The Hidden Cost Of Selling Your Life Insurance Policy
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.