LIFE SETTLEMENT
OVERVIEW
What is a Life Settlement?
A Life Settlement is the sale of an existing in-force life insurance policy to an institutional third party via the secondary market in exchange for an immediate lump sum cash payment that’s less than the policy’s face value, but higher than the policy’s cash surrender value (CSV). The settlement amount is (on average) 4 times the CSV of the policy – and by selling the policy, the owner is relieved of all future premium payments.
Historically, life insurance has provided a solution for the Policy Owner to meet various family or business needs – but, over time, needs change. Until recently, if an insurance policy was no longer needed or financially feasible, there were only three options to consider: (1) allow the policy to lapse; (2) continue to pay premiums and keep the policy in place; (3) surrender the policy to the insurance company for the cash surrender value.
Like stocks, bonds, real estate and other investment holdings, life insurance has become a fully evolved asset with a True Market Value (TMV) – an asset which can be sold by its owner at the highest market price.
All policies are eligible for a Life Settlement including Term Life, Universal Life (UL), Indexed or Variable Universal Life (IUL/VUL), Survivorship and Whole Life, with the general rule of thumb being that the insured needs to be 70 years old with a minimum of $500,000 of insurance.
The settlement amount will be determined by a combination of:
- Policy type
- Policy face amount
- Insurance company rating
- State of residency
- Policy premiums/year
- Age, gender and life expectancy of insured
Why Take the Life Settlemet "L.E.A.P."?
- It’s Legal – The legal basis for life settlements as a legitimate option for life insurance owners may be found in the Grigsby v. Russell decision from the U.S. Supreme Court in 1911, where it ruled that life insurance is just like any other private property you own and can therefore be sold.
- It’s Ethical – Advisors have a fiduciary obligation to provide their clients with all available information, choices and options.
- It’s Approved – As of 2019, 43 states and the territory of Puerto Rico regulate life settlements, affording approximately 90% of the United States population protection under comprehensive life settlement laws and regulations.
- It’s Profitable – On average, the purchase price is 4 times more than the Cash Surrender Value and if it’s a Term Policy, it might be worth more than the client spent over the lifetime of the policy.
What a Life Settlement is Not
Melville Capital focuses on traditional Life Settlements which does not include the following types of transactions:
- Stranger Owned Life Insurance (STOLI) – also referred to as “Stranger-originated life insurance” (“STOLI”) means an arrangement to initiate or facilitate the issuance of a policy for the intended benefit of an investor who has no “insurable interest” in the life of the insured. In the typical scenario, the insured either gets paid for their participation when the policy is originated or at the end of the two-year contestability period, with the investor becoming the owner and beneficiary. Many states have laws prohibiting STOLI transactions or are in the process of making laws to prohibit STOLI transactions.
- Investment opportunities – A Life Settlement is not a proposal to invest in the purchasing of policies. Melville Capital does not seek capital for investment purposes and we only transact with institutional investors who understand this marketplace. These investors are entities such as commercial and investment banks, hedge funds, pension funds and private equity funds. Be especially leary of any individual or institution seeking to invest in insurance policies to sell to individual investors.
How does the Life Settlement Process Work?
Bidding Process Consists of:
- Collection of application, policy authorizations and medical information (10-30 days)
- Complete Life Expectancy underwriting (5-7 days)
- Send complete case to funding entities
- Negotiate and obtain offers (10-15 days)
- Communicate value to owner
Approximately 6-8 weeks to complete the bidding process
Completing the Settlement Process:
- Contacts are ordered, delivered to the policy owner or referral source (7 days)
- Review, sign and return of settlement contract package (7 days)
- Legal review by buyer and clean-up of any deficiencies (7-14 days)
- Escrow account opened and change instructions sent to carrier
- Record ownership and beneficiary changes by insurance carrier (7-14 days)
- Escrow company releases cash settlement to client (3 days)
Approximately 5-7 weeks to complete the closing process
What is the taxation implication of a Life Settlement?
Please be advised that Melville Capital is not a tax advisor and does not provide tax advice. Melville Capital does not make any representations as to the tax treatment of a sale of a life insurance policy and recommends that you seek out a professional tax advisor prior to submitting a policy for sale and accepting any offers. The following is provided strictly for informational purposes only. As with any financial transaction, it is important to do an in-depth analysis of any possible life settlement.
As with any large financial transaction, you must understand the tax consequences of selling your life insurance. As a result of the Tax Cuts and Jobs Act of 2017 (TCJA), the tax consequences of selling your life insurance have become simpler.
When you sell your policy, you will be taxed in three tiers:
- Proceeds received up to the tax basis (total premiums paid) are free of income tax.
- Proceeds received that are greater than the tax basis up to the amount of the cash surrender value are taxed as ordinary income rates.
- Proceeds received that are in excess of the amount from tier 2 get taxed as capital gains.
Let’s look at the mechanics of a very basic example:
- Life Insurance Policy Cash Surrender Value: $195,000
- Total Premiums Paid by Policy Holders (Tax Basis): $175,000
- Amount Received in Life Settlement Transaction: $200,000
Let’s look at the mechanics of a very basic example:
- Life Settlement Proceeds: $200,000
- Paid Premiums (Tax Basis): $175,000
- Taxable Income: $25,000
The amount of those gains that will be treated as ordinary income is the cash value of the policy minus the tax basis (the dollar amount of premiums paid on the policy):
- Cash Surrender Value: $195,000
- Paid Premiums (Tax Basis): $175,000
- Amount taxed as ordinary income: $20,000
The remaining amount of the taxable income ($25,000-$20,000=$5,000) is the amount that will be taxed as long-term capital gains.
The TCJA made figuring out your tax basis significantly easier. Previously, based on Revenue Ruling 2009-13, there was a different tax basis calculation for people selling their insurance policies and those surrendering.
TCJA removed the need to factor in the cumulative cost of insurance and makes the basic calculation for both life insurance settlements and surrenders the same. Those selling their policies no longer need to reduce the taxable basis by the cumulative cost of insurance charges.
In short, the end result is lower capital gains tax.
Is it Legal?
Yes, life settlements are both legal and regulated. In 1911, the U.S. Supreme Court issued a decision in Grigsby v. Russell, which recognized the rights of the life insurance policy owners to transfer ownership of their life insurance policies to a third party that was unrelated to the policy owner/insured and did not hold an insurable interest in the policy owner/insured. This landmark ruling paved the way for the birth of the life settlement industry in the United States because the Court upheld a policy owner’s right to assign his/her life insurance policy.
Currently, 43 states and the territory of Puerto Rico regulate life settlements, affording approximately 90% of the United States population protection under comprehensive life settlement laws and regulations. Of these states, 31 states have a statutorily mandated two-year waiting period before one can sell their life insurance policy, while 10 states have five-year waiting periods and one state (Minnesota) has a four-year waiting period. Most states have provisions within their life settlement acts whereby one can sell their policy before the waiting period if they meet certain criteria (e.g., owner/insured is terminally or chronically ill, divorce, retirement, physical or mental disability).
Moreover, 20 states follow the National Conference of Insurance Legislators (NCOIL) Life Settlement Model Act, representing almost 53% of the U.S. population.
Interesting Statistics
- According to the American Council of Life Insurers, 88% of Universal Life policies are lapsed or surrendered without ever paying a death benefit.
- Furthermore, it is believed that 90%+ of term life insurance policies are lapsed without ever paying a death benefit.
- A study by the London Business School showed that the average sale price is 4x’s the Cash Surrender Value offered by the insurance carrier.
- There is approximately $14.5 trillion of in-force policies in the U.S., with more than 10% owned by senior citizens.
- The Wharton Financial Institutions Center estimates that more than 20% of policyholders over the age of 65 hold policies whose economic values far exceed their cash surrender values.
- Studies conducted by two of the leading research organizations for the life insurance industry, Conning, Inc. and Matthew Greenwald Associates, estimate that approximately $500 billion currently qualify for Life Settlement transactions.
- According to a recent U.S. Government Accountability Office (U.S. GAO) study, U.S. policy owners received $5.62 billion more than the policy cash surrender values from life settlements over a 3-year period.
- According to Conning & Co., an independent analyst firm, the annual volume of life settlement transactions will average approximately $3 billion per year over the next decade. This is an established and growing industry.
