Life settlements.

• Author: Gavartin, Amy

ADVISERS ARE CONSTANTLY LOOKING FOR ways to supplement the depleted finances of their clients. For seniors, one option that has become more popular is the secondary market for life insurance or life settlements. Several articles have recently been published on this topic, and many have tried to portray this industry as the "next sub-prime crisis" waiting to happen but gloss over the underlying fact that the use of life settlements has uncovered vast amounts of hidden value from existing life insurance policies. Over the past 10 years, owners of life insurance policies who have chosen to sell have received approximately $6-7 billion more than their cash surrender value (CSV) (Thomas, "LISA Pans Article," Life and Health Insurance News (September 14, 2009), www.lifeandhealthinsurancenews.com/News/2009/9/Pages/LISA-Pans-Article.aspx).

It is not uncommon for the settlement amount to be three to five times the CSV, and the policy owner is relieved of all future premium payments on the policy. All types of policies are eligible for a life settlement, including term, universal life, whole life, variable universal, and second-to-die policies. The general rule of thumb in today's market is that the insured should be over age 70 with a minimum of $250,000 of insurance.

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The tax treatment of life settlement proceeds has been unclear until recently. However, the IRS issued guidance during 2009 that clarifies when and to what extent policyholders must recognize capital gain when they sell a life insurance policy.

Background

The definition of a life settlement is the sale of an existing life insurance policy from the current policy owner to a third party via the secondary institutional market in exchange for an immediate one-time cash payment that is less than the policy's face value but more than the policy's CSV. There are many reasons a policy owner could come to the conclusion that he or she no longer needs or wants a policy: Owning an underperforming policy, retirement of an executive or sale of a business, divorce or death of a spouse or beneficiary, estate size growth or reduction, changes in health, and economic hardship or bankruptcy are just a few examples that can cause policy owners to cancel or surrender their life insurance. All these changing circumstances lead to an overwhelming outcome: 88% of universal life policies and 95% of term policies never pay a death claim (Kadlec, "Extra Value," Time (October 22, 2006), www.time.com/time/magazine/article/0.9171.1549320.00.html).

The hard numbers are staggering: According to the American Council of Life Insurers, in 2006 $2.22 trillion worth of life insurance policies lapsed or were surrendered, a total that increases by approximately 4% per year (American Council of Life Insurers, Life Insurers Fact Book 2006, www.acli/com/ACLI/Tools/Industry+Facts/Life+Insurers+Fact+Book/FE06.htm). Yet only an estimated $15-$20 billion of life insurance policies were sold to the secondary market in 2007 (Breus, "Virtues and Evils of Life Settlement," Journal of Accountancy (June 2008)). The research firm Conning and Company reports that seniors have approximately $500 billion of life insurance in force, and policyholders will contemplate canceling about $125 billion of those policies (Stern, "Life Settlements: The Legitimacy of a Long-Term Care Funding Source," Case in Point (June-July 2009), www.snapforseniors.com/tabid/973/Default.aspx). There lies the opportunity.

The legal and historical underpinnings of life settlements are deep. In 1899, New York's highest court held that policy owners have property rights in life insurance and as such can "go to the best market [they] can find, either to sell it or borrow money on it" (Steinback v. Diepenbrock, 52 N.E. 662, 664 (1899)). The Supreme Court...