The Hidden Cost Of Selling Your Life Insurance Policy

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There appears to be growing interest in an evolving market for the buying and selling of individual life insurance policies called “life settlements.” This article examines an important point for financial advisors to cover with their clients who may be considering such a transaction.

A life settlement transaction is identical in form to a viatical settlement, i.e., the policy owner sells a life insurance policy to an unrelated third party for some discount of the death benefit. While viatical settlements are for terminally ill individuals, life settlements involve older people owning large policies who have experienced a decline in health, resulting in a life expectancy of four to 12 years.

A typical life settlement proposal usually makes the following points:

If you own a life policy that is no longer wanted, needed, or affordable;
And, the policy is beyond the contestability period;
And, the policy has a net death benefit of at least $250,000;
And, the insured is at least 65 and has experienced a negative change in health resulting in a life expectancy of 12 years or less;
Then, the policy may be sold for significantly more than its cash value.

The problem with this sales pitch is that it omits the most important criterion for the transaction to make good financial sense for the owner, namely: The owner must have no interest in leaving any estate to children, other family members or any educational, religious, or charitable institutions.

This is vitally important because the policy most likely has a higher expected rate of return than any other asset the owner currently has or could expect to acquire. As an estate-building asset, nothing is likely to beat it. As long as the client has any interest in leaving an estate, the life settlement is unlikely to be financially advantageous.

Heres an example, suppose your client, named Bill, purchased a $1,500,000 universal life insurance policy 10 years ago when he was 55. The premium was $30,000 per year and Bill was underwritten as a standard risk. Based on his health at that time, Bills life expectancy was about 25 years or until age 80.

Bill has a diversified portfolio of assets, including a home, a pension, and some stocks and bonds. He hopes to leave an estate to his children and several charities. Unfortunately, Bills health has declined since he purchased the life policy. Now at 65, his life expectancy is only about seven years. At this time, Bill is offered a life settlement of $150,000 above the policys cash value. What should Bill do?

If Bill takes the $150,000 and invests it, he would have to earn almost 60% annually after tax in order to accumulate the same $1,500,000 after seven years. At a more realistic after-tax return of 8%, Bill would have to live 30 years (to age 95) in order to accumulate the same $1.5 million.

Alternatively, if Bill keeps the policy and continues to pay the $30,000 premium and dies at his life expectancy, the rate of return to his estate on the $30,000 annual investment would be over 50% per year. Even if Bill lives twice as long as expected and continues to pay the premium each year, the annual rate of return on the $30,000 annual investment is over 15%. None of Bills other assets have that type of expected return.

Based on this analysis, it seems that this life insurance policy is worth more than the $150,000 offer.

In fact, $150,000 is probably the most the settlement company can afford to offer, because it has to recover various expenses, including: commissions, underwriting, other transaction costs, plus taxes on the death benefit.

If the settlement company incurs transaction expenses of 8% of the face amount and Bill dies as expected after seven years, the settlement company earns only a 16% return (see example pictured). And, since life settlement investors usually expect double-digit returns, anything offered over $150,000 would make the return to the settlement company too low.

Of course, we dont know exactly when Bill will die, so the actual rate of return is unknown.

Brokers usually compare a life settlement to the alternative of lapsing the policy. More appropriately, it should be compared to the alternative of keeping the policy:

If the owner needs cash for other purposes, almost any other asset should be liquidated instead of the life policy, as long as leaving an estate is still part of the overall financial plan;
Alternatively, the owner could offer to let the policy beneficiary take over premium payments or offer to sell or gift the policy to the beneficiary;
If the policy is business-owned, it probably has a higher expected return than any other asset on the balance sheet. If necessary, the business may want to borrow money to pay the premiums, since the cost of borrowing is probably less than the expected return on future premium payments.

It is unlikely that generally older, wealthier individuals who bought large life insurance policies in connection with an estate plan are no longer interested in building or maintaining an estate. In a sense, a life insurance policy on an individual whose health has declined since date of issue is like a bond that just had its coupon doubled or tripled at no extra cost. Selling such a policy is rarely the most suitable financial recommendation for these individuals.

Life settlement brokers have called these transactions “ideal financial and estate planning solutions.” To the contrary, if the insured is concerned about an estate, the “appreciated” policy should be the last thing to consider selling. Moreover, if the insured owns such a policy, there is the potential for significant gift tax leverage to the heirs.

For example, if the policy is gifted to an Irrevocable Life Insurance Trust, the value for gift tax purposes will be much less than the death benefit, which may be estate tax-free provided the insured lives three years after the transfer.

Some life settlement brokers suggest that agents may face malpractice lawsuits if they fail to make their clients aware of the option to sell their policies. Whether there is reason to worry about this or not, it is more reasonable to ask how a financial advisor could recommend selling what is most likely the highest yielding asset in the insureds estate–especially if the advisor receives compensation for facilitating such a sale. In the vast majority of cases, the advice should be, “sell anything else first.”

In addition to the long-term financial disadvantages, anyone selling a policy will have other things to worry about. First, the policy may change ownership many times, often without knowledge or consent. Secondly, authorization must be provided for ongoing access to personal medical records. Finally, there is an ongoing “tracking” process until death. None of these are particularly pleasant to contemplate.

Many life settlement brokers maintain that the arrival of “institutional funding” from banks and investment companies has improved quality standards, consumer protection and transactional discipline. What is not mentioned is that institutional funding also expects a high rate of return. When added to transactional expenses such as taxes, reinsurance, commissions, and administration, a high expected return to the institutional investor necessarily implies that the policy owner is selling an extraordinary asset for a fraction of its true value to the estate.

In all but a few cases where the individual has no desire to pass on an estate, a policyholder should consider the benefits of keeping the insurance policy versus accepting a life settlement.

is senior vice president and chief actuary at the MassMutual Financial Group, Springfield, Mass. He can be reached at jskar@massmutual.com.


Reproduced from National Underwriter Edition, March 17, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.