Life Settlement Piques Curiosity of Well-Read Retiree

Donald is a 72-year-old retiree who enjoys his morning newspapers. While reading the Wall Street Journal recently, he came across an article describing how an arbitration panel had ordered insurance conglomerate AIG to pay millions for its involvement with life settlements.

Donald’s curiosity was piqued by the article’s brief description of a life settlement because he had a $3 million permanent life insurance policy he might be willing to part with if he could get something for his years of investment. He contacted his financial advisor to learn more.

Donald’s advisor said that arranging a life settlement is certainly an option available to him. But Donald needed to carefully study the details before committing to the idea.

How it works

Under a life settlement, a third party would buy Donald’s life insurance policy for more than its cash surrender value but less than its net death benefit. The third party would take over the premium payments and either sell the policy on the secondary market or collect the death benefit when Donald died.

A third-party buyer would calculate the value of Donald’s life insurance policy based on his age and medical condition (the policyholder generally must be over age 65), the policy type (commonly universal life, whole life or convertible term insurance), his insurer’s rating, and the premiums needed to keep the policy in force.

In most cases, the sale proceeds from a life settlement are tax-free (at the federal level) up to the amount of total premiums paid on the policy. But Donald’s advisor said they should review his state’s tax treatment of the transaction.

In Donald’s case …

Donald’s $3 million life insurance policy had a cash surrender value of $725,000 and his tax basis in the policy, based on his paid premiums, was $400,000.

His advisor said that a life settlement may indeed be beneficial because Donald had enough other insurance in place and could use the payout — as well as the cash that would be freed up from no longer having to pay premiums — to cover other expenses. Plus the policy’s cash surrender value was only a fraction of its face amount.

A word of caution

Life settlements are controversial to some, partly because the third-party buyers are essentially making money when someone dies. There are also fraud and abuse risks that warrant close scrutiny of any buyer. Donald appreciated his financial advisor’s input and decided to sleep on the decision and, of course, read up on it further.

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