What Is a Life Insurance Settlement?
In the most basic terms, a life settlement is a way for you to swap your current life insurance policy for immediate cash. Therefore, life settlements are often attractive to those who have unexpected expenses or some immediate need for money.
The process begins when the seller, who currently holds the policy, chooses a third party to sell it to. The third party then pays the seller a lump sum of cash for the policy and will go on to pay any future premiums on the policy. In exchange, when the seller dies, the third party receives the death benefit.
Seeking a life settlement is different from surrendering a life insurance policy for its cash value. Opting for the cash value involves only you and your life insurance provider. A life settlement includes a third party that buys the policy from you.
The goal of a life settlement can seem unnerving to some because the company or provider that is purchasing the policy is essentially looking to profit off the seller’s death. The sooner the seller dies after selling the policy, the more the third party stands to make.
For this reason, the cash you would receive from selling your policy will fall somewhere between the cash value of surrendering the policy and the death benefit.
The third party is incentivized to offer you more than the cash value, so that you sell the policy to them instead of surrendering it. However, they will typically offer less than the death benefit, so they can make a profit when you die.
How Life Settlements Work
When you have a policy and want to sell it in a life settlement, the older and sicker you are, the easier it will be for you to sell it, and the more money you’ll be able to get for it.
Life insurance settlements can be a legitimate source of cash when the alternative is to let a life insurance policy lapse.
In general, candidates for life settlements are typically older than 65 and hold life insurance policies with death benefits higher than $100,000. Younger policyholders may qualify if they have certain serious health conditions. However, if you’re younger than 65 years old with no serious health problems, you’re unlikely to get a bid for more than the surrender value of the policy.
When you’re seeking a life settlement, you will have to fill out a lot of paperwork and share your medical records. The buyer will use this information, along with your race, sex, family medical history and lifestyle, to determine your life expectancy. You may even have to get a medical exam to qualify.
The Financial Industry Regulatory Authority (FINRA) says there are legitimate reasons for life settlements, as well as reasons to be wary.
“When you sell your life insurance policy, whoever buys it is acquiring a financial interest in your death,” FINRA cautions. This kind of transaction “may target seniors who may be in poor health. It can be prone to aggressive sales tactics and abuse,” FINRA says.
Regulation Handled by States
Life settlements are regulated at the state level, with 42 states and Puerto Rico having laws of varying degrees. That leaves eight states and the District of Columbia with no regulation on these transactions. Critics say this is inconsistent and confusing.
Most of the states that regulate life settlements require a minimum of two years between the purchase and sale of a life insurance policy. A total of ten states require five-year waits. Minnesota requires four years.
Most of these states grant exemptions from the waiting periods in specific circumstances, such as divorce, retirement or terminal illness.
Investing in Life Settlements
Life settlement companies often bundle policies into funds and sell interest from the funds to investors. Doing this mitigates the risk of individual, original policyholders outliving expectations.
This is another area in which abuse has occurred and risks can be high. One potential risk to investors is that insurance companies may refuse to pay benefits because of alleged problems with the policies. or the insurance companies may go bankrupt. Investing fees may be high and include large commissions for brokers.
In some cases, government regulators have sued life settlement companies, accusing them of misleading investors. For example, a California firm was accused by the Securities and Exchange Commission of hiding from investors that the insurance policyholders were living longer than expected.
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Why Sell Your Life Insurance Policy?
Every year, about 4.5% of life insurance policies in the United States are allowed to lapse. The owners of those policies simply stop paying the premiums and lose their financial interest in these policies, which equals to a loss of about $900 billion in benefits to policyholders annually.
There are several valid reasons someone might no longer need a life insurance policy. For example, maybe the beneficiary is deceased or no longer needs the support. Maybe the policy was purchased to provide for children who are now adults able to provide for themselves.
Downsides and Cautions
Unlike life insurance proceeds inherited by your beneficiaries, the money you get in your life settlement will be subject to taxation. And it may affect whether you’re eligible to receive public assistance, such as Medicaid. These funds could also limit your ability to get another life insurance policy, should you need or want one, because it will count against the amount for which your life is insured.
FINRA says they can have high costs and unintended consequences. It’s tough to find out what a fair price would be for your policy.
You should do as much research as possible and ask a lot of questions about the fees, commissions, taxes and other costs. If you’re using a broker, you can look into his or her professional background using FINRA’s BrokerCheck.
FINRA also gives the following recommendations:
- Study your life insurance policy so you completely understand what’s in it and what other options you have.
- Research life settlements.
- Compare offers from more than one potential buyer.
- Deal only with licensed purchasers and brokers.
- Check with your state insurance commissioner to see if your settlement company or broker is licensed and if there are complaints on record.
- Ask what will ultimately happen to your policy and how your personal, medical information may be protected or exposed.
How Much Does a Life Settlement Pay?
How much a life settlement pays will depend on your personal situation and policy. The payout can vary heavily from person to person.
The older and sicker you are or the more valuable your policy is, the bigger your payout will likely be.
The goal of selling a life insurance policy is to get more than the policy’s cash value should the policyholder surrender it to the insurance company. However, this would be substantially less than the value of the death benefit. Typically, this would be about 10% to 25% of the policy benefit amount.
The payout for a life settlement is likely to fall somewhere between the cash value of surrendering the policy and the death benefit.
Remember that the goal of the third party buying your policy is to make a profit from the transaction. The closer the payout is to the death benefit, the less money they stand to make when you die.
The settlement amount is likely to be further reduced by the costs of the transaction, including commissions and fees, as well as taxes due. However, each case is different, depending on several factors.
Whether you qualify to sell your policy and how much you can get for it are determined by your age, health status and the details of your life insurance policy, including the cost of the premiums.
Life Settlements vs Viatical Settlements
Life settlements share many similarities with viatical settlements. In both scenarios, the seller works to sell their life insurance policy to a third party, like a company or provider. In exchange, the seller receives a one-time lump-sum payment while the company receives the death benefit when the seller dies.
The main difference between the two types of settlements is who is eligible for each. Life settlements are generally only an option for those with valuable policies and who are already old. But the typical requirements for a viatical settlement are even more stringent.
Viatical settlements are exclusively for those who are terminally or chronically ill. The seller of the policy typically has a life expectancy of less than two years.
Part of what makes viatical settlements appealing to potential buyers is that the seller is likely to die very soon, resulting in a higher and faster return on investment.
Many of the reasons why someone may consider a life settlement apply to those considering a viatical settlement as well, but terminally ill sellers may have the extra motivation of needing the immediate cash to handle their medical expenses.
Another key difference between settlements is that, while life settlements can be taxed, viatical settlements are usually not taxable in most cases.
How Can I Protect Myself Against Fraud?
The first step to protecting yourself against fraud is to be fully aware of what a life settlement is. You are selling your policy to a third party for a lump-sum payment. That third party hopes to make a profit off receiving the death benefit when you die.
Understanding the process and the motivation of any buyer can help prevent you being taken advantage of or ending up in a bad situation.
Another key point to remember when looking to avoid fraud is being aware of state regulations. States often require a significant waiting period between when a policy was purchased and when it can be sold.
Any situation where you are acquiring a life insurance policy in order to sell it could be fraud.
You should also ensure that you are dealing with a legitimate third party. Verify that the company you are working with is in fact regulated and licensed in your state and has a legitimate track record.
Read More: Life Settlement FAQs
Alternatives to Life Settlements
Before committing to a life settlement, it’s a good idea to make sure you understand all the costs and downsides. You should also explore whether other options might be better for your situation.
Other possibilities to examine:
- See if you can get a loan against your policy value.
- Cash out the policy to the insurance company for a reduced sum.
- Pursue accelerated death benefits if you are terminally ill or have a long-term condition that qualifies. This allows you to receive policy benefits before you die.
- Do a 1035 exchange to exchange one insurance policy for another without paying taxes on the gains on the first life insurance contract. This transaction is governed by Section 1035 of the Internal Revenue Code.
- Ask your beneficiaries to cover the cost of your premium payments.
- Ask your insurance company if the policy can be changed to eliminate premiums and lower the amount of the death benefit.
- Consider donating the policy to a charity or community foundation. The Insuring a Better World Fund can help with that.
- To raise cash, look into selling annuity payments.
As with all financial decisions, you must consider your personal needs and do your research before you sell your life insurance policy. For some, life settlements make sense, but for others, there are better options.
Read More: How to Use Life Insurance While Alive
Frequently Asked Questions
To qualify for a life settlement, you must be interested in selling your life insurance policy and usually must be 65 or older. Your policy also needs to be valuable enough to make a transaction worth it.
There is no set amount of time for how long a life settlement takes. It will vary depending on your personal circumstances and situations. But it is not instantaneous, and you can expect it to take even a few months to be finalized.
Life settlements typically are not tax free. You may have to pay taxes on the lump sum you receive for selling your policy.