What is Reverse Life Insurance?

The image shows an older couple on the couch signing papers.

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Traditional life insurance has been around for at least a hundred years. But a new twist on life insurance is making its way into the mainstream life insurance marketplace today.

A reverse life insurance sale allows policyholders to convert their life insurance policies into a lump sum of cash upfront provided that they meet certain conditions. This type of life insurance transaction is rapidly gaining in popularity for many reasons.

What is reverse life insurance?

In a nutshell, a reverse life insurance option is where a cash value life insurance policy owner sells his or her policy in the secondary market to a third party in exchange for a lump sum of cash upfront. This type of transaction is also known as a life settlement, or in the case where the insured is terminally ill, a viatical settlement. This type of transaction should not be confused with a reverse mortgage, which draws equity out of your home on a monthly basis. It is also different from a Medicaid life settlement.

History of reverse life insurance transactions

Reverse life insurance got its start in the early 1980s in the midst of the AIDS epidemic. Early reverse life settlement providers called viators would approach AIDS patients with terminal illnesses and offer them cash upfront for their life insurance policies. The patients would get a substantial cash payout and the viator would then assume ownership of the policy and collect the death benefit upon the death of the patient. These transactions were referred to as viatical settlements.

This early form of reverse life insurance was largely unregulated, and the industry was rife with contradictions and corruption. As time went on, the reverse life insurance industry matured and became more regulated and streamlined. The Tax Cuts and Jobs Act of 2017 provided a boilerplate set of rules for the taxation of these transactions, at least at the federal level.

Ttax rules at the state level still vary widely from one state to another. For example, the tax rules in New York can be very different from the tax rules in other states. Most life settlements companies are now required to provide potential sellers with a disclaimer that outlines all of their fees and charges.

The reverse life insurance industry today is much more organized, and many reverse life settlement providers use turnkey programs that can get their payouts to insureds in a matter of weeks or months. The exact amount of time that it takes depends upon the financial circumstances of the insured and other factors.

This form of life insurance is also rapidly gaining in popularity. A growing number of senior citizens who need cash now are finding that their life insurance policies are tangible assets that they can cash in, which gives them a real shot in the arm financially. The reverse life insurance industry is now booming, and is expected to grow into a major segment of the life insurance industry within the next few years.

The life insurance settlement process

There are several distinct steps that occur in every reverse life insurance transaction. They are listed as follows:

  1. The insured reaches age 65 and owns a permanent life insurance policy with a face value (death benefit) of at least $100,000.
  2. The insured decides to sell the policy and approaches one or more life settlement companies. The insured may also hire a life settlement broker to do this on his or her behalf.
  3. The life settlement companies get a copy of the insured’s life insurance policy and medical records. They use this information along with the insured’s life expectancy to determine the current market value of the life insurance policy.
  4. The life settlement companies go back to the insured and make an offer to him or her of how much they are willing to pay for the policy. The insured accepts the highest bid and the other firms bow out of the process. Pricing can depend on a variety of factors, such as the insured’s health and prevailing interest rates.
  5. The insured signs over the ownership of the cash value life insurance policy to the settlement company but remains as the insured on the policy.
  6. The settlement company names itself as the new primary beneficiary on the policy and assumes the responsibility of paying the annual life insurance premiums.
  7. Upon the death of the insured, the settlement company collects the death benefit and thus recoups its premium outlay and also makes a profit.

It is possible to sell only a portion of a life insurance policy so that a certain amount of death benefit will still be paid to the policy’s original beneficiaries. The amount that the insured wants to sell versus the amount that he or she wants to retain will depend upon the insured’s financial circumstances as well as the financial circumstances of the beneficiaries.

A couple discussing reverse life insurance options with a life settlement company.

Insureds should have a close, heart-to-heart discussion with their beneficiaries, family members, and other loved ones before beginning the reverse life insurance process. This step will have a major financial impact on both the insured’s and the beneficiaries’ finances.

Income tax treatment

Reverse life insurance transactions have their own set of tax rules. For every sale of a life insurance policy, the sale proceeds are broken down into three separate tiers, each of which is taxed as follows:

  1. The amount of sale proceeds that equals the total amount of premium payments made into the life insurance policy since its inception is treated as a tax-free return of principal.
  2. The amount of sale proceeds that exceed the total amount of premium paid and is equal to the cash value is taxed as ordinary income.
  3. The amount of sale proceeds that exceed the amount of cash value in the policy is taxed as a long-term capital gain.

Example

Fred is 70 years old and owns a universal life policy with a death benefit of $200,000. He has paid a total of $25,000 in premiums to keep the policy in force. He sells his policy to a life settlement company for $40,000. There is $30,000 of cash value in the policy. The sale is taxed as follows:

  1. $25,000 of the sale proceeds are treated as a tax-free return of principal.
  2. $5,000 ($30,000 of cash value minus $25,000 of premium paid) is taxed as ordinary income.
  3. The remaining $10,000 ($40,000 of sale proceeds minus $30,000 of cash value) is taxed as a long-term capital gain.

In this example, the sale proceeds were only $40,000 while the cash value was $30,000. These two numbers were used for simplicity’s sake. But in reality, the amount of the payout that the insured receives is typically at least two to three times the amount of cash value in the policy. But it is always still much lower than the face amount (death benefit).

Viatical settlements are usually tax-free, provided that certain conditions are met. Consult your tax advisor for more information on this topic.

How selling your life insurance policy can benefit you

As you can see, a reverse life insurance transaction can make your current financial circumstances much easier to deal with by giving you cash now in return for your policy.

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But there are also some drawbacks that come with a reverse life insurance sale, and you need to be fully informed about all of the possible ramifications that come with taking this step. The pros and cons of reverse life settlement transactions are broken down as follows:

Pro: Get cash now

The obvious advantage of getting cash now is by far the biggest advantage of selling your life insurance policy. But it also relieves you of the responsibility of paying the insurance premiums every year, thus freeing up additional retirement income in your budget.

Pro: Better than letting your policy lapse

You may no longer need the coverage that the policy provides because your beneficiaries, such as your family, now have adequate savings and resources to make it on their own without depending upon the death benefit paid by the policy. Therefore it makes sense for you to get what you can out of the policy now. This is vastly superior to just letting your policy lapse.

Pro: Use the money for any purpose

You can use the money you get for any purpose that you may have, such as paying for medical expenses that are not covered by your health insurance, buying long-term care insurance that can cover things such as paying for an assisted living facility, investing in a new venture or buying a second home. There are no restrictions on how you can use the sale proceeds.

Pro: Get more cash than you would in any other circumstance

Furthermore, a reverse life insurance transaction will pay a considerably larger sum than you could get from making a cash withdrawal from your policy’s cash value, surrendering your policy, and taking the remaining cash surrender value, or borrowing from your cash value. Most financial advisors will tell you that a reverse life insurance transaction is the way to go if you want to tap into the cash value in your policy.Con: Disinheriting your beneficiaries

The chief disadvantage of selling your life insurance policy is that you are effectively disinheriting your beneficiaries. They may be counting on the death benefit paid by the life insurance company to pull them through a tight spot, and if it isn’t there, then they may end up in real financial trouble. Again, this is why you need to clearly communicate to your beneficiaries what will happen if you sell your life insurance coverage.

Con: Taxes

Taxes are another factor to consider. If you have a very large policy that you’d like to sell, be sure to find out what the income tax implications will be before you get started. You may end up putting yourself in a higher tax bracket if you have accumulated a substantial amount of cash value in your life insurance policy.

Con: Only certain policies are eligible

Reverse life insurance transactions can only be done with cash value life insurance policies. Term life policies are ineligible for this unless it is a convertible term life insurance policy. But whole life insurance, universal life insurance, and variable universal life insurance are all eligible for reverse life insurance transactions. Annuities are likewise prohibited from this type of transaction.

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Reverse life insurance transactions have only been around for about 40 years, and at this point, they have barely made an imprint on the life insurance marketplace. That will change in the future as more and more senior policyholders cash in their life insurance policies for a lump sum payout that they can use however they wish.

Consult your financial planner or life insurance agent for more information on reverse life insurance transactions and whether one is right for you. Finding the right settlement option can provide you with lasting peace of mind.  Want to find out how much you could get for your life insurance policy? Get an instant valuation using our life settlement calculator.

Author:
Chris Granwehr is the Founder of Dawn Life Settlements and a former senior manager with Mason Finance, an industry-leading life settlement provider in California. He's a member of the Life Insurance Settlement Association, and he has a passion for empowering customers financially through a faster, easier life settlement system.