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By Martha C. White
May 11, 2021
Man deciding between three paths: to keep, sell or return his life insurance policy.
Money; Getty Images

The term “life settlement” might sound arcane, but it actually describes something fairly straightforward: the sale of life insurance you no longer need or now can’t afford. While a settlement isn’t the right move for everyone, it allows you to get money for a policy so the funds can be put to other uses.

Conventional wisdom holds that there are only two options for unwanted or unaffordable permanent life insurance — that is, of the whole-life or universal types, which combine a death benefit with an investment component that has its own separate value. The policy can either be allowed to lapse or surrendered in exchange for the return of a portion of the money you invested in it.

Life settlements offer a third option, that of selling the policy to a third party, who pays you for it and then collects the death benefit when you die. This option promises a better return for you than mere surrender. Settlement is generally limited to policyholders aged 65 or 70, at minimum, who own a permanent life insurance, or term life policy that’s convertible to a permanent one, that has a death benefit of at least $100,000.

If you fit that profile, here’s what you need to know about life settlement, including how to decide whether it might be a good match for your financial needs and priorities.

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Should I sell my life insurance policy?

When life changes, so can your insurance needs. Life insurance is bought for particular reasons, and sometimes those reasons pass or the policyholder’s circumstances change and the policy’s benefits are no longer required.

Chris Huntley, president of InsuranceDodo.com, cites a case in which you took out a policy to make sure that your spouse could pay off the mortgage or your kids wouldn’t have to drop out of college if you died unexpectedly. Once the mortgage is paid or the kids graduate, you might not need that policy anymore, Huntley says.

If you’ve bought term life insurance you no longer need, you can simply stop paying its premiums without losing any money, because those policies have no residual investment value. But permanent life insurance is structured differently, with a portion of the policyholder’s premium being invested. That money, which accrues throughout the person’s life, is referred to as the “cash value” portion, and it remains even after your need for the death benefit may have passed.

You can then preserve the cash value by continuing to pay the premiums for coverage you no longer need, or let the policy lapse. Lapsing the coverage relieves you of paying the premiums, but all of the money you have in the policy essentially goes to waste.

Those options, both unpalatable, are why it makes sense to instead consider either surrendering the policy or seeking a life settlement for it.

Policy surrender versus life settlement

If you surrender a permanent life insurance policy, you receive what’s called its “cash surrender value.” That’s the amount of money that has been earned from the premiums invested in the policy, minus a surrender fee or penalty.

While you might not be assessed a surrender fee if the policy has been in place for a long time, the charge can be very steep — as much as double-digit percentages of the cash value — if you terminate a policy within the first several years after taking it out.

If you instead opt for life settlement, the policy is not surrendered but sold to a third party. The buyer is generally either an investment group or a third-party broker. The new owner will then turn around and sell your policy to investment firms that specialize in this practice.

After the investors pay you for the policy, they take over paying the premiums on the policy until your death, at which point they collect the death benefit. The person selling the policy has to sign off on allowing the buyer access to their medical records, both at the time they sell the policy as well as at regular intervals (such as quarterly).

How to shop for a life settlement

The big benefit of life settlements is that you, as the policyholder, get a one-time infusion of cash that can ease whatever current financial constraints you might face. As a rule, you can expect a lump sum that’s greater than you’d get from surrendering the policy but less than the policy’s death benefit.

According to Huntley, where the offer falls within that range hinges mainly on three highly variable specifics,: The premium payment amount, the amount of the death benefit and the health of the policyholder.

Different life settlement companies may weigh those factors differently, of course, and so arrive at differing values for your policy. Because life settlements range so widely, and because the pricing practices of buyers can be opaque, insurance experts say it’s important to shop around, to make sure you’re getting the best price available for your or a loved one’s policy.

Also, financial regulators urge caution about unsolicited offers to buy life insurance policies, or of high-pressure salespeople that demand a commitment right away. The National Conference of Insurance Legislators put out a model law that encompasses disclosures and information policyholders and their families should know before signing up for a life settlement.

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The cons to a life settlement

Even when dealing with honest brokers for life settlement, review the not-insignificant caveats of these offers for a policyholder and their family or beneficiaries before accepting one. Here’s a rundown of potential drawbacks.

The death benefit goes away

The biggest and most obvious drawback of a life settlement is that selling the policy confers the death benefit to the new owner, and takes it away from you or your heirs.

Possible tax implications

A one-time lump sum might sound great, but it can lead to a big tax bill the following April because the net proceeds are subject to income tax. The calculations for determining those amounts and the tax rates can be complex, so it’s advisable to consult with a tax preparer to make sure that the person selling the account sets aside enough money to fulfill the tax obligations.

A potential loss of benefits

Since proceeds from a life settlement are treated as income, they can jeopardize eligibility for certain programs. In particular, senior citizens who depend on public assistance programs could risk losing those benefits. That loss could, in turn, lead to a further poor outcome for people who live in apartments with income restrictions, who could then be at risk of exceeding the maximum allowable income for those facilities.

Debts may be collected before you die

In general, a person’s debts die with them, and with few exceptions, life insurance benefits can’t be tapped to pay the debts of a deceased person. A windfall from a life settlement, though, is fair game for creditors, so policyholders considering bankruptcy or facing a mountain of debt should consider the implications of selling a life insurance policy.

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Life settlement or not?

Huntley says the best candidates for a life settlement policy are people whose health profile has changed — or, more specifically, has worsened — since purchasing their life insurance policy.

It’s also important to make sure you’re not giving up any other benefits your policy might include, Huntley says. “You always want to check back in with your agent or company to double-check on the benefits your policy has. Sometimes these policies have other benefits, like long-term care or in-home care or nursing care,” he says — in which case you might be better off hanging onto the policy rather than selling it.

Even the companies that buy life insurance policies say these settlements aren’t the right choice for everybody. “We recognize that a life settlement is not the best solution in every case,” says Brian Barclay, president and senior managing director of Magna Life Settlements, a company that executes life and viatical settlements. “But for those sellers who can no longer afford the policy, whose needs have changed [or] who have immediate liquidity needs… a life settlement is absolutely an option worth exploring,” he says.

Further, Magna, on its website, emphasizes the necessity to check the tax implications of a settlement, and suggesting that the remaining net proceeds after taxes from selling the policy should be compared to after-tax proceeds from surrendering it, to see if the sale makes financial sense.

If neither settlement nor surrender seems like a good choice, you can explore other options with your insurer or financial advisor. You may, for example, be able to tap the policy’s cash value in the form of a loan, but borrowing from a whole-life policy comes with its own potential drawbacks.

Other options are available if you have not just health issues, but a terminal or catastrophic illness that is likely to take your life within no more than a year or two. You can seek a life settlement type designed for such situations, known as a viatical settlement, which is often more advantageous to the terminally ill than a life settlement. Also, if your life expectancy is a matter of weeks or months, you may qualify to receive an accelerated death benefit, which can help pay for end-of-life care.

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