Tales Of An Ugly Duckling

August 3, 2007

A life settlement is the sale of a life insurance policy by the policy owner to an institutional buyer. The buyer is called a life or viatical settlement company. Life settlements have become increasingly popular over the past five to ten years as a method of realizing more value from an unwanted policy.

Example: Jim is 73 and his business owns a $3 million term insurance policy on his life (key-person insurance). Jim is about to retire and the term policy is becoming very expensive. If the company cancels the policy, it will receive nothing. Jim was treated for prostate cancer five years ago and is informed by his life insurance broker that the policy can be sold to a life settlement company. The life settlement company estimates that Jim has a life expectancy of eight years and is willing to pay the policy owner $400,000 for the policy, plus a commission of $60,000 to the life insurance broker. The life settlement company views the policy as an investment that will yield $3 million in the future. The business receives $400,000 rather than the unearned premium on the policy. Part of this settlement may be taxable (see below).

A typical candidate for a life settlement is an individual over the age of 65 who no longer wants or needs his life insurance policy and who has experienced a change in health since he bought his policy.

Consider a life settlement when:
A key person retires.
A business is sold and buy-sell life insurance is no longer needed.
Real estate is sold and life insurance bought for estate liquidity is no longer needed.
Term insurance is becoming expensive as a client gets older.
An old universal or whole life policy is becoming too expensive to maintain.
A universal or whole life policy is about to be replaced with a better product.
Consider selling the old policy to realize more than just the cash value.

Example: Kelly is 74 and her family trust owns a $5 million universal life policy issued in 1993. The policy's cash value is $350,000 and the annual premium is $78,000. She has paid $1.9 million in cumulative premiums. The policy is reviewed and an updated projection shows that it will lapse at age 81 because the current interest rate earned by the policy's cash account is 4.5%, well below the original projection of 9%. Kelly was treated for breast cancer in 1998. The policy is sold for $1 million. The sales proceeds are less than Kelly's basis and are, therefore, not taxable. The sales proceeds exceed the cash value by $650,000 and are used to help fund a new policy with the same death benefit. The new policy has a guaranteed annual premium of $48,000 and the death benefit is guaranteed to age 100.

Income Tax On Sales Proceeds
The seller may recognize a gain from the sale of the policy. For example, Jill sells a universal life policy to ABC Settlement Company for $700,000. Her basis (premiums paid) in the policy is $300,000 and the policy's cash value is $450,000. The gain is calculated as follows:

Gain up to the cash value is $150,000 ($450,000 in cash value less $300,000 in premiums paid). This gain is taxed as ordinary income.

Gain in excess of cash value is $250,000 ($700,000 in proceeds less $450,000 in cash value). This gain is probably taxed as capital gain (most tax practitioners take this position). This is not certain and the IRS may try to treat this portion of the gain as ordinary income.

The buyer will have to report the death proceeds as income to the extent they exceed basis. The income tax exemption for the death benefit is lost because the policy was sold for value ("transfer for value").

There is some uncertainty regarding basis. The IRS, in two private rulings, concluded that a taxpayer's basis in a life insurance policy did not include the cost of life insurance protection. The IRS determined that the basis in the policy was equal to the amount of premiums paid by the taxpayer less the sum of (a) the cost of insurance protection (including mortality and expense charges) and (b) any amounts received under the contract that had not been included in gross income (ILM 200504001 and Ltr. Rul. 9443020).

Most tax practitioners do not agree with this position and argue that Section 72(e) of the Code defines basis as cumulative premiums paid, without a reduction for cost of insurance protection.

Due Diligence In Selecting A Buyer
The client's advisors must perform due diligence before deciding to sell a policy to a life settlement company. Here are some questions to ask:

Is the settlement company licensed as a life settlement company by your state
insurance department?

What are the confidentiality policies of the life settlement provider and broker regarding the protection of the identity and medical records of the insured?

Is the settlement company funded by a reputable bank, hedge fund or insurance company?

Has the settlement company been the subject of any insurance department or SEC investigation?

What are the terms of the purchase and escrow agreements?

How many bids for the purchase of the policy were solicited? Obtain a minimum of 20 bids from settlement companies funded by reputable institutions.

Bid Rigging
The New York Attorney General recently sued a major life settlement company, charging that it made secret payments to life settlement brokers. In exchange for these payments, the brokers allegedly suppressed competitive bids from other life settlement companies, thus defrauding policyholders. To protect clients from bid rigging, advisors should use two or more settlement brokers and require full disclosure of all bids.

Stranger Or Investor-Owned Life Insurance
So far we have described "vanilla" life settlements, i.e. a legitimate sale of an old policy that a client no longer wants. The "vanilla" settlement is simply motivated by a desire to realize more value from the policy.

"Vanilla" settlements must be distinguished from "stranger-owned" or "investor-owned" life insurance (SOLI and IOLI) transactions. A typical SOLI transaction looks like this:

A 75-year-old client is approached by an insurance broker to buy a $10 million universal life policy.

The client will receive $150,000 to enter into the transaction.

The policy will be owned by an irrevocable trust and the trust will primarily benefit a group of unrelated investors.

The policy will be funded by loans from the investors for 2 years.

At the end of 2 years the policy will be sold to a buyer and the sales proceeds are expected to pay off the premium loan and yield a profit to the investors.

There are many variations on this transaction. Most major life insurance
companies will not issue a policy if it is aware that this type of transaction is being implemented. There are many reasons not to enter into this type of transaction. One important reason is that the trust may not have an insurable interest in the individual being insured. The New York State Insurance Department issued a legal opinion disallowing this type of transaction.

Two important messages:
Buyer beware!
Do not confuse the problematic SOLI/IOLI transaction with the legitimate vanilla life settlement.

Life settlements have fundamentally changed the life insurance industry. They are an exciting new tool to give clients more value from their insurance policies. Advisors to wealthy clients should ALWAYS think about life settlements before any policy is cancelled or replaced.