Life insurance is a mainstay in estate and business succession/buy-sell planning. Despite its widespread use, however, many advisors and their clients focus on a policy’s death benefits or current cash surrender value (CSV), rather than seeing the value of the life insurance policy as an investment asset with an existing fair market value. Through consideration of a life settlement, advisors and their clients can appropriately value and potentially monetize life insurance policies to solve immediate financial or non-tax-planning needs. A life settlement is the regulated sale of a life insurance policy to a third-party institutional buyer for an amount greater than the policy’s CSV but less than its current death benefit. After aggregating data, the process can take 30 to 90 days.
The life settlement option is particularly relevant when: (1) a client otherwise plans to discontinue paying premiums; (2) the policy’s cash value is diminishing; and/or (3) the client outlives or no longer needs the insurance coverage for its intended planning purpose. Life settlements also can support exit strategies for underfunded (or poor performing) policies owned in irrevocable insurance trusts and other premium finance and split-dollar transactions.
Three Threshold Questions
Clients should explore a life settlement for a policy when they can answer “yes” to the following three questions: (1) Is there a desire or need to end the life insurance death benefit coverage or tax-free buildup inside the policy? (2) Is the insured’s projected life expectancy within acceptable parameters for life settlement buyers? and (3) Is the policy the kind that’s eligible (that is, marketable) for a life settlement?
1. Desire/need for policy exit. The need or desire for maintaining life insurance coverage can change over time. For example, based on recent higher exemptions and the use of sophisticated transfer-tax planning, the client may no longer face the same estate tax exposure or estate liquidity needs. Alternatively, perhaps the client’s cash flow is currently tied up in illiquid investments, and they want to explore short-term liquidity options. A current or expected change in the client’s finances may make the policy too expensive to maintain, while changes in family composition (for example, death or divorce of a spouse) may eliminate the original need for the death benefits. The insured also could be aging out of the desired coverage, meaning the premiums to maintain the policy will skyrocket if the client lives past a certain defined age.
For businesses, life insurance originally acquired to fund the buy-sell of certain business interests may no longer be required due to an owner’s retirement or a sale of the company. In the corporate context, life insurance coverage may have been acquired initially to secure certain bonding or repayment of debt obligations or representations and warranties in transactions and/or to fund deferred compensation. Over time, those original planning objectives cease to exist, and the parties assume they should simply stop paying premiums and cancel or surrender the underlying policies.
2. Insured’s longevity. The projected longevity of the insured is a key factor in whether the policy will be marketable for a life settlement and the projected size of the sale proceeds. Generally, life settlements involve policies that insure individuals in their 60s to 90s with life expectancies of up to 15 to 18 years. An ideal insured has a policy issued with a “preferred” or “standard” risk rating but has since experienced a decline in health. This decline effectively creates a health arbitrage or mismatch, resulting in very inexpensive premiums for what life insurers would now consider a high-risk insured (even if the insured’s overall quality of life remains good, thanks to access to higher and better quality medical treatment that most wealthy individuals can afford).
3. Policies eligible for life settlement. Life settlements are available in all states and Washington, D.C. All types of policies can qualify, including term. Most buyers are looking for policies with death benefits of at least $100,000 to $100 million. Policies with low or no cash value are most commonly settled. Having a policy with a high cash value or loans may be detrimental to the valuation of the policy for life settlement purposes (leaving less net death benefit for the buyer).
Practically speaking, however, certain policy types and attributes will garner higher values in a life settlement:
- Universal life, including survivorship, is the most attractive category of policy purchased, including variable universal life policies and indexed universal life policies.
- Certain products will generate the most value, such as guaranteed universal life (GUL), as well as policies with riders, such as no lapse guarantee (NLG) and return of premium. Pay special attention to GUL/NLG contracts as buyers will purchase policies without reviewing medical records. Buyers see these policies as safer long-term investments, as there’s almost no risk of carriers increasing the internal cost of insurance (mortality charges and expenses).
- Convertible term also can have value if the insured’s life expectancy qualifies. Annual renewable term, however, typically doesn’t have value, as the premiums can ladder up exponentially unless there’s a low life expectancy prior to the escalating cost of the policy.
- Perhaps surprisingly, the least purchased policies have been whole life insurance contracts, as they typically have higher cash value and loans. For institutional buyers with billions to invest in maintaining the acquired policies, purchasing high cash value policies that result in a lower net death benefit isn’t as attractive.
Insurance carrier ratings and behavior can also impact value. Highly rated carriers demand higher offers than carriers with lower ratings or those that have stopped issuing new life insurance policies.
*The full version of this article, The Role of Life Settlements in Estate Planning, appears in the April 2022 issue of Trusts & Estates magazine.