Unlocking Financial Potential: The Complete Guide to Life Settlements

Summary:

Explore the intricate world of life settlements, a unique financial strategy that allows individuals to sell their life insurance policies for a lump-sum cash payment. In this comprehensive guide, we delve into the nuances of life settlements, how they work, reasons to consider them, and their differences from viatical settlements. Uncover the legal landscape, historical significance, and key considerations surrounding this financial option.

What is a life settlement?

A life settlement is a financial transaction that involves the sale of an existing life insurance policy to a third party in exchange for a one-time cash payment. This payment typically falls between the policy’s surrender value (the amount the insurance company would pay if the policyholder were to cancel it) and the full death benefit (the amount paid out to beneficiaries upon the policyholder’s death).

Upon the completion of the sale, the new owner of the policy takes over the responsibility for paying the policy’s premiums and becomes the beneficiary. This means that when the insured person passes away, the new owner receives the death benefit.

How life settlements work

The process of a life settlement begins when the policyholder, who may no longer wish to maintain the policy, decides to sell it. This decision can be influenced by various factors, such as changing financial circumstances or a desire to cash in on the policy’s value.

Here’s how a life settlement typically works:

  1. The policyholder initiates the process by contacting a life settlement provider or broker.
  2. The provider assesses the policy’s value and potential marketability, taking into account factors like the insured person’s age, health, and life expectancy.
  3. If the policy is deemed eligible for a life settlement, it is presented to potential investors, often institutional buyers.
  4. Investors may make offers on the policy, and the policyholder can choose to accept or decline these offers.
  5. If the policyholder accepts an offer, a purchase agreement is drafted, and the sale proceeds.
  6. The new policy owner takes over premium payments and becomes the beneficiary.
  7. When the insured person passes away, the new owner receives the death benefit.

One significant advantage of life settlements is that the cash payment the policyholder receives is typically tax-free, making it an attractive option for those in need of immediate funds.

Why choose a life settlement

People opt for life settlements for a variety of reasons:

  • Supplementing retirement income: Life settlements are often chosen by seniors who want to bolster their retirement savings. This lump-sum payment can provide financial security during retirement.
  • Unaffordable premiums: If the policyholder is struggling to pay the premiums, selling the policy can provide a more substantial cash payout than surrendering it to the insurance company.
  • No longer needed: Sometimes, the reasons for having the policy, such as providing for dependents, no longer exist. In such cases, selling the policy can be a sensible financial move.
  • Financial emergencies: Unexpected financial crises, like medical expenses or family emergencies, may necessitate selling the policy to cover these immediate needs.
  • Corporate policies: Companies may hold life insurance policies on former employees. By engaging in a life settlement, the company can liquidate an asset that was previously illiquid.

Life settlements generally provide more money than the policy’s surrender value but less than its full death benefit, striking a balance between immediate financial relief and long-term financial planning.

Life settlements vs. viatical settlements

While both life settlements and viatical settlements involve selling life insurance policies, they cater to different demographics and circumstances.

Life settlements: These are typically pursued by individuals who are not terminally ill. Life settlements are commonly chosen by seniors who wish to cash in on their life insurance policies for financial reasons, often as a means to supplement retirement income.

Viatical settlements: Viatical settlements, on the other hand, are primarily geared toward individuals with terminal illnesses. In a viatical settlement, someone facing a limited life expectancy sells their life insurance policy for an immediate cash payout. This allows them to access funds to cover medical expenses, improve their quality of life, or fulfill end-of-life wishes.

It’s essential to note that viatical settlements carry higher risks for investors because the timeline for the insured person’s death is uncertain. If the policyholder lives longer than expected, the return on investment may be lower due to ongoing premium payments.

Legal aspects of life settlements

Life settlements are generally legal in the United States, provided they adhere to specific regulations and do not fall under the category of stranger-owned life insurance (STOLI), which is illegal. The legality of life settlements has evolved over time, with several legal rulings contributing to their acceptance.

One of the most notable legal cases in this context is the 1911 U.S. Supreme Court case of Grigsby v. Russell.

Grigsby v. Russell: This case revolved around John Burchard, who sold his life insurance policy to his doctor, A. H. Grigsby, as he could no longer afford the premium payments. When Burchard passed away, Grigsby sought to collect the death benefit, leading to legal disputes.

In his ruling, Supreme Court Justice Oliver Wendell Holmes equated life insurance to standard property. He argued that the policy could be freely transferred, similar to other forms of property like stocks and bonds. Furthermore, he recognized several rights associated with life insurance as property:

  • The policy owner can change the beneficiary unless the insurer imposes restrictions.
  • The policy may serve as collateral for a loan.
  • Owners can borrow against the insurance policy.
  • Policies can be sold to other individuals or entities.

This legal precedent solidified the notion that life insurance policies possess intrinsic value and can be transferred, setting the stage for the development of the life settlement industry.

Who does a life settlement broker represent?

A life settlement broker represents the interests of the policy owner. Brokers typically have a fiduciary duty to act in the best interests of their clients. Their primary responsibility is to secure the highest possible offer for the policy being sold.

Brokers play a pivotal role in connecting policyholders with potential buyers, negotiating terms, and ensuring that the transaction proceeds smoothly.

Which life insurance settlement option guarantees payments?

If you seek a life insurance settlement option that guarantees payments until the death of the policy’s beneficiaries, you can explore a structured settlement. A structured settlement involves receiving periodic payments over a specified period, providing a steady stream of income to beneficiaries.

Structured settlements are popular because they offer predictability and financial security. However, it’s essential to carefully consider the terms and conditions of the structured settlement to align with your financial goals and needs.

What is a single life settlement option?

A single life settlement option is a financial arrangement where any agreed-upon payments cease upon the death of the annuitant or beneficiary. This means that the payments, once initiated, continue only as long as the annuitant is alive.

In contrast, a joint life settlement option continues to make payments even after the annuitant’s death, provided that the secondary beneficiary, typically a spouse, survives the annuitant. Joint life settlements offer more extended financial security and are often chosen by couples looking to ensure ongoing support for the surviving spouse.

Pros and cons of life settlements

Weigh the risks and benefits

Here is a list of the benefits and drawbacks to consider.

Pros
  • Access to immediate cash: Life settlements provide a lump-sum cash payment, offering immediate financial relief.
  • Tax benefits: The cash payout from a life settlement is typically tax-free for most policyholders, enhancing its financial appeal.
  • Supplement retirement income: Seniors can use life settlements to supplement their retirement income, improving their financial security.
  • Prevents lapse: Instead of letting a policy lapse due to unaffordable premiums, policyholders can sell it for a more substantial payout.
Cons
  • Reduced death benefit: Selling a policy through a life settlement means the beneficiaries will receive a reduced death benefit compared to the policy’s face value.
  • Complex process: Life settlements involve legal and financial complexities, requiring expert guidance.
  • Variable payouts: The amount received through a life settlement can vary widely based on the policy’s terms and the insured person’s health and age.
  • Loss of coverage: Once the policy is sold, the original policyholder loses coverage and cannot reinstate it.

Frequently asked questions

Is selling a life insurance policy legal?

Yes, selling a life insurance policy through a life settlement is generally legal in the United States. It involves a transfer by the policy owner and does not fall under stranger-owned life insurance (STOLI), which is illegal.

What taxes apply to life settlement proceeds?

Life settlement proceeds are typically tax-free for most policyholders. However, it’s advisable to consult with a tax professional to understand any potential tax implications based on individual circumstances.

Are viatical settlements still common?

Viatical settlements, once common among individuals with terminal illnesses, have become less prevalent due to advancements in medical treatments that extend life expectancies. They are now less common than life settlements.

How does the investor assess the policy’s value?

Investors evaluate a policy’s value based on various factors, including the insured person’s age, health, life expectancy, and the terms of the policy. The healthier and younger the insured, the higher the potential value of the policy.

Key takeaways

  • A life settlement involves selling an existing life insurance policy to a third party for a lump-sum cash payment.
  • The purchaser takes over premium payments and becomes the beneficiary, receiving the death benefit upon the insured person’s demise.
  • Life settlements are often pursued by seniors looking to supplement retirement income.
  • Other reasons for choosing a life settlement include unaffordable premiums, policy redundancy, and unexpected financial emergencies.
  • Life settlements differ from viatical settlements and are generally legal in the United States.
View article sources
  1. Introduction to life settlements – Harvard University
  2. How does life settlement affect the primary life insurance market? – Penn Institute for Economic Research
  3. What is a life settlement? – Department of Financial Services
  4. What are life settlements? – Division of Financial Regulation
  5. How to use life insurance to build wealth – SuperMoney