Life settlements, a financial transaction where a life insurance policyholder sells their policy to a third party for more than its cash surrender value but less than its death benefit, are becoming an essential tool for institutions that manage Trust-Owned Life Insurance (TOLI) portfolios. This growing importance necessitates a deep understanding of life settlements to effectively manage and optimize the value of life insurance assets within trusts.
Why Life Settlements Are Increasingly Important
In recent years, the significance of life settlements has surged due to demographic shifts. More insured individuals are living well into their 90s, often outliving the projections made during their initial estate planning. This longevity trend means that many life insurance policies, originally intended to provide death benefits within a certain timeframe, are now more valuable than anticipated. As these individuals live longer, the policies may become less necessary or too costly to maintain, making life settlements a viable option to realize the value of these assets.
Read More: More of Your Clients Will Be Living to 100 and That Could Be a Problem
As life settlements have grown in importance, it has become a highly regulated transaction. It is currently regulated in over 90% of states in the US.
Why Sell or Buy a Policy
Policyholders may find that their beneficiaries are no longer in need of the death benefit initially planned for, or that the premiums are no longer affordable. The secondary market for life insurance policies often offers significantly more than the policy’s cash surrender value, presenting an attractive financial opportunity. Selling a policy in a life settlement transaction typically yields much more than simply surrendering it back to the insurance company.
Life insurance policies purchased through life settlements offer a non-correlated asset class, appealing to investors looking to diversify their portfolios. These policies are increasingly being incorporated into the investment strategies of large financial entities like pension funds and hedge funds, highlighting their value and stability.
The Life Settlement Process
The process of executing a life settlement involves several key steps:
- Preliminary Evaluations: Initially, preliminary evaluations can be obtained to determine if selling the policy is viable.
- Underwriting: This step involves gathering health records of the insured without the need for a paramedical exam, unlike traditional life insurance underwriting.
- Broker “Auction” Process: A broker facilitates an auction to generate the highest possible bids. Through successive rounds, offers are incrementally increased, and bidders drop out until the highest bid is reached.
- Closing Process: If an acceptable offer is received and the policy is sold, the process culminates with the delivery of closing documents and the finalization of the transaction.
Case Study
Consider a case study presented in our 2018 webinar on Life Settlements. A trust department had a $2.8 million UL policy purchased in 1998 that was now underfunded with $72k cash value remaining. The insured was an 84-year-old female with impaired health, and the premium had increased to $150k. The policy had significant value on the secondary market, so instead of surrendering the policy, they were able to monetize the policy for $1.1 million, which was then able to be used to fund the client’s lifestyle.
Taxation of Life Settlements
Tax implications for life settlements can affect both buyers and sellers. For sellers, the amount up to the premiums paid is not taxable. Any amount up to the policy’s cash value is taxed at ordinary income rates, while the amount exceeding the cash value is taxed at capital gains rates. For buyers, the settlement proceeds may also be subject to taxation depending on the jurisdiction and specific circumstances of the transaction.
Read More: Be Aware of a Taxation on Life Insurance Sales
What To Do When Considering a Life Settlement
When considering a life settlement for a client’s policy, trustees should keep the following in mind:
Evaluate Client’s Candidacy
Age and health are crucial considerations when selling a life insurance policy. Typically, insureds must be 65 or older, with the average seller being 75. Younger individuals with serious health issues may also qualify. Investors prefer policies with shorter life expectancies and death benefits of at least $50,000, though $500,000 or more is ideal. The 2023 LISA (Life Insurance Settlement Association) member annual market data survey reports over 3,000 life settlement transactions and sales 5x higher than the cash surrender values offered by the life insurance carrier.
Create a Process
Trustees must establish a prudent and documented process for evaluating life settlement opportunities. This process should ensure that decisions align with fiduciary responsibilities and serve the best interests of the beneficiaries. A well-structured approach helps trustees navigate the complexities of life settlements while maintaining their duty of care.
Document for the Trust File
Detailed documentation of the decision-making process and outcomes should be maintained to support transparency and accountability. Keeping comprehensive records ensures that all actions are traceable and justifiable, safeguarding the interests of all parties involved.
Conclusion
As a TOLI trustee, it’s critical to be aware of all policy remediation options, including life settlements. Understanding and leveraging life settlements can transform how you manage life insurance policies, ensuring you fulfill your fiduciary duties while maximizing the financial outcomes for your clients and their beneficiaries.
Optimize your trust-owned life insurance management with tolimonitor, our TOLI solution. By leveraging the unparalleled expertise of our independent life insurance experts, you can confidently navigate the complexities of TOLI, including identifying when a life settlement may be beneficial. Request a consultation to learn how our team can help you maximize the value and effectiveness of your institution’s ILIT portfolio.
