New life insurance market

California CPA, March-April, 2004 by Bill Tsotsos

Imagine a world where buyers are willing to purchase your car at substantially more than its trade-in value--and you get to choose the highest bid. No advertising, no haggling, no expense to you. Science fiction? Nope. Such a world exists--not for car owners, but for owners of life insurance policies intended for lapse or surrender. These owners can receive a cash settlement--while they are still living.

The life settlement industry has created a secondary market for acquiring life insurance policies from qualifying policyholders, who receive an offer guaranteed to exceed the cash value. In 2002, life settlement providers paid approximately $340 million to acquire policies with an aggregate cash value of $94 million.

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Policyholders qualifying for life settlements are generally older than 65; have deteriorating health, but are not terminally ill; and have "ascertainable and limited" life expectancies between two and 15 years. Qualifying policies are at least two years old, pay death benefits between $100,000 and $5 million and are issued by a life insurance company with an "A" rating or higher.

AN EVOLVING INDUSTRY

Relatively new, the life settlement industry evolved from "viatical" settlements, which responded to the needs of terminally ill policyholders. Viatical settlements enable an insured to receive benefits, prior to death, to pay for the costs of care. Life settlements, also known as senior settlements, do not involve a terminal illness (less than 24-month life expectancy) but a determinable life expectancy based upon the insured's age, health and lifestyle.

The policy's market value is the net present value of the death benefit, factoring in the policy's duration and carrying costs. Other factors affecting the market value include the type of life policy, the policy's cash value and any loans against the policy.

A life settlement transaction creates a two-tiered taxable event. The first tier is the difference between the cost basis and cash surrender value, taxed as ordinary income. The second tier is the excess of settlement proceeds over the surrender value.

The IRS has not provided specific guidance, however, whether this is considered to qualify as a long-term capital gain. The tax treatment of a viatical settlement is markedly different. The IRS considers these tax-exempt accelerated death benefits.

WHEN TO SELL--OR BUY?

Life settlements are a viable option when policy premiums are no longer affordable. Recent sharp declines in short-term interest rates have devastated the cash flow of seniors living on a fixed income. With life settlements, premiums disappear and policyholders receive a lump sum of cash.

Perhaps the senior has outlived all beneficiaries and the inclusion of life insurance would create a taxable estate. Maybe the senior, due to health reasons, does not qualify for long-term care insurance. Settlement proceeds may be used to fund long-term care.

From a business perspective, life settlements can be considered when a business is for sale or the owner is retiring. If your client is a charity or nonprofit organization, it may make sense to consider selling donated life policies to realize cash and eliminate future premiums.

Why do companies buy life insurance policies? Many life settlement providers are backed (funded) by well-known financial institutions that view life insurance as an asset in a diversified portfolio. They rely on actuarial and other quantitative data to acquire a policy that will produce a specified rate of return at maturity. These policies are held in a blind trust that may be used as collateral for a bond offering in a process known as securitization.

FIDUCIARY ISSUES

Life insurance is purchased for a variety of reasons and should be a part of every financial and estate plan. As with any asset, these policies should be reviewed regularly. Typically, however, they are not.

A good insurance policy at the time of purchase (similar to owning a stock) does not necessarily mean you have a good policy years later. In today's low interest rate environment, how many policies written years ago--when rates were substantially higher--might require restorative action?

Every financial and estate plan should address the amount and type of life insurance required to meet the plan's objectives. As with any financial asset, life insurance must be reviewed and evaluated regularly. This review would include an exit strategy and, when appropriate, the ultimate disposition of the life insurance asset.

Secondary markets exist for virtually every financial asset. With the introduction of life settlement, that list now includes life insurance.

Bill Tsotsos is a regional director for Gateway Financial Distributors, a national wholesaling specialist in life settlement. You can reach him at (909) 834-2023.