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.