By Ronald P. Perilstein, CLU
Traditionally, life insurance buying decisions are built around two basic benefits. The first is protection against the adverse financial consequences of death. The second driving force lies in the tax advantages of life insurance that make it such a powerful tool to achieve specific personal and business financial planning goals.
Nevertheless, circumstances can change that reduce the need of the death protection and/or the value of the tax-advantages of a life insurance policy, or both. What happens then?
If you surrender a policy with cash value, you get back the premiums you paid plus the earnings (if any), minus the cost of the insurance protection and any surrender charges (usually in the first 10-20 years). In addition, you must pay ordinary income tax on any cash value gains you receive; a tax that you had previously avoided because of the tax deferral afforded to the build-up of cash in permanent insurance policies. And, let’s not forget that your potential death benefit is also sacrificed when you surrender a policy.
With a term policy there is no cash value so there is no surrender value or investment gain. You simply let the policy lapse and the potential death benefit terminates.
Because life insurance is fundamentally designed as a buy-and-hold financial instrument, the options above do not favor a policyholder from either a tax or financial point of view. But a new option has evolved in the life insurance marketplace that retains the value of life insurance as a personal, business and estate planning tool, and allows policyowners to reapply this value to lifetime needs. This concept is called lifetime settlement.
Lifetime settlement is not the surrender of the policy, but a transfer of ownership. It involves the sale of your life insurance policy to a settlement funding company. As a result of the sale the funding company becomes the owner and beneficiary of the policy, assumes the obligation to pay premiums, and ultimately receives the death benefit proceeds. Instead of determining the value of your policy from the cash value point of view, the settlement funding company discounts your policy’s death benefit, based on underwriting criteria and other factors.
The settlement that is offered is a cash payment to you, the original policyowner. The amount of cash offered for your policy will be less than the face amount of the policy so the settlement funding company can earn a profit from the death benefit, when received. But, obviously, the amount of the settlement offered to you must be greater than the cash surrender value you could already obtain in order to create an incentive for you to sell.
How does lifetime settlement work as a problem-solving tool?
The number and kind of innovative applications of the lifetime settlement concept have grown rapidly and dramatically since the concept first took shape a few years ago. Strategies focus on businesses and high net worth individuals whose current and future financial planning circumstances have made existing policies no longer necessary.
For example, you may have initially purchased life insurance to achieve the liquidity needed to pay your estate taxes, but changing circumstances may have made your estate highly liquid now. If the money that was to be received at your death were now available during your lifetime, it could be reinvested to maximize asset growth or to purchase alternative risk management vehicles, such as long term care coverage.
If your estate has reduced in value, the resulting estate tax liability will be reduced as well. The amount of life insurance purchased for your heirs to meet this liability may now be more than is necessary or desired. In addition, lifetime settlement proceeds can be gifted to heirs or given to charity during lifetime as a method of reducing your estate, and its resulting taxes, even further.
Perhaps you now have a need to remove your insurance policy from your estate to avoid higher estate taxes. Removing it simply by transferring it from personal ownership to trust ownership may be subject to the three-year “lookback” rule of Sec. 2035. This rule prevents taxpayers from transferring certain assets simply to escape estate taxes. However, a lifetime settlement is considered a transfer for value and is, therefore, not subject to this rule.
Another reason to consider a lifetime settlement is when the policy becomes too expensive to maintain. The problem may be as simple as lower income or premiums that did not vanish because of lower interest rates or company dividends. Also, interest payments on large policy loans will make it expensive to maintain.
You may wish to discontinue a current policy for suitability reasons, i.e., from single-life coverage to survivorship or second-to-die coverage. A lifetime settlement could prove to be more cost-effective than surrender. Similarly, you might decide late in life to undertake charitable planning that you had previously deferred in favor of your family’s needs. Through lifetime settlement, you could now re-allocate funds from one planning vehicle to another, using the settlement proceeds to fund charitable gifts or charitable trusts.
In another example, life insurance purchased to fund buy-sell agreements may have become unnecessary if ownership of your practice has changed. In addition, a physician whose contribution to the practice that had been protected by key person insurance may have retired or moved on.
If you are not sure whether you fall into these problem-solving scenarios you can begin with a few simple questions to see if lifetime settlement may be an appropriate tool for you to consider.
Since you last reviewed your estate planning decisions:
• Have your family circumstances changed?
• Have the projected income needs of your heirs changed?
• Has the projected need for estate liquidity changed?
• Has the suitability of your insurance policies changed?
• Has the performance of your life insurance policies changed?
• Has the affordability of your life insurance policies changed?
Since you last reviewed your practice’s buy-sell agreement:
• Has the ownership structure of your practice changed?
• Has the suitability of the insurance policies that fund your buy-sell agreement changed?
• Has the performance of the insurance policies that fund your buy-sell agreement changed?
What are the tax implications of lifetime settlements?
The taxation of lifetime settlements has not been defined by tax legislation, but the transaction has two tax components that are defined by the precedent of similar transactions.
First, the tax treatment of policy gains is no different from the tax treatment of surrendering the policy. When a cash value policy is surrendered, the difference between the premium payments (basis) and the dividends or interest earned (gain) by the policy, is taxed as ordinary income. The same treatment applies for a lifetime settlement transaction on the portion represented by the gain minus basis.
However, a lifetime settlement transaction involves selling the policy, not for its cash surrender value, but for a percentage of the face amount. Because life insurance is treated like a capital investment, the amount paid by the settlement funding company above the cash surrender portion is taxed at capital gain rates.
How does the process work?
The settlement funding company typically examines several factors supporting its purchase of a life insurance policy. Any type of policy can be considered. Whole life, universal life, and term—individually-owned, corporate-owned, or trust-owned. But larger face amounts, from half a million dollars to multimillion dollar policies, are necessary.
The settlement company’s underwriters evaluate individual factors, including your age and your medical history. These are then combined with factors from the existing policy, including face amount, length of policy ownership, cash values and premium payments needed to sustain the coverage. Finally the life insurance company issuing the policy is subjected to analysis.
Once an offer is made and accepted by you, the settlement company then provides a closing package with all of the appropriate forms. With the processing of the closing paperwork, funds are usually deposited into an escrow account in your name, to be released upon transfer of ownership of the policy.
As with all substantial financial transactions, your must have confidence in the company providing the service. The lifetime settlement concept continues to expand rapidly as a critical financial and estate planning tool, and you can expect more companies to enter the market to take advantage of this booming interest.
Most of the current state legislation regarding settlements derives from the life insurance industry’s own licensing and oversight requirements. These are contained in the Viatical Settlements Model Act, adopted by the National Association of Insurance Commissioners in 1994.
Because viatical settlements are tax-free transactions, the regulations are stricter than those affecting lifetime settlements, where terminal or chronic conditions do not apply and certification is unnecessary. The act was written to ensure that only stable financial institutions could participate, to formulate pricing guidelines for fair payment to consumers, and to establish fair trade, auditing and monitoring standards for providers.
Traditionally, the words life insurance “planning” have been synonymous with life insurance “purchase.” With lifetime settlement the planning process includes not only a purchase decision but a selling decision as well.
The bottom line is that the lifetime settlement concept converts life insurance from a contingent asset—one whose value is completely dependent upon the someone’s death—to a liquid asset having a market-priced economic value during the insured’s life.
Ronald P. Perilstein, CLU is president of The Arjay Group, Inc., a member of the PartnersFinancial national network, located in Narberth, Pa.