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.