You buy life insurance for a pretty straightforward reason—to safeguard your loved ones’ financial well-being. But over time, circumstances can change. For one reason or another, you may find yourself tempted to walk away from the policy—you could just let it lapse by not paying the premiums or surrender it for its current cash value.
But you may wonder if there is a third option—can I sell my life insurance policy for more than its cash value? The answer is yes…or at least maybe.
These transactions, called life settlements, do exist—but you may have questions. Are they legal and safe? Are there reputable companies that buy life insurance policies? Who should—and should not—consider this course of action?
Bottom Line Personal brought these questions and others to Doug Mishkin, president and CEO of the insurance consultancy Algren Associates and former chairman of the National Association of Independent Life Brokerage Agencies, to clarify how life settlements work and how to sell a life insurance policy if you decide that’s the best step for you.
Changing Circumstances
Most people take out life insurance to protect their families from the financial repercussions of losing a primary breadwinner. In some cases, a business will take out a life insurance policy on a key executive to protect against the potential losses associated with that person’s untimely demise. But these products are designed not just as protection but as investment assets. As the years go by and the policyholder continues to make premium payments, the policy’s cash value grows. That is the case for whole life, universal life, variable universal life, indexed universal life and convertible term policies. Over time, the cash value of a life insurance policy can become a formidable asset. But there are situations when hanging onto it isn’t the best idea…
Financial hardship. Perhaps your children are no longer young and are doing great financially. During your retirement, you may find it difficult to make ends meet and struggle to come up with the premium payment each month. Does it make sense for you to continue sacrificing part of your already-scant income for a payout your kids don’t really need?
Changing face of business. In the case of a “key man” policy, what happens if the executive has retired or otherwise left the company that holds the policy? It likely does not make sense for the business to keep paying the premiums.
Struggling policies. Sometimes people take out insurance policies only to find that the policies’ cash growth underperforms expectations. This is especially problematic if they have borrowed against the policy or are using credit to pay its premiums. As loan rates compound, the policy’s cash value is eaten away, and its poor performance means it is not covering the rising loan balance. Result: The policyholder must continually put up increasing collateral to keep the policy afloat.
People experiencing any of these circumstances might find themselves ready to rid themselves of their life insurance policies. They have three options…
Let the policy lapse. Failing to pay premiums triggers termination of your coverage, meaning no more death benefit. If there are no loans on the policy, the insurer subtracts the value of all unpaid premiums and surrenders the remaining cash value to the policyholder. You pay taxes on any portion of that payout that exceeds the total of the premiums you’ve paid.
Surrender the policy. You may choose to proactively cancel the policy and collect the cash value in a lump sum. The IRS will treat any amount above what you’ve paid in premiums as a taxable gain.
Life settlement. Rather than letting the policy lapse or surrender it, you let it remain in effect by selling it to a third party that will treat it as an investment. That third party—typically an investment company—will continue to pay the premiums for the rest of your life. When you die, the third party collects the death benefit. The whole idea of a life settlement is that it pays more than you would receive merely by surrendering the policy. Typically, the settlement offer is between 2% and 8% of the total death benefit. If the offer is less than or equal to what you would get by surrendering the policy, there’s no point in pursuing this option.
How a Life Settlement Works
The parties who purchase other people’s life insurance policies typically are investment companies that are licensed in this niche product. They tend to hold portfolios of policies and sometimes sell interests in them to individual or institutional investors. Policyholders typically sell their policies through licensed life-settlement brokers, not directly to the investment companies.
In a sense, selling a life insurance policy is the mirror image of buying one. When you first purchased your life insurance policy, you disclosed information about how healthy you were. The company selling you the policy wanted to make sure you were a safe bet to insure…in other words, that you’d be paying premiums for many years before the company would have to make a death payout.
When you go to sell your policy, the opposite is the case. You once again disclose your health information, but this time, the prospective buyer will be more interested to know if you appear not to have long to live. Buyers don’t want to spend many years paying premiums waiting for their investment to pay off—that is, waiting to receive your death benefit. For that reason, if you’re below age 65 and in good health, you’ll have a very hard time finding anyone to buy your policy. Even if you’re in your 70s and in good health, you might not be offered enough to make a life settlement more attractive than a surrender.
What Are the Risks?
Financial risk. The primary risk of a life settlement is that you will sell your policy and then die a short time later, depriving your heirs of what could have been a large benefit. Even if you weren’t to die right away, not having life insurance may be a bitter pill to swallow. These considerations must be carefully weighed against the reasons you’re considering jettisoning the policy.
Tax risk.Life settlements typically are paid in a lump sum equal to the cash value, plus an additional amount that makes the life settlement more attractive than just surrendering the policy. Example: Let’s imagine that you’re being offered $130,000 for selling a policy that has a cash value of $100,000 and a death benefit of $1 million…and that over the years you’ve paid $50,000 in premiums. That $50,000 is known as your “basis.” You’ll get the basis back tax-free, but the remaining $50,000 worth of cash value is subject to income tax, and the additional $30,000 is subject to capital gains tax. You’ll need to look at all of this carefully to decide if an offer is worthwhile.
Privacy. Many people feel vulnerable disclosing their private health information to a third party. While this is understandable, bear in mind that licensed brokers and buyers of life settlements are bound by HIPAA privacy laws and will not disclose your information to unauthorized parties.
Hiring a Broker
Look for a licensed broker who can shop your policy around to multiple potential buyers to get you the best deal. A good place to start your search for a broker is with your insurance advisor…or you can find a broker through the Life Insurance Settlement Association at LISA.org.
Talk to a few brokers before choosing one, and be sure to ask about their fee structures. You want to get the best sense of what the all-in costs will be, including commissions (as much as 6% of the death benefit), fees for medical records and actuarial fees. Only then will you really be able to calculate whether you should proceed with a life settlement.
If you’re leaning toward a life settlement and perhaps even have a broker in mind, don’t pull the trigger until you talk it over with your financial, insurance and tax advisors.
