Did You Know You Can Sell Life Insurance You No Longer Need? Here Are the Pros and Cons
The term "life settlement" may sound esoteric, but it actually refers to a simple transaction: the sale of life insurance that you no longer require or can no longer afford. While a settlement isn't for everyone, it does allow you to get money for a policy so that the funds can be put to other uses.
According to conventional wisdom, there are only two options for unwanted or unaffordable permanent life insurance: whole-life or universal policies, which combine a death benefit with an investment component with its own separate value. The policy can be allowed to lapse or surrendered in exchange for a portion of the money invested in it being returned to you.
Life settlements provide a third option, which is to sell the policy to a third party, who will pay you for it and then collect the death benefit when you die. This option offers a better return than simple surrender. Settlement is generally limited to policyholders who are at least 65 years old and have a permanent life insurance policy or a convertible term life policy with a death benefit of at least $100,000.
If you fit that description, here's what you should know about life settlement, including how to determine whether it's a good fit for your financial needs and priorities.
Should I sell my life insurance policy?
When your life changes, so do your insurance requirements. Life insurance is purchased for specific reasons, and those reasons may pass, or the policyholder's circumstances may change, and the policy's benefits are no longer required.
Chris Huntley, president of InsuranceDodo.com, cites an example in which you took out a policy to ensure that if you died unexpectedly, your spouse could pay off the mortgage or your children wouldn't have to drop out of college. You might not need that policy once the mortgage is paid off or the children have graduated, according to Huntley.
If you purchased term life insurance that you no longer require, you can simply stop paying the premiums and not lose any money because those policies have no residual investment value. Permanent life insurance, on the other hand, is structured differently, with a portion of the policyholder's premium invested. The money that accumulates throughout a person's life is known as the "cash value" portion, and it remains even after your need for the death benefit has passed.
The cash value can then be preserved by continuing to pay premiums for coverage you no longer require, or by allowing the policy to lapse. If you cancel your coverage, you will no longer be required to pay premiums, but all of the money you have invested in the policy will be lost.
Those two unappealing options are why it makes sense to consider either surrendering the policy or seeking a life settlement for it.
Policy surrender versus life settlement
When you surrender a permanent life insurance policy, you are paid the policy's "cash surrender value." That is the amount of money earned from premiums invested in the policy, less any surrender fee or penalty.
While you may not be charged a surrender fee if the policy has been in place for a long time, the fee can be very high — as much as double-digit percentages of the cash value — if you cancel a policy within the first few years of taking it out.
If you choose life settlement, the policy is not surrendered but rather sold to a third party. In most cases, the buyer is an investment group or a third-party broker. The new owner will then sell your policy to investment firms that specialize in this field.
After you pay for the policy, the investors take over paying the premiums until you die, at which point they collect the death benefit. The person selling the policy must sign off on granting the buyer access to their medical records both when they sell the policy and on a regular basis (such as quarterly).
How to shop for a life settlement
The main advantage of life settlements is that you, as the policyholder, receive a one-time cash infusion that can alleviate any current financial constraints you may be experiencing. In general, you can expect a lump sum that is greater than the surrender value of the policy but less than the death benefit.
According to Huntley, where the offer falls within that range is primarily determined by three highly variable factors: the premium payment amount, the amount of the death benefit, and the policyholder's health.
Of course, different life settlement companies will weigh those factors differently and thus arrive at different values for your policy. Because life settlements vary so widely, and buyer pricing practices can be opaque, insurance experts say it's critical to shop around to ensure you're getting the best price available for your or a loved one's policy.
Furthermore, financial regulators warn against unsolicited offers to buy life insurance policies, as well as high-pressure salespeople who demand a commitment right away. The National Conference of Insurance Legislators issued a model law that includes disclosures and information that policyholders and their families should be aware of before entering into a life settlement agreement.
The cons to a life settlement
Even when dealing with trustworthy brokers for life settlement, it is important to review the important caveats of these offers for the policyholder and their family or beneficiaries before accepting one. Here is a list of potential drawbacks.
The death benefit goes away
The most significant and obvious disadvantage of a life settlement is that selling the policy transfers the death benefit to the new owner, taking it away from you or your heirs.
Possible tax implications
A one-time lump sum may sound appealing, but the net proceeds are subject to income tax, which can result in a large tax bill the following April. The calculations for determining those amounts and tax rates can be complicated, so it is recommended that the person selling the account consult with a tax preparer to ensure that enough money is set aside to fulfil the tax obligations.
A potential loss of benefits
Because the proceeds of a life settlement are considered income, they may jeopardise eligibility for certain programs. Senior citizens, in particular, who rely on government assistance programs, may lose those benefits. This loss could, in turn, have a negative impact on people who live in income-restricted apartments, putting them at risk of exceeding the maximum allowable income for those facilities.
Debts may be collected before you die
In general, a person's debts die with them, and with a few exceptions, life insurance benefits cannot be used to pay a deceased person's debts. A windfall from a life settlement, on the other hand, is fair game for creditors, so policyholders considering bankruptcy or facing a mountain of debt should think about selling a life insurance policy.
Life settlement or not?
People whose health profile has changed — or, more specifically, has worsened — since purchasing their life insurance policy, according to Huntley, are the best candidates for a life settlement policy.
According to Huntley, it is also critical to ensure that you are not foregoing any other benefits that your policy may provide. “You should always check in with your agent or company to double-check the benefits of your policy. “Sometimes these policies have additional benefits, such as long-term care, in-home care, or nursing care,” he says, implying that you might be better off keeping the policy rather than selling it.
Even companies that buy life insurance policies admit that these settlements aren't for everyone. “We recognize that a life settlement is not always the best solution,” says Brian Barclay, president and senior managing director of Magna Life Settlements, which executes life and viatical settlements. “However, for those sellers who can no longer afford the policy, whose needs have changed, or who have immediate liquidity needs,” he says, “a life settlement is absolutely an option worth exploring.”
Furthermore, Magna emphasizes the importance of checking the tax implications of a settlement on its website, recommending that the remaining net proceeds after taxes from selling the policy be compared to the after-tax proceeds from surrendering it to determine whether the sale makes financial sense.
If neither settlement nor surrender appears to be a good option for you, you can discuss other options with your insurer or financial advisor. You may be able to borrow against the policy's cash value, for example, but borrowing against a whole-life policy has its own set of potential drawbacks.
Other options are available if you have not only health issues, but a terminal or catastrophic illness that will take your life within a year or two. You can look for a life settlement type designed for such situations, known as a viatical settlement, which is often more beneficial to terminally ill people than a life settlement. In addition, if your life expectancy is only a few weeks or months, you may be eligible for an accelerated death benefit, which can help pay for end-of-life care.