How Life Settlements Work

When an insured party can no longer afford their insurance policy, they can sell it for a certain amount of cash to an investor—usually an intentional investor. The cash payment is primarily tax-free for most policy owners. The insured person essentially transfers ownership of the policy to the investor. As noted above, the insured party receives a cash payment in exchange for the policy—more than the surrender value, but less than the policy’s prescribed payout at death.

By selling it, the insured person transfers every aspect of the policy to the new owner. This means the investor who takes over the policy inherits and becomes responsible for everything related to the policy, including premium payments. So, once the insured party dies, the new owner—who becomes the beneficiary after the transfer—receives the payout.

There are many reasons why people choose to sell their life insurance policies and are usually only done when the insured person doesn’t have a known life-threatening illness. The majority of people who sell their policies for a life settlement tend to be older people—those who need money for retirement but haven’t been able to save up enough. That’s why life settlements are often called senior settlements. By receiving a cash payout, the insured party can supplement their retirement income with a largely tax free payout.

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Other reasons for choosing a life settlement include:

• The inability to afford premiums. Instead of letting the policy lapse, an insured person can sell the policy using a life settlement. Failure to pay the premiums may net the insured a smaller cash surrender amount, or none at all, depending on the terms. A life settlement on a current policy, though, usually results in a higher cash payment from the investor.

• The policy is no longer needed. There may come a time when the reasons for having the policy don’t exist anymore. The insured party may no longer need the policy for his or her dependents.

• Cases of emergencies. In cases where an unexpected event arises, such as the death or illness of a family member, the owner may need to sell the policy for cash to cover expenses.

• Cases involving key individual insurance policies held by companies on executives. This is typical for people who no longer work for the company. By taking a life settlement, the company can cash out on a policy that was previously not a liquid asset.

Special Considerations

Life settlements effectively create a secondary market for life insurance policies. This secondary market has been years in the making. There have been a number of judicial rulings that have legitimized the market—one of the most notable being the 1911 U.S. Supreme Court case of Grigsby v. Russell.

John Burchard wasn’t able to keep up the premium payments on his life insurance policy and sold it to his doctor, A. H. Grigsby. When Burchard died, Grigsby tried to collect the death benefit. The executor of Burchard’s estate sued Grigsby to get the money and won, however, the case ended up in the Supreme Court.  In his ruling, Supreme Court Justice Oliver Wendell Holmes likened life insurance to regular property. He believed the policy could be transferred by the owner at will, and had the same legal standing as other types of property such as stocks and bonds. In addition, he said there are rights that come with life insurance considered as a piece of property:

• The owner can change the beneficiary unless the insurer has restrictions in place.

• The policy may be used as collateral for a loan.

• Owners can borrow against the insurance policy.

• Policies can be sold to another person or entity.

Viatical Settlements Compared To Life Settlements

• Viatical settlements became popular during the 1980s, when people living with AIDS had life insurance they didn’t need. This led to another part of the industry—the viatical settlement industry, where people who have terminal illnesses sell their policies for cash. This part of the industry slowed down after people with AIDS began living longer.

• When someone becomes terminally ill and has a very short life span, they may sell their life insurance to someone else. In exchange for a large amount of money, the buyer takes on the premium payments, becoming the policy’s new owner. After the insured party dies, the new owner receives the death benefit.

• Viatical settlements are generally riskier because the investor basically gambles on the death of the insured. Even though the original policy owner may be ill, there’s no way of knowing when he or she will actually die. If the insured person lives longer, the policy becomes cheaper, but the actual return becomes lower after factoring in premium payments over time.