Many individuals take out life insurance policies for valid planning reasons which later are no longer needed or desirable. Alternatively, the policy owner may need current liquidity. While many policies can be surrendered for their cash value or the owner may take loans against the policy, there may be other options. One of those options is to enter into a life settlement. Although we have written before about life insurance planning[1], this writing is intended to focus on life settlements.[2]
It is my experience that knowledge of life settlement is limited, even among tax, legal, and insurance professionals. Given the number of clients with life insurance policies and the duties generally owned to clients, it would serve professionals well to understand life settlement options. Trustees of trusts owning life insurance policies likewise should be mindful of their duties in considering options for life insurance policies in trust administration. In this regard, it is important that a life insurance policy be considered an asset just like any other item on a client’s balance sheet – real estate, securities, bonds, jewelry, art, etc. There are options for how to administer that asset, how to monetize that asset, and how to dispose of (or exchange) that asset. Often, analyzing those options begins with a policy appraisal just like any other asset.
These considerations are particularly important given that some studies have found that cash surrender value averages approximately 4% of a policy’s face amount whereas life settlements average 25-30%.[3] Despite this potential for a significant difference in value, a 2016 survey found that approximately 86% of seniors were unaware of the option of selling their policies.[4] The same study found that 79% of seniors feel their advisors should inform them about life settlements as an option for disposition of their policies.[5] However, recent survey found that 59% of CPA’s did not feel qualified to discuss life settlements and 28% found it was not part of their job responsibilities. Clearly, there is a disconnect between expectations of clients and their professional advisors.[6]
What is a Life Settlement?
In discussing life settlements, it is important to understand what that term means. Generally, at least for purposes of this writing, I refer to a sale of a life insurance policy to a third party for an amount less than the policy’s death benefit but greater than the policy’s cash surrender value. As such, this option allows the policy owner to monetize their policy by accepting an amount less than what would be recovered upon the death of the insured but for an amount greater than if the policy owner surrendered the policy for cash value. Following the sale, the buyer takes responsibility for all future premium payments and has the right to the death benefits on the death of the insured.
It is worth noting that the term life settlement can be distinguished from a viatical settlement.[7] A viatical settlement involves the sale of a policy by a terminally or chronically ill insured which has different regulatory and tax consequences from a life settlement. Aside from those differences, however, similar considerations may apply in determining whether a policy owner should sell their policy versus engage in other methods of monetizing the policy.
The right to sell life insurance has been recognized in the law at least since 1911.[8] As stated above, a life settlement does not involve a terminally or chronically ill insured. However, a life settlement typically will produce more value for an insured with a life expectancy shorter than what was expected when the policy was placed (life expectancy of 25 to 144 months is typical[9]). Some of the more relevant factors that go into valuing policies are: (1) the death benefit, (2) the life expectancy of the insured, (3) the carrying costs (i.e. premiums and other charges) of the policy, and (4) the expected return objective of the investor.[10] In considering acquisition of a policy, third party investors will have certain performance expectations. Aside from that, a significant reason for investors in life insurance policies is that returns are not driven by traditional market values making the investment an alternative that diversifies a portfolio.[11]
When speaking with Jamie Mendelsohn of the Ashar Group, she stated they are representing sellers and successfully brokering policies with insureds whose mean life expectancy is as long as 20 years in today’s market. Negotiating on average a dozen different bids on their auction platform. Ashar data shows the majority of policies being purchased are universal life products, although all policy types can be sold in the market.
Although this writing is not intended to fully describe the life settlement process, there are certain common components. Generally, there are a number of persons involved in the process: (1) the policy owner, (2) the insured, (3) a broker, (4) a provider (facilitates the transaction for the buyer), (5) the buyer, and (6) an escrow agent.[12] The same person may fill multiple roles. For example, the policy insured may also be the policy owner. Also, not all sellers work through a broker. However, it is advisable that sellers work through an experienced broker because they will owe a fiduciary duty to the seller to work in the seller’s best interest whereas the provider owes duties only to the buyer (such as those contacting clients through direct marketing),[13] usually by submitting requests for proposal, evaluating responses, and analyzing the options available to the seller.[14] Often, before this process begins, the broker will value the policy to determine if a policy sale is expected to generate more value than surrendering for cash value.
In order to engage in a policy sale, the seller typically submits an inquiry to determine feasibility of the policy sale. If the sale is viable, the insured will not be required to undergo a medical examination but will be required to release their health records for policy underwriting and to provide additional health information to the buyer following the sale.[15] From there, the seller or their broker submit the policy to the market and negotiate the best price after which an offer is accepted and the policy sale is closed. The method by which the policy is marketed can affect the ultimate outcome. As stated above, working through a broker who owes fiduciary duties to the policy owner rather than selling directly to the provider/buyer can be important such as marketing the policy through and auction and competitive bid process.[16]
When May a Life Settlement be Appropriate?
There are a number of reasons why a policy owner may desire to sell a life insurance policy. Common reasons include[17]:
- The policy is no longer needed by the policy owner. For example, policies acquired to fund anticipated estate tax liabilities may no longer be needed due to changes in estate tax exemptions or the net worth of the insured. Another example is when a policy was purchased to fund a buy-sell agreement that is no longer needed.
- A notice that the policy will lapse is issued by the carrier and the owner cannot or does not desire to continue funding premiums.
- The policy is no longer suitable, no longer affordable, or is underperforming.
- The sale will generate more liquidity to fund into new investments, including a new life insurance policy, than other options for policy disposition.
- The policy owner is in need of cash to fund other obligations. For example, these other obligations may include debt service, funding of long-term care needs, to fund charitable gifts, or maintenance of lifestyle in retirement.
Regardless of the reasons a policy owner may feel the need to dispose of an existing life insurance policy, knowing that life settlement may be an option can be very valuable information given the opportunity to obtain more value than a policy surrender. As indicated above, one of the first steps in this process is to work with a broker to determine policy value and viability of a policy sale. From there, if the sale is not viable, the policy owner can know that other options are most beneficial. If the sale is viable, then the broker can commence the process of soliciting proposals.
What are the Tax Consequences of a Life Settlement?[18]
Of course, in evaluating a potential life settlement, tax consequences must be addressed. Although the tax consequences of life settlement transactions were somewhat uncertain prior to the Tax Cuts and Jobs Act of 2017,[19] that legislation adopted statutory provisions which directly address the tax treatment of life settlements.[20] In addition to addressing the tax consequences of the sale, these provisions also put into place certain reporting requirements.[21]
As a result of these changes, the determination of the tax consequences of a life settlement are fairly straightforward. First, it is important to determine the owner’s cost basis in the policy. Typically, that will be the cumulative premiums paid reduced by withdrawals and dividends received from the policy. Sales proceeds up to cost basis are received tax free by the seller. Then, the difference between cost basis and cash surrender value is treated as ordinary income. Any additional proceeds are taxed as long term capital gains.
While it is important to analyze the tax consequences of a life settlement, it is likewise important to note that that treatment now is on parity with a surrender of the policy for cash value. Consequently, the previous result of having potentially worse tax treatment from a life settlement versus policy surrender has been neutralized. The analysis between those two options can be based on the value received by the policy owner without accounting for tax differences between the two.
Conclusion
Life insurance is an asset. Many individuals do not view life insurance this way, nor do many of their advisors. However, viewed this way, a life insurance policy should be considered like many other assets on an individual’s balance sheet. The asset may be borrowed against, sold, exchanged, or otherwise disposed of by the owner (such as through surrender). When clients need liquidity, a life insurance policy is an asset which may be available to provide that liquidity. When a policy needs to be disposed of, for reasons such as those described above, a life settlement transaction should be evaluated. Often, the first step in analyzing options is to obtain a policy valuation which can be provided by a broker. From there, the client can make an informed decision about their alternatives.
Most professional advisors are quick to look at a client’s assets to see what assets are available for monetization. Also, advisors often can evaluate the costs of maintaining a policy in force versus surrender. However, as illustrated by some of the surveys cited in this writing, advisors do not appear to be well educated about life settlements and many do not consider it part of their obligation to their clients to become knowledgeable about that option. That represents a clear disconnect between client expectations and professional obligations with the views of many professional advisors. Of course, those holding policies in a fiduciary capacity, such as the trustee of a trust, have even greater duties in evaluating options for assets under their administration (i.e. how often would a trustee not know the value of other assets held in the trust). It is important that policy owners, professional advisors, fiduciaries, and others in related positions understand life settlements in order to properly evaluate options. Significant value can be added with just a bit of learning. That learning is both understanding the life settlement opportunity, but also making sure clients and advisors communicate when existing a life insurance policy is being considered.[22]
[1] Edmondson, Gray, “Are Your Life Insurance Death Benefits Taxable,” Dec. 20, 2019, https://esapllc.com/lifeinsurance2019/; Charles Allen, “Back to the Basics with Life Insurance and Estate Tax,” March 29, 2022, https://esapllc.com/life-insurance-estate-tax-review-2022/; Parker Durham, “Your Estate Plan and Life Insurance – A Complementing Pair,” Jul. 18, 2023, https://esapllc.com/estate-planning-life-insurance-2023/,
[2] This writing does not address the types of policies typically sold on the life settlement market. However, it is important to understand that the type of policy will have an impact on a life settlement transaction.
[3] Warring, “Turn Unneeded Policies into Cash: A Life Settlement Can Be a Better Alternative Than Surrendering a Policy,” J. Accountancy, Vol. 200, No. 3 (Sept. 2005); and Life Settlements – The Concept Catches On (Conning Research & Consulting, Inc., 2006).
[4] Herson, “More than 8 in 10 Seniors Unaware of Life Settlement Option,” ThinkAdvisor, May 12, 2016, https://www.thinkadvisor.com/2016/05/12/more-than-8-in-10-seniors-unaware-of-life-settlement-option-2/
[5] Id.
[6] Mendelsohn, Jason T., “Spotlight on Life Settlement Transactions: Getting the Best Value,” The Tax Advisor, June 1, 2019, https://www.thetaxadviser.com/issues/2019/jun/life-settlement-transactions-best-value.html.
[7] IRC § 101(g) defines “terminally ill” or “chronically ill” for purposes of addressing the tax consequences of viatical settlements.
[8] See Grigsby v. Russell, 22 U.S. 1949 (1911). Note that this case also recognized that the buyer need not have an “insurable interest” in the insured.
[9] Leimberg, Stephan R., E. Randolph Whitelaw, Richard M. Weber, and Liz Colosimo, “Life Settlements: Risk Management Guidance for Advisors and Fiduciaries,” 33 Est. Plan. 3 (Aug. 2006).
[10] Brohawn, Michael, “Understanding the Ins and Outs of Life Settlements,” 46 Est. Plan. 7 (July 2019).
[11] Id.
[12] See supra Note 9.
[13] See supra Note 6, also outlining certain due diligence questions to ask potential brokers. In recent years, there has been a proliferation of direct-to-consumer marketing online and on television where providers representing buyers solicit owners to sell policies. It is important for policy owners to understand that calling these providers or completing questionnaires on their online platforms will not necessarily result in the best price for their policy since the process involves a single buyer without a competitive bid process where the person engaging the seller represents only the buyer’s interests.
[14] There are a number of qualified brokers. For example, I have successfully worked with the Ashar Group (see Jamie Mendelsohn cited above) on behalf of a number of clients. A review of their website illustrates the value added by brokers representing the interests of policy owners.
[15] See supra Note 10.
[16] Mendelsohn, Jamie, “Maximizing Life Settlement Value Through a Policy Auction,” NAEPC Journal of Estate & Tax Planning, Issue 41, Jan. 2023, https://www.naepcjournal.org/issue/41/maximizing-life-settlement-value-through-policy-auction/.
[17] See supra Notes 9 and 10. I note that the reasons listed here are largely relevant for individual sellers. However, policies owned by businesses, trusts, or charitable organizations, also may be sold in a life settlement transaction. Reasons for those owners to sell policies may be different from those typically present for individual sellers.
[18] Note that viatical settlements will be taxed differently than life settlements. For treatment of viatical settlements, see IRC § 101(g).
[19] See Zaritsky & Leimberg, “Tax Planning with Life Insurance: Analysis with Forms,” ¶2.16.
[20] See IRC § 1016(a)(1)(B) and Rev. Rul. 2020-05. For a statement of the IRS position before the TCJA changes, see Rev. Rul. 2009-13.
[21] IRC § 6050Y The relevant documents are IRS Forms 1099-LS and 1099-SB.
[22] For advisors, this may be through a routine client review, part of a standard checklist, or otherwise. As illustrated in the data cited in this writing, being knowledgeable about life settlements and working with clients through that process creates an opportunity for advisors to show expertise and add value while also mitigating risk and liability.
