As the burgeoning life settlement market matures and gains wider industry acceptance, a growing number of high net worth clients entering their golden years are selling their life insurance policies to secure much-needed cash. But experts say seniors now weighing this option, and the advisors who counsel them, should consider the alternatives before making a decision.

Experts interviewed by National Underwriter say affluent policyholders who need the insurance, especially for estate planning purposes, but who also are having difficulty paying the large premiums, can avail themselves of several funding vehicles that too often are ignored by advisors keen on recommending a policy sale–and earning a hefty commission on the transaction.

Among them: doing a 1035 exchange of the old contract for a reduced, paid-up term policy; entering into a private annuity or private split-dollar arrangement with a close relative or policy beneficiary; and securing a premium-financed loan from a bank or other lending institution.

“Nine times out of 10, no one does a demonstrable analysis as to whether keeping the policy makes more sense than a life settlement,” says Stephan Leimberg, president and CEO of Leimberg Information Services, Bryn Mawr, Pa. “Advisors who haven’t done this analysis have failed in their fiduciary responsibility to the client. It’s that clear.”

In the event of a policy sale, that failure can have consequences beyond the loss of the insurance. If the client is well advanced in age or suffering from ill health, purchasing a new policy (should one be needed) may no longer be an option because of prohibitively high premiums or lack of insurability.

Also to consider are the tax and legal consequences resulting from the policy sale. Leimberg observes that clients who settle have to pay ordinary income and capital gains taxes on the sales proceeds, taxes that do not apply to death benefit proceeds. And, unlike policies held in trust, income resulting from a life settlement does not escape the estate tax. Nor do the sale proceeds enjoy protection from claims in probate court or the privacy of distributions made to policy beneficiaries.

“Whether we like them or not, life settlements are here to stay,” says Leimberg. “But people need to know about the tax implications, which are not only underplayed but often are very little understood by advisors.”

To be sure, sources say, a life settlement is suitable for policyholders who meet certain criteria. Prime candidates include clients age 65 or older who have a life expectancy of less than 12 years and who no longer have an insurance or estate planning need. Life settlement companies also look for policyholders who have significant health challenges or are otherwise uninsurable; and who own policies for which the ratio of the cash value to the face amount is low. For insureds, the fact that they can secure more money by selling the policy than by surrendering the contract for its cash value is the overriding attraction.

The prospect of receiving a cash windfall should not, however, preclude an objective and dispassionate analysis of the transaction. Michael Weinberg, president of the Weinberg Group, Denver, Colo., says the decision for or against a sale will hinge on whether the present value of the death benefit less the present value of future premium payments and other costs (i.e., the intrinsic economic value) will be greater or less than the life settlement payout before the policyholder’s projected life expectancy. An intrinsic economic value that is greater than the life settlement offer would dictate holding the policy; a value that is less than the offer would argue for a policy sale.

Reduced to a math problem, the issue is seemingly easily resolved. Yet the core question to be answered–the insured’s longevity–can involve guesswork.

To assist in the analysis, Weinberg and Leimberg are co-marketing to advisors a software application, Life Settlement NumberCruncher, that offers a range of life expectancies based on widely recognized mortality tables. Depending on the preferred table, an assumed discount rate and an assumed tax rate (ordinary income or capital gain), the software can graphically depict the insured’s projected life expectancy relative to a “crossover point,” above or below which the individual stands to achieve a gain or loss from a settlement.

Should an analysis argue for a sale, says Weinberg, then the advisor will have to make a second determination (depending on the client’s objectives and insurability) as to whether to use part or all of the settlement proceeds to fund a new policy. The size of the settlement–a figure hinging in part on the type of policy to be sold–can help decide this question.

“The type of policy will not affect the analysis, but it will certainly impact the offer the client receives,” says Caleb Callahan, a certified financial planner and director of life settlements at Valmark Securities, Akron, Ohio. “Universal life products provide by far the biggest bang for the buck on the secondary market. These policies are worth more to investors.”

But Callahan adds that payouts in 2008 and beyond are likely to be less generous than in year past. “Regulation, litigation and realization of returns are all making the investor community more conservative,” he says. “And so they’re not likely to offer the large sums they paid in 2007 and prior years.”

And what if an analysis dictates holding the policy? Assuming also the client needs cash, either to fund the remaining premiums and/or other financial objectives, then the individual should consider several alternatives. One option, observers say, is to exchange the old contract for a reduced, paid-up term policy, thereby eliminating ongoing premiums. The client could also draw down the policy’s cash value to pay the premiums or sell a portion of the policy, funding the remaining death benefit at reduced cost.

As a fourth option, a policyholder might agree to split the premiums and policy benefits with a third-party, such as a family member or trust. When the policyholder dies, the third-party recovers its share of contributions to the premiums from the death benefit proceeds, plus a stipulated amount of interest.

Alton Crafton, a chartered financial consultant and president of Advance Financial Designs, Wichita, Kans., says that private split-dollar arrangements wherein a trust is both an owner and beneficiary of the policy are attractive for another reason: They allow the trust grantor (insured) to keep policy benefits out of the estate while also minimizing gift taxes. (Payments made to the trust to fund the premiums can be applied against the annual gift tax exclusion.)

“The advantage of private split-dollar is that only a portion of the gift to the trust–the true cost of insurance–is applied against the gift tax exemption,” says Joseph Burgess, a chartered financial consultant and principal of North Star Resource Group, Minneapolis, Minn. “The grantor gets the cash value and the death benefit remains outside the estate. This is a true tax play.”

For funding very large policies–those for which premium costs can total hundreds of thousands of dollars annually–the best course of action may be premium financing, experts say. A growing number of affluent clients are turning to this technique–taking out a loan from a bank or other financial institution to cover the premiums for a period of years–to meet short-term cash flow or investment objectives.

For some cash-strapped clients, the goal may be simply be to keep an existing policy in force to cover an estate planning need. More often, however, well-heeled clients will secure a loan to fund a new policy because their estate planning needs have grown; and because monies that would otherwise have been allocated to fund the premiums can be invested in high-yield assets that produce a return greater than the cost of the loan.

Whatever the objective, cautions Ted Bernstein, president of Life Insurance Concepts, Boca Raton, Fla., advisors and their clients need to scrupulously follow certain best practices to avoid either of two outcomes: (1) a pre-arranged life settlement (i.e., a premium-financed policy purchased for the purpose of subsequently selling at a higher price; or (2) a life settlement that is forced on the policyholder because the loan package is onerously structured or fails to include an exit strategy.

“Premium financing done right is about leveraging unused insurance capacity,” says Bernstein. “The financing has to be done for the right reason–to fulfill a long-term insurance need–and with carrier compliance and acknowledgement.”