be tempting, there are several important factors that you should consider before you commit to selling your life insurance policy. For instance, the amount of money you receive is typically much less than the death benefit proceeds that would be paid to your beneficiary. So, the company or investor who purchases your policy will typically only be giving you pennies on the dollar for it.
Also, if the death benefit funds were earmarked for specific needs – such as replacement of the insured’s lost income and/or payoff of a home mortgage – loved ones and survivors could be left in a difficult financial situation.
That is because any amount that is over your cost basis (i.e., the amount of premium you’ve paid in) can be taxable. So, if you have paid $25,000 of premium into your life insurance policy, and you receive $40,000 from selling it to an investor, then $15,000 of that will be taxable.
| Advantages of a Life Insurance Settlement | Disadvantages of a Life Insurance Settlement |
|---|---|
| Advantages of a Life Insurance SettlementRecieve a lump sum of cash | Disadvantages of a Life Insurance SettlementEliminates financial protection and liquidity for survivors (such as debt payof and income replacement) |
| Advantages of a Life Insurance SettlementNo longer reuire to pay the policy's premium | Disadvantages of a Life Insurance SettlementEliminates income-ax free receipt of funds for beneficiaries |
| Advantages of a Life Insurance Settlement | Disadvantages of a Life Insurance SettlementMay not qualify if life insurance is needed in the future |
| Advantages of a Life Insurance Settlement | Disadvantages of a Life Insurance SettlementTakes away other benefits the policy may have included, such as long-term care funding |
| Advantages of a Life Insurance Settlement | Disadvantages of a Life Insurance SettlementProceeds received from the buyer can be taxable to the seller of the policy |
| Advantages of a Life Insurance Settlement | Disadvantages of a Life Insurance SettlementThe process of elling your life insurance policy can be complicated nd loaded with a lot of "fine print" |
Total amount of premium paid into the policy: $25,000
Amount paid from the life settlement investor to purchase the policy: $40,000
Taxable amount of proceeds: $15,000
($40,000 payment for policy minus $25,000 cost basis = $15,000 in taxable proceeds)
Selling your life insurance policy could provide you with a large sum of cash. However, doing so can also take away some or all of the financial security that your survivors may require to move forward – especially at a difficult time in their lives.
Plus, if you sell your life insurance coverage now and then discover that you need this type of tax-advantaged financial protection in the future, you may not be able to qualify if you have contracted certain types of health issues.
Therefore, depending on what your current and potential future financial needs are, there could be some viable alternatives available to you so that you can keep your life insurance protection in place.
One option could be to take a loan from your policy. If you own a permanent life insurance policy and it contains a significant amount of cash value, the funds can be borrowed, meaning that you can receive them tax free. This differs from a cash value withdrawal where any of the funds that are considered gain will be taxable.
While there is typically interest charged on the borrowed funds, it may not be necessary to repay the money that you’ve borrowed. Rather, when the time comes for paying out the death benefit to your beneficiaries, the amount of the loan’s unpaid balance will be deducted from these proceeds, and the rest is received income-tax free by the recipients.
Another plus to going this route is that interest will usually continue to accrue on the full amount of cash value (i.e., the amount that you had in the policy’s cash value before taking the loan). This is because you are technically borrowing from the insurance company (not directly from your policy) and using the policy’s cash value as collateral.
So, if your cash value is $80,000 and you borrow $30,000, interest will accrue as if you still had $80,000 in the account. Plus, because this interest grows on a tax-deferred basis, the policy’s cash value can build up more quickly than a comparable taxable account.
More retirees are using tax-free life insurance policy loans to supplement income in retirement because they can use all of the funds to pay for living expenses and other needs, regardless of what the then-current income tax rates may be.
Another possibility could be to draw from the death benefit proceeds on your life insurance policy. The accelerated death benefit, or ADB, is a provision in many life insurance policies that allows you to receive a portion of these funds early for use while you are alive.
Also referred to as “living benefits,” the ADB feature may be included as a part of your base policy or added via a rider or an attachment. In the latter case, accelerated death benefits may require an additional amount of premium.
If you still want and/or need your life insurance policy in force, but the premiums are becoming difficult for you to pay, you could opt for assistance with these payments. Depending on the type and amount of life insurance coverage you have, premium financing may be a viable alternative for keeping the necessary financial “safety net” in place.
Before you make any type of commitment regarding your life insurance coverage, though, it is recommended that you review your objectives and then determine what portion – if any – of your overall financial plan should be revised. In doing so, working with an experienced retirement planning professional can help.
While selling your life insurance policy could provide you with a lump sum of cash, these transactions are not right for everyone. In fact, in many cases, life insurance settlements could result in future financial hardship for you and/or your loved ones.
That’s why it is recommended that you discuss your objectives, as well as your potential solutions, with a financial professional at Alliance America. Our financial professionals can review your current policy (or policies) to determine whether or not it is still beneficial for you – and if not, alternate solutions can be considered.
Alliance America is an insurance and financial services company. Our financial planners and retirement income certified professionals can assist you in maximizing your retirement resources and help you to achieve your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.
