Many seniors are now selling their life insurance policies to raise cash. In 2006 alone, policies worth $6.1 billion in death benefits changed hands -- and that was before the Wall Street tsunami wiped out so many 401k's.
This trade wouldn't be possible, however, except for one controversial aspect: The party on the other end profits from your death -- and the sooner, the better.
When you (or a family member who may actually own the policy on your life) sell the insurance, the buyer becomes the owner and beneficiary. Upon your death, this stranger stops paying premiums and collects the death benefit.
These transactions used to be called viatical settlements. Their debut was especially ghoulish because early investors generally were small companies that offered big discounts from the death benefit to buy policies from AIDS patients, who weren't expected to last long and desperately needed cash for medical bills. (Some investors lost a lot of money when new drug combinations greatly prolonged the lives of AIDS patients.)
Now these deals are called life settlements and are moving to the financial mainstream. Institutions such as Goldman Sachs, JPMorgan Chase and Credit Suisse, as well as hedge funds and German pension funds, invest in packages of life settlements because the rate of return is not correlated to the stock market, making life settlements a portfolio diversifier. Even some life insurance companies are becoming investors.
How the process works
As the life-settlement business grows, it's getting cleaner, and pricing is becoming more consistent. Investors usually prefer people over 65 who are insured for $500,000 or more. If you have a cash-value policy, they'll generally offer far more than you would get by surrendering it to the insurance company -- often two and a half times that amount, says insurance adviser Norman Hood of Rushville, Ill. Investors will also buy term policies, which have no cash value, if the policy is convertible to a cash-value policy and the premiums make sense to the investor.
The size of a settlement varies with the insured person's age, health and life expectancy, but sellers generally get 20% to 30% of the death benefit.
The hunt for this treasure starts with a life-settlement broker, which you can locate online or through a financial adviser. These middlemen gather your health and financial data and solicit settlement offers from investors. One transaction feeds a bunch of mouths, so brokers expect competing offers to vary, sometimes drastically.
Insist that the broker get five or six offers and show you all of them, as some states require. Be suspicious if anyone tries to steer you toward a single offer, because it may be the deal with the highest commission. You've kissed away a fortune if you discover that the broker took a cut of 30% of the death benefit when 10% of the settlement amount is fair.
It is getting easier to assess life-settlement offers. Some institutional investors have banded together to create disclosure forms and other standards as they try to drive out smaller middlemen and other investors. Some independent insurance analysts and agents will estimate your policy's value for a flat fee, such as $1,000 or $2,000.
Questions to ask yourself
"Remember that you bought it to meet a certain need -- family planning, estate planning, business -- and make sure that the need truly is gone," says Mark Johannessen, a financial planner in McLean, Va., and a former president of the Financial Planning Association. If you still have a mortgage in retirement or are supporting or educating children or grandchildren, you should probably keep the insurance.
What's the net payout? The key is what you'll keep after taxes. A life settlement is the sale of an asset, a taxable event.
Most sellers make a three-tiered tax calculation: First, you don't owe taxes on the premiums you've paid through the years (minus any outstanding policy loans). Second, you owe ordinary income taxes on the difference between premiums paid (your basis) and the cash value. Third (and this is the big break), you pay capital gains on the amount by which the payout exceeds the cash value -- which is likely to be most of the haul.
If you have any questions about these tiers, consult a tax attorney. Knowing how big a bite the IRS would take is a major factor in determining the best settlement.
Is there a way to save on the cost of insurance? If you need insurance in old age but can no longer afford it, you may have options other than a settlement. Universal life, for example, has built-in flexibility in what you pay, says Glenn Daily, a fee-only insurance consultant in New York.
"A lot of people don't understand that they can change their premium," Daily says. If you have ample cash value, you may be able to skip or reduce your premiums for a while without danger that the policy will lapse.
Would a policy loan work instead? Life-settlement brokers focus on two numbers: the amount you'd get if you surrendered the policy to the insurance company and the substantially higher payout from a settlement. But those aren't your only options. If you need cash and want to keep the insurance in effect, you can take out a policy loan up to almost the amount of the cash value.
You won't get nearly as much as in a life settlement, but your beneficiaries will still get the bulk of the death benefit tax-free when you die (the benefit payment is reduced by the loan principal and accrued interest). There's no tax on loan proceeds and no requirement to repay the money, as long as you don't let the policy lapse.
What about family members? If you are ill and have only a year or so to live, it would be crazy to sell the policy for any amount (or to let a family member with power of attorney do so). Your insurer may offer accelerated death benefits, freeing up the death benefit while you're still alive.
If investors find your policy extremely attractive because your life expectancy is short, it's worth making maximum effort to salvage the policy.
"You might want to schedule a meeting with your beneficiaries and say, 'This is what I'm thinking about doing. Here's what it might cost to keep this policy in effect,'" says Adam Hamm, North Dakota's insurance commissioner.
Your sons and daughters or other heirs might pitch in to help pay the premiums or lend you the money because they'll end up with a much bigger and tax-free payout if you maintain the coverage. "If the offer is $200,000 today, before taxes, or $1 million tax-free if you keep the policy, what would you do if you were the beneficiary?" Hamm asks.
Smart shopping
Get multiple offers. "There are about 60 different life-settlement companies, and they all have unique buying criteria," says Daniel Anderson, the chief executive of Madison Brokerage, in Morristown, N.J. That means the brokers such as Anderson who present your information to investors can, and should, drive a hard bargain on your behalf.
Your goal is to hold out for the highest percentage of the death benefit and hope a particular institutional investor is looking for a person like you to round out its diversified pool of death benefits to come.
Find out how much money each participant in the deal is getting. "In some cases, the brokers are making the same amount as, or more than, the consumer," says Jim Poolman, who helped develop the National Association of Insurance Commissioners' model life-settlements law, which several states have enacted, with more expected.
"Consumers have the right to look at their brokers and the people involved and say, 'Maybe I don't want to pay that much,'" says Jack Kelly, the director of government relations for the Institutional Life Markets Association. The association requires life-settlement brokers to fill out disclosure forms for consumers before selling policies to its members (which include Goldman Sachs and Credit Suisse). Go to the Institutional Life Markets Association's Web site for a copy.
Ask specifically how much money each person or company is getting, not just percentages. Sometimes the commission percentage is based on the full death benefit, and sometimes it's based on the purchase price.
Ask who will own your policy. The creepiest thing about life settlements is that a stranger will benefit from your death. Fortunately, most investors are now large banks and other institutional investors that own big pools of policies (similar to the way mortgages have been traded) and not individuals who are counting the days until you die.
Also inquire about how often the life-settlement company will contact you after you sell your policy. You don't need frequent calls asking if you've been in the hospital. An occasional form letter should suffice.
Ask about privacy. To get a quote, you must authorize the broker to view your medical records. Find out who else will have access and who will have your name after you sell the policy. Hood, the Illinois insurance adviser, says you should insist that the broker withhold your name, address and other identifying information from anything sent to big investors, who should care only about your age, your health and the type and cost of the insurance they're being pitched to buy.
Talk with independent experts. Before accepting an offer, run it by an independent financial adviser whose compensation is not based on whether you sell the policy. Be particularly wary of any insurance salesperson who is pushing hard to have you sell your policy and then buy a new one.
"There's the potential to earn two commissions from the sale -- one from the life settlement and another from a life insurance sale," says John Gannon, the senior vice president of investor education for the Financial Industry Regulatory Authority. For more information, see the authority's Investor Alerts.