There’s almost no financial asset that can’t be sold at some point in the process.
That includes a life insurance policy, and that’s what a life settlement is all about.
There are certain advantages and disadvantages to a life settlement, and you need to know all the details of both before considering a sale.
What is a Life Settlement?
A life settlement takes place when you sell your current life insurance policy to another party. It enables you to sell it for an immediate cash benefit. However, it’s quite a bit more complicated than the sale of other assets, particularly any type of financial asset.
A life settlement can be structured in different ways and you’ll need to carefully weigh if it will be to your advantage.
Life settlements are most typically done by those who are 65 or older. At that point in life, there may be either a reduced need for life insurance, and the inability to continue making the premium payments, or a combination of both.
In most cases, the owner of the policy will simply allow it to lapse. But a life settlement provides the owner with an alternative to lapsing, and one that will provide cash on the sale.
The buyer of the policy will make all premium payments going forward. But it will receive the death benefit, either when the policy matures or when the original person insured dies. In most cases, the buyer of a life settlement is an institution, not an individual.
It can be a win for both parties.
How Does a Life Settlement Work?
A life settlement works with a whole life insurance policy (and occasionally term). That’s a policy that has a cash value, in addition to a death benefit. This is very different from a term life insurance policy, which has only a death benefit.
In a life settlement, the purchaser buys the policy for more than the cash value. But at the same time, the purchase price is typically less than the net death benefit, which is the combination of the death benefit and any accumulated cash value.
To complete the sale, the owner has to work through a third-party, typically a settlement broker. The owner must fill out an application, which will include all the information relevant to the policy, extending to medical records.
The medical records are used to determine probable life expectancy of the policy owner.
The settlement broker or the potential buyer calculates the value of the policy. Upon evaluation, an offer may be made to the owner of the policy. If a broker is involved, they may even seek offers from other potential buyers. The owner of the policy can accept or reject any offers made.
If an acceptable offer is given, the contract and any other necessary documents will be prepared to formalize the sale.
All parties to the policy, including the policy owner, the insured, and even listed beneficiaries must sign the paperwork. The buyer will forward proceeds for the sale, which will then be held in an escrow account.
The insurance company that issued the policy will be notified of the change in ownership, as well as a listing of new beneficiaries. If the change is approved by the insurance company, the escrow funds will be released, and the life settlement will be completed.
The Benefits of a Life Settlement
The main reasons for a life settlement are either the elimination of the policy premium, which is no longer affordable, or if the policy itself is no longer needed.
For example, if the policy owner retires, and is no longer dependent on earned income, life insurance for the purpose of replacing lost wages will no longer be needed. It may be more beneficial for the policy owner to sell the policy if the proceeds of the sale are higher than the cash value of the policy itself.
Still, another reason is simply to raise cash for more immediate concerns. By definition, life insurance is established primarily as a death benefit. But a life settlement is one of the ways that the same policy can also provide living benefits.
For example, additional funds may be needed to pay for either healthcare expenses or long-term care.
Alternatively, the policy owner may simply want additional cash for other purposes, such as paying off a mortgage or relocating to another region. The cash gained from the life settlement will make these possible.
The Disadvantages of a Life Settlement
The most obvious is that once the policy is sold, the death benefit will no longer be available. For example, let’s consider a policy that has a face value of $200,000, and a cash value of $100,000.
Upon the death of the owner, his or her beneficiaries would receive $300,000. But if the policy is sold through life settlement for, say $150,000, the $300,000 death benefit will be lost.
The policy owner will of course get the benefit of $50,000 more than the cash value of the policy. But the death benefit – which is double the sale price of the settlement – will be lost.
Also, be aware that a life settlement may not be a solution if you need quick cash. They generally take several months to complete. This is because an evaluation of your life expectancy must be performed, as well as the time it may take to find willing buyers.
Should You Do a Life Settlement?
Since a life settlement is a complex transaction, there are certain factors to keep in mind.
If your ability to afford the premiums is the primary reason for selling the policy, you may want to speak with your insurance carrier about applying the cash value of the policy toward the premiums. That will keep the life insurance policy in force, while relieving you of the need to make the payments.
How much you’ll get for the life settlement will go a long way toward determining your decision to make the sale.
In completed settlements, the policy owner typically receives four times the cash surrender value of the policy. But that will need to be compared to the value of the death benefit.
One important factor to be aware of with a life settlement is that usually involves tax consequences. Some of the proceeds received from the settlement may be taxable.
Before finalizing a life settlement, you should first discuss the terms of the contract, as well as the financial aspects, with your tax advisor. Any potential tax liability may affect the desirability of the settlement.