Life settlements are sometimes viewed by financial services professionals as only a personal insurance or estate planning tool. As a result, policies that are business-owned or paid for frequently get overlooked as prospects for a life settlement. However, a change in business ownership, personnel or condition can cause a decreased need for life insurance and, consequently, the opportunity for a life settlement.
Business Owner Exits
First and foremost, when a business owner leaves, whether due to retirement, disability or sale of the business, advisors should be alert to the possibility of a life settlement. Frequently, the business will own or be paying for any number of policies on the life of the departing owner. For example, a key person insurance policy might have been purchased to offset the loss that would have been sustained by the business had this person died prematurely. A policy could have been obtained to fund a buyout of the owner’s interest in the business. Because many buyouts are set up as cross purchase arrangements, it is also fairly common to find policies that are no longer needed in the hands of co-owners as well. Additionally, there could be term insurance policies that were bought for creditor protection on a business loan that are no longer required.
While in some instances, the exiting business owner will have a use for some of the coverage, a significant portion of the insurance may no longer be needed, wanted or affordable. A very large percentage of policies bought for buy-sell arrangements and key person needs are term insurance. So in addition to having a decreased need for coverage, the rising cost of the term insurance may be quite unappealing, if not altogether unaffordable, especially for an aging, retired business owner.
A life settlement can take some of the sting out of a living buyout. This was the case when the 74-year-old founder and one-third owner of a large successful manufacturing business decided to retire. The company owned $5 million of term insurance on his life that had been acquired some years before for stock redemption purposes. Instead of simply letting the policy lapse, a life settlement was explored, and an offer of approximately $1 million was received for the policy. The proceeds helped the company complete the buyout of the retiring owner. For this company, there was also a collateral benefit: the life settlement proceeds left the company’s balance sheet and cash flow situation in a healthy enough capital position so that it could continue to expand. This might not have been possible had the company still been saddled with a $1 million obligation to the former owner. Had the buyout arrangement been set up as a cross purchase instead of a stock redemption, a life settlement could have been just as valuable because the co-owners could have similarly used the proceeds to help fund their purchase of the retiring owner’s stock.
Reduced Life Insurance Needs
A life settlement can also be valuable in situations where there is still an insurance need, but a smaller one. Another case involved a retiring business owner who sold his business, which was paying for $4 million of term insurance on his life as a fringe benefit. He wanted to have $1 million as permanent coverage, but was not sure he could afford to pay for it. Because his health had declined, new coverage was not an attractive option. The policy was split up in a term conversion with the insured keeping $1 million and selling the balance in a life settlement for $400,000. The settlement proceeds made the conversion of the balance of coverage to permanent insurance affordable, and there were still funds left over to supplement his retirement income.
Life insurance-funded executive benefit arrangements, such as deferred compensation and split-dollar plans, are also often drastically impacted by the departure of a key executive or business owner. While policies bought for deferred compensation plans are often, but not always, retained to pay benefits or reimburse the company for those payments upon death, in some situations a life settlement may be a more attractive option. Split-dollar plans that were intended to be rolled out with minimal tax consequences are no longer being given such favorable tax treatment. In addition, over time, those policies may not be attractive to keep as the economic benefit costs and government term rates increase with age. A life settlement can provide an attractive exit strategy that was previously unavailable and allow the exit from a split-dollar arrangement to occur earlier than originally planned.
Additional life settlement opportunities exist beyond buy-sells, key person insurance and fringe benefit situations. When a successful physician retired a few years ago, his qualified plan owned a $1 million whole life insurance policy on him. At first, he bought the policy from the plan, after borrowing out the cash value, intending to keep up the insurance through dividends and interest payments. When the dividend scale was reduced, it soon became clear that the costs to carry the policy were going to be burdensome. A life settlement was suggested, and the doctor was able to net $125,000 and be free of the loan, interest and premium payments.
Sometimes it is business misfortune that drives a life settlement transaction. The 69-year-old founder and major stockholder of a 35-year old company he had taken public found himself in the unpleasant position of having his company subjected to a reorganization in bankruptcy when market conditions and foreign competition drastically undercut his business. His remaining stock in the company was now worthless, and although continuing on as an advisor, he was replaced as CEO.
In addition to a number of company-owned policies being dealt with in the bankruptcy proceedings, he personally held some $20 million of insurance that had been paid for by the company through a bonus arrangement. As dictated by his new life situation, he no longer wanted or needed these policies personally, but rather was looking for cash to help maintain his lifestyle. These universal life policies had approximately $2.8 million of cash surrender values. A life settlement brought him $6 million and the ability to continue living in the manner to which he had become accustomed. The company-owned policies may also be settled in the future.
A business is the engine that creates wealth for many large estates, and planning for such an estate usually entails the ownership of life insurance for estate liquidity. When a business is transferred, whether through gift or sale, the estate liquidity needs may be substantially reduced, and some insurance policies held for estate planning purposes may no longer be needed.
In conclusion, when businesses change hands, are subject to changes in their organization or have owners or executives who retire, quite often there are life insurance policies that were purchased for purposes or needs that cease to exist or simply become unaffordable. Life insurance policies that arise out of a business enterprise often extend far beyond just business-owned policies. Therefore, it is important for financial advisors to cast a wide net in the search for policies that may require re-evaluation when circumstances change. In addition to key person situations, other arrangements like pension and profit-sharing plans, cross purchase agreements, creditor-assigned policies, executive benefit plans and bonus programs are often impacted by changing business situations. The need for personally owned or trust-held policies for estate liquidity can be impacted as well. Should it be determined that all or a portion of the life insurance coverage associated with a business is no longer needed, wanted or affordable, a life settlement should be considered to maximize the value of those policies.
Note: Case examples for this article have been modified to improve readability and protect privacy.