What Are Senior Life Settlements? A Guide

The image shows a happy couple celebrating with wine after getting a senior life settlement.

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Senior life settlements are becoming increasingly common as more and more senior citizens are now selling their life insurance policies because they no longer need them, or they need cash quickly to pay for medical or long-term care expenses. This type of transaction has only been around in one form or another for about 30 years, but the life settlement industry is quickly carving out a sizable niche in the life insurance industry in the United States.

What is a senior life settlement?

So what is a life settlement? In a nutshell, a life settlement (also known as a senior life settlement or reverse life insurance) is an arrangement where a senior citizen who is at least 60 or 65 years old sells their existing life insurance policy to a willing buyer at fair market value. In most cases, the buyer is a life settlement company that specializes in buying life insurance policies from senior citizens, but the buyer can also be a friend, relative or private investor.

In 1911, the Supreme Court of the United States ruled in Grigsby vs. Russell that it was permissible to transfer ownership of a life insurance policy for consideration. The life settlement industry has based its operations on the interpretation of this ruling.

Some life settlement companies pass on part or all of the ownership of their policies to private or institutional investors that purchase life insurance policies. They may invest in a range of policies issued by several different insurance carriers to create a complete life insurance portfolio. But this market only works with existing policies. New life policies or new policies that just took effect are not eligible for this type of transaction.

The chief regulatory agency that works with life settlements is the National Association of Insurance Commissioners. FINRA and the SEC also have boilerplate rules in place that must be followed.

How life settlements work

Getting a life settlement usually takes around 3-4 months, but with today’s technology, it can happen in as little as 3-4 weeks. The process happens in several steps:

  1. In many cases, the insured policy owner contacts a life settlement broker, who works as an intermediary and guide for the policy owner throughout the entire life settlement transaction. The broker can help the insured by negotiating on the insured’s behalf to get the best possible price.
  2. The buyer will request a copy of the insurance policy and the medical records of the insured. Other pieces of information may also be needed in some cases.
  3. Once the underwriting department of the buyer has determined the fair market value of the policy, it will make the insured an offer for the policy.
  4. If the insured agrees to sell the policy at that price, then the insured (seller) on the policy transfers ownership of the policy to the life settlement company or another buyer, who also names itself as the new primary beneficiary on the policy. The buyer will then assume the responsibility of making the insurance premium payments on the policy to the life insurance company until the death of the insured.
  5. In return, the insured person receives a substantial lump-sum payment upfront that he or she can use in any way that he or she sees fit. The cash payment from the sale of a life insurance policy may be used to pay for medical or long-term care expenses or to buy a second home or pay off debt. The cash payout received can be at least two to three times the size of the amount of cash value in the policy, but it will always be less than the death benefit.
  6. The settlement company collects the net death benefit after the insured passes away and thus recoups its premium outlay and also makes a profit. Typically the payout to the insured will be equal to a little over 20% of the face value (death benefit) of the policy. But this is usually considerably more than the policy’s cash surrender value or what the insured would get if he or she lets the policy lapse. The life settlement market has continued to grow rapidly for this reason.

This tradeoff effectively provides the insured with a lump sum of cash immediately. And the amount that the insured receives will be much more than what he or she would get if they tried to tap into the benefit of the policy in any other way. Cash withdrawals, policy surrenders, and policy loans can never exceed the amount of cash value in the policy, and in many cases they will yield substantially less.

Senior life settlements: What you should know before selling 

However, the insured needs to do his or her homework before making one of these sales. Their current beneficiaries will be removed from the policy, thus disinheriting them from the death benefit payout. The insured must make certain that the current policy beneficiaries (which are often family members) understand this so that they aren’t handed an unpleasant surprise when the time comes for them to collect the death benefit to which they think that they are entitled. There can be several estate planning factors to consider.

Nurse talking to senior couple in hospital room.

The insured also should have at least one meeting with a qualified tax or financial advisor in order to go over the details of the sale and also try to gauge whether he or she is getting a fair price for the policy being sold. This should be done either before or during the sale to ensure that any nuances pertinent to the sale are handled properly.

The three factors that determine the sale price of a given policy are:

  1. The amount of the death benefit – A larger death benefit equals a higher payout.
  2. The cost of the premiums – Lower premiums also mean a higher payout.
  3. The health condition of the insured – If the insured is in poor health, then the payout will also increase because the life settlement company can reasonably expect the insured to die that much sooner. And that means they won’t have to pay the policy premiums for as long, and they can collect on their investment earlier.
  4. The transaction costs – There are many costs and fees associated with life settlements, and insureds need to be sure to read all of the fine print in order to anticipate these costs.

How the taxation of senior life settlements works

Unlike with the payment of a life insurance policy’s death benefit, there are usually tax consequences that come with senior life settlements. And these rules pertain to all types of permanent life insurance, including whole life, universal life, and variable life insurance. The proceeds from these sales are broken down into three tiers:

  1. The total amount of the premiums paid into the policy is considered a tax-free return of principal. There is no taxation on this portion of the sale proceeds.
  2. Any amount of cash value in the policy that exceeds the total amount of premiums paid is taxed as ordinary income. This means that the insured will pay tax on this amount at their top marginal tax rate.
  3. Any amount of sale proceeds that exceed the total cash value in the policy is taxed as a long-term capital gain.

An example of senior life settlement taxation

Bill owns a $500,000 whole life policy that he no longer wants or needs. So he sells it to a life settlement provider in the secondary market and receives $110,000 in cash upfront. The policy has a cash value of $90,000, and Bill has paid a total of $75,000 in premiums over the life of the policy. The sale transaction is taxed as follows:

  1. $75,000 of premiums paid – tax-free return of premiums
  2. $90,000 of cash value minus the $75,000 of premiums paid – equals $15,000 to be taxed then he will owe $3,750 of tax for this tier of the sale.
  3. $110,000 minus $90,000 of cash value – equals $20,000 of long-term capital gains. This amount will be taxed at a lower rate than the cash value.

Senior life insurance settlements are usually done for one of the following reasons:

  • The insured no longer needs the policy. The policy beneficiaries have either passed away or become financially independent. They no longer need the death benefit coverage but don’t see any point in lapsing the policy.
  • The insured no longer wants to pay the future premiums to the insurer for the policy. They have become a financial burden to the insured who has retired.
  • The insured needs cash now for whatever reason. It could be for medical or long-term care expenses or another unexpected (or expected) expense.

What are accelerated death benefit riders?

Before an insured decides to sell his or her policy, he or she should review their policy to see whether it contains any accelerated death benefit riders. Riders provide additional forms of protection for the insured above and beyond the death benefit. Sometimes they come at an additional cost while other riders are built directly into the base policy.

These riders can provide the insured with some or all of the policy’s death benefit while the insured is still living. If the insured becomes permanently disabled or unable to perform at least two of the six activities of daily living (i.e. eating, walking, transferring, toileting, bathing, and personal hygiene), then at least a portion of the death benefit will be paid out to cover the cost of caring for the insured.

Insureds who have policies with these riders should compare how much they could get from the rider compared to what they will get from a life settlement. And they should not forget that the rider income is tax-free, while the settlement income will be partially taxable in most cases. If the insured feels certain that they will need some form of long-term care in their later years, then the rider may be a better deal than selling the policy.

Are “regular” life settlements different?

For all practical purposes, there is no material difference between a “regular” life settlement and a senior life settlement. Virtually all life settlements are done for senior citizens, so the terms are essentially interchangeable. The only exception to this is when a terminally ill insured who is younger than age 60 wants to sell his or her policy in order to pay for medical bills. However, these specialized transactions are known as viatical settlements, described below.

What are viatical settlements?

Viatical settlements first appeared in the 1980s in the wake of the AIDS epidemic. Life settlement companies called viators approached patients who had a terminal illness and offered to buy their life insurance policies and pay cash upfront.

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Many patients agreed to this and received at least a portion of their death benefits in cash that they could use to pay for medical expenses. But these initial transactions were almost completely unregulated by either Congress or the IRS, and the fledgling industry was rife with corruption and contradictions.

Since then, much has changed, and the life settlement industry has become strictly regulated to protect seniors from any bad actors looking to cash in on their life insurance.

How the taxation of viatical settlements works

Much of the uncertainty surrounding these transactions lasted until fairly recently when Congress passed the Tax Cuts and Jobs Act of 2017. This legislation greatly simplified the rules governing the taxation of viatical settlements and clearly defined the criteria that must be met by both the buyer and the seller in order to qualify for the tax-advantaged status.

However, even after this legislation went into effect, there was and still is an element of uncertainty regarding how viatical settlements are taxed. In general, viatical settlements are tax-free because they are considered to be an advance of the death benefit (which is always tax-free).

But there are also state taxes to consider, and the tax laws for each state can differ somewhat in several respects. For example, the laws governing the taxation of viaticals in New York or Rhode Island may be very different than the laws that Florida or Wyoming use.

In order to be classified as a viatical settlement, the buyer and the seller must meet certain criteria. The buyer must be properly licensed and in the regular business of buying life insurance policies, and the seller must be able to furnish an affidavit signed by a doctor mandating that the policyholder has a life expectancy of no more than two years.

Am I eligible to sell my life insurance policy?

If you are at least 60 or 65 years old and have a cash value life insurance policy or convertible term policy with a death benefit of at least $100,000, then you can probably sell your policy to a life settlement company or other buyer.

If you are terminally ill and have less than two years to live, then you can sell your policy in a viatical settlement. The latter option is also available if you are chronically ill and are permanently incapable of performing at least two out of the six ADLs.

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Senior life settlements can provide much-needed cash upfront to an insured who meets all of the necessary criteria. The exact amount that each insured receives will depend on several factors, such as the face amount of the policy, the cost of the policy’s premiums, and the health of the insured.

Consult your financial advisor, the Life Insurance Settlement Association (LISA), FINRA or the National Association of Insurance Commissioners (NAIC) for more information on senior settlements and whether one is right for you. And for an accurate estimate of how much you could sell your life insurance policy for, try our instant 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.