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A 21st century approach to life insurance

By Russell G. Roll, CPA, JD

Individuals buy life insurance for a variety of reasons. Some of the more common reasons include income replacement, estate tax needs (i.e., estate liquidity), the funding of a buy-sell agreement among business partners, and various other business purposes. In addition, many affluent individuals often acquire life insurance as a form of asset diversification when engaging in generational wealth planning. Regardless of the motivation(s) driving the initial acquisition of a life insurance contract, circumstances inevitably change over time, quite often resulting in a very legitimate questioning of the continued need to maintain a policy.

Traditionally, at the stage in the life of the contract (and the insured) when an individual, with the advice of his or her counsel, concluded that the continuation of the contract was unnecessary, the options available were severely limited. In the case of term insurance, the option was simple: stop paying for it, and let the contract lapse. In the case of permanent insurance (i.e., whole life, universal life, and the like) the option was just as simple, while not usually so painful financially speaking: surrender the policy, and collect whatever value had accumulated in the contract (as prescribed by the carrier who issued the contract). In either case, the options were quite limited, and the outcome was exclusively controlled by the carrier who issued the contract.

This traditional approach to the disposition of a life insurance contract represents a classic example of monopsony. Unlike the well-known term “monopoly” (where many buyers compete to purchase the goods and/or services of a single seller), a monopsony exists when many sellers compete to acquire the funds of a single buyer by selling their goods and/or services to that single buyer. These concepts obviously represent two distinct situations, yet they are equally as dangerous to the very notion of a free-market exchange and realization of value.

As is typically the case in a relatively free market, where the market sees a threat to its continued freedom, it responds. In response to the question of who controls the realizable value of an existing life insurance contract, and how that value is maximized and realized, the market for life settlements was created.

A life settlement in this context is quite simple, in theory. It is the sale of an existing life insurance policy, in the free market, for a cash payment (at fair market value) to a buyer who will hold the policy as an investment. In this context, I will note that in any life settlement transaction involving reputable brokers and investors, the investor will be a licensed funding organization that will maintain no nefarious motivation to see harm befall the insured once the transaction takes place. This sale will always, by definition, take place at a price higher than the accumulation value of the policy (i.e., the price set by the carrier, or monopsonist).

Origins of the Life Settlement Market

The notion of selling existing insurance contracts in the open market dates back to the mid-1800s in Europe. However, it became quite prevalent in the 1980s in the United States with the epidemic rise of AIDS. With this epidemic, the practice of selling existing insurance contracts became quite commonplace and served quite legitimate and even noble purposes. Individuals suffering from this disease were able to secure the cash necessary to pay for experimental pharmaceuticals (which due to their very nature were not covered by most insurance plans) and thereby extend their lives. This phenomenon was (and still is) referred to as the “viatical settlement market.”

The free-market forces extended this development from one catering to individuals with terminal illness such as AIDS to one which caters to any owner of an existing insurance policy who simply no longer wants or needs the policy. While theoretically a life settlement opportunity exists for any policy that has survived its contestability period (generally two years past issuance), in practice, the secondary market (or life settlement market) is primarily attracted to policies insuring lives over the age of 65, who have an actuarial life expectancy of 15 years or fewer, and with face amounts of at least $100,000.

Reasons to Consider Participation in the Life Settlement Market

While the specific reasons for considering the life settlement market are always different, they have one common thread. The policy in question was purchased to fill a specific purpose, and that purpose no longer exists.

With regard to income replacement, children grow up and become independent. Moreover, as one’s net worth grows, the relative importance of current income tends to diminish. With regard to estate liquidity needs, tax laws constantly change, and even in the absence of changes in the law (and without regard to those laws’ continued relative permanence), plans are designed and implemented to mitigate or eliminate the tax consequences of dying. With regard to the myriad of business reasons why individuals purchase life insurance, suffice it to say that business structures and relationships change. The funding of a buy-sell agreement among partners often becomes a moot point as partners retire or move on to other ventures in an amicable separation.

Regardless of the specific reason why life insurance was acquired in the first place, one thing is most certain: those reasons will not exist forever (or, more appropriately, for a “lifetime”). As reasons disappear over time and circumstances change, prudent people will reconsider why they continue to pay for things such as life insurance, and whether in fact they should continue to do so.

Mechanics of the Life Settlement Market

Herein lies the true 21st century approach to dealing with life insurance. While most policy holders would consider a life insurance contract as a periodic expense, the fact is that the contract represents an asset. A lawyer would refer to it as personal property. As such, it can be purchased and sold in the open market at its fair market value.

Mechanically, the contract is presented to the market for bids much like a piece of real estate. Pertinent information concerning the contract is packaged for consideration by the life settlement market, so that the free market can make a competitive determination of its value. This pertinent information includes such things as the cost to carry the policy (i.e., the ongoing premium cost), the face amount of the contract (i.e., the death benefit), the strength of guarantees contained in the contract, and – probably most importantly – information concerning the life expectancy of the insured. This latter point requires that basic medical information (medical records only – no physical examination is generally required to place an existing policy into the life settlement bidding process) be made available to the investors in the market who wish to bid on the contract. From this medical information, each participant in the market will make its own determination as to the insured’s life expectancy.

With this information, the life settlement market will engage in a somewhat subjective mathematical exercise to determine the value of the policy or the price it is willing to pay for the policy. This price will be determined by considering the cost to carry the contract, the length of time required to carry it, and the amount to be realized upon maturity. The remaining variable is the rate of return each participant in the bidding process desires or requires on its investment.

Once the life settlement market speaks as to the true fair market value of the policy in question, as demonstrated by its participants’ unwillingness to increase its collective bid for the contract, contracts are prepared for the sale of the policy. While these documents are necessarily more complex than the bill of sale signed to transfer an automobile, they serve the same basic purpose. By contract, the purchaser of the policy takes all incidents of ownership in the policy (most naturally, the right to receive the death benefit upon maturity), and assumes all responsibility with respect to the policy (i.e., the obligation to continue paying premiums). The seller of the policy relinquishes these rights and obligations in exchange for the sale price. After a statutory waiting period (if one applies in the jurisdiction where the sale takes place, such as Pennsylvania), the transaction is concluded.

Tax Consequences of a Life Settlement Transaction

At this point, no reader of this article can be surprised that there are tax costs for entering into a life settlement transaction. But surprisingly enough, these costs are not that onerous.

The exact consequences to the transaction should be reviewed by the seller of the policy with his or her counsel. But generally speaking, a portion of the gain on the sale represents ordinary income (to the extent the accumulation value of the contract, or the monopsonist’s value, exceeds the owner’s basis in the contract). All gain in excess of this amount represents capital gain, presumably long term in nature.

In many situations, the owner of a life insurance contract may be surprised to learn that a valuable asset is hidden in a folder which the owner believes holds nothing more than copies of paid invoices. The life settlement market, if properly approached, can provide individuals with a mechanism to maximize and realize the value of such a hidden asset. This is true in the case of all forms of life insurance. In any case, the evaluation of insurance that is no longer perceived as necessary or desirable should be performed by an individual capable of considering all of the options available.

Russell G. Roll, CPA, JD, is a partner in the firm of LRA Advisors, located in Pittsburgh, Pa.

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