Much has been written about retained death benefit life settlements, wherein the policy owner does a life settlement but, in addition to or in lieu of cash, retains a contractual right to some portion of the death benefit. While these arrangements can be beneficial for a policy owner who needs to keep some death benefit in force, there are certain risks to these transactions that should not be ignored, yet they are rarely discussed.
It is most important that clients understand that all they are getting is a contractual promise by the purchaser to keep the policy in force and pay a portion of the death benefit to the seller. If the buyer becomes insolvent and does not keep the policy in force, the seller can be out of luck.
There are usually certain contractual protections for the seller, primarily involving the right to notice if the policy is going to lapse and to take over the policy and keep it going. But the practical efficacy of these protections is questionable.
Remember that the insurer is not required to allow reinstatement if the policy has already lapsed after the expiration of the grace period. Will the seller realize the policy is in jeopardy in time to save it? Given that the policy may have been sold because the premiums were becoming unaffordable, will the seller have the cash ready to keep the policy going?
Buyers typically pay premiums at levels they predict will maximize their return upon death. Producers who have sold life settlements routinely receive notices that the buyers are not paying the “planned” or billed premium or that the policy is about to lapse. Furthermore, where a buyer routinely pays during the grace period, how is one to know if this is the one time that the buyer will fail to pay in time?
While the buyer may offer an irrevocable beneficiary arrangement, this does not solve the lapse problem. Moreover, it can create new ones. An irrevocable beneficiary arrangement is just that, irrevocable.
The seller must choose the beneficiary at the time the transaction occurs and it cannot be changed. So a change in the relationship with a named beneficiary cannot be remedied by simply naming a new beneficiary.
Another consideration for sellers to be aware of is that the income tax consequences of these arrangements are uncertain and because the specific terms of these transactions do vary, the tax consequences can differ from deal to deal. While Rev. Rul. 2009-13 answered some questions about the income tax treatment of life settlements to sellers, these alternative arrangements were not specifically addressed.