A viatical settlement is a financial transaction in which a terminally ill policy owner sells his life insurance policy to a third party for cash and can then, in turn, use that cash to pay medical expenses. Provided that the person selling the policy is terminally ill, this transaction is not a taxable event to the seller of the policy.
These viatical settlements are regulated by the various state insurance departments to prevent abuse.
Actually, most modern policies now issued by virtually every life insurance company contain a provision whereby terminally ill policy owners can obtain cash from the policy without having to sell the policy to someone else.
The cash that can be made available can be as much as 75 percent of the policy’s face amount, so long as a physician documents that death is expected to occur within 24 months.
An outgrowth of the viatical settlement is a somewhat similar financial transaction known as a life settlement. In this instance, a policy owner who has an unneeded or unwanted life insurance policy can sell the policy to someone else for a price that may exceed the policy’s cash value.
A term insurance policy can even have considerable value, particularly if the insured person is in poor health. The new owner names himself as the new beneficiary of the policy, and this new owner is responsible for future premium payments.
Since this transaction qualifies as a transfer for value, the death proceeds that are ultimately paid to the purchaser/beneficiary are taxable.
The income tax that is levied on the seller of a cash value policy is determined in two segments – ordinary income on the amount that the cash value exceeds the sum of all net premium payments and capital gains rates on any additional monies received.
A growing number of experts now believe that informing clients about offering life settlements should fall under the fiduciary duty of a financial adviser, and when I sat for the Certified Financial Planner examination several years ago, the topic of life settlements was covered on the exam.
Prior to the advent of life settlements, the only value that was available to a policy owner who wished to terminate his policy was simply the policy’s surrender cash value, if any.
Life settlements became very popular in the period from 1995-2008, since they opened a secondary market for life insurance in which policy owners could receive greater value for their policies at the time of sale than was formerly the case.
The current situation is somewhat different, since life expectancy is increasing and this phenomenon delays the ultimate payoff that an investor would receive, thus reducing his rate of return.
Recent sales of policies reflect the downturn in the settlement market, since a 79-year-old man sold his universal life policy with a $1.5 million face amount in 2012 to a reputable company for $196,000.
In another case, a 70-year-old man had a term life policy with a $5 million face value that the same settlement company purchased for $150,000.
In years past, those sellers would have received substantially more for their policies, in all likelihood.
Until recently, life settlements were a viable option for affluent policy owners who were age 65 or older and who had no ongoing need for life insurance, perhaps because they have sold a business, gone through a divorce or the death of a spouse or no longer expect their estate to need the policy benefits to cover estate taxes, said Lawrence J. Rybka, chief executive of Valmark Securities Inc., a broker-dealer with a small life settlements business.
Life insurance policies with face amounts of $500,000 and up are usually worth selling, if there is no ongoing need for the life insurance coverage.
The life settlement market has shrunk. The industry bought up policies with $8 billion in face value in years 2007 and 2008. It’s now less than $1.5 billion, Rybka noted.
Rather than sell a policy, it may make better financial sense for a policyholder’s child to start paying the premiums on a parent’s life insurance policy if the child is the beneficiary and can afford to cover the costs.
Clients who don’t need the life insurance policy but have plenty of cash may want to consider whether to continue paying the premiums themselves, because keeping the policy in force could provide a tax-free return of 12 to 15 percent for their beneficiaries/premium payers. Such policyholders might be better off by selling other assets to pay future premiums.
Life settlement transactions have come under scrutiny by state insurance regulators, which oversee the industry, and the Securities and Exchange Commission has recommended that Congress expand the definition of “securities” to include life settlements. To date, no action has been taken.
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Greg Roberts is a certified financial planner with 35 years of financial and estate planning experience.
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