Here's more information on settlements and other ways to use your insurance if you're short on time, as well as advice on selecting the best option for you.

What is a viatical settlement?

This is a type of life settlement, which is the sale of a whole, universal, or convertible term life insurance policy to a third party. A viatical settlement is sold in the same way that a life settlement is sold: the policyholder receives a lump sum in exchange for the buyer taking over premium payments and collecting the death benefit.

However, unlike life settlement, the viatical option is only available to people who are terminally ill or have serious, chronic, and debilitating conditions, with a life expectancy of two years or less.

Viatical settlements first appeared in the early years of the AIDS epidemic, nearly four decades ago. According to Brian Barclay, president and senior managing director of Magna Life Settlements, a company that executes life and viatical settlements, getting HIV was a death sentence at the time, and many of its victims were actuarially projected to live much longer.

The settlements allowed early AIDS patients to use their policies to offset end-of-life medical and living expenses. As medical advances allowed people to live much longer after contracting HIV, viaticals remained a viable option for anyone who is terminally ill and has an eligible insurance policy.

The advantages of viatical vs. life settlements

Despite their similarities, life settlements and viatical settlements differ in two important ways that can make the letter a more profitable option.

For starters, a viatical settlement can result in a higher price. Because the buyer will theoretically be paying premiums for no more than two years before receiving the death benefit, they will almost certainly make a better offer than if the policyholder was expected to live longer. (However, as with a life settlement, you can expect a viatical settlement on permanent life insurance, such as a whole life or universal life policy, to result in an offer that is greater than the policy's cash value but less than the death benefit value.)

Furthermore, the proceeds of a viatical settlement may be taxed more favorably. While the proceeds of a life settlement are taxed as income, the proceeds of a viatical settlement may not be. According to IRS regulations, if the money is used to pay for qualifying healthcare expenses, for example, you may be eligible for favorable tax treatment.

Pros and cons of a viatical settlement

Getting money upfront for life insurance is a welcome option for a policyholder who, for example, requires expensive care at the end of their life, to name one financial challenge. Those considering a viatical settlement for themselves or a loved one, however, should carefully consider the implications of selling a life insurance policy to a third party, just as they would with a life settlement.

When a permanent life insurance policy is sold, the death benefit is no longer available to the policyholder's heirs. It also implies the loss of a critical financial safeguard. If the policyholder has outstanding debts, creditors or collection agencies may be able to claim a portion of the sale proceeds. A death benefit paid to your heirs after you die, on the other hand, is immune from such a claim.

Furthermore, the usual warnings about not rushing into a deal apply, especially if the offer to buy the policy is unsolicited or accompanied by a high-pressure sales pitch. The AARP warns seniors and their families that unscrupulous operators may take advantage of the distress or panic caused by a terminal illness.

Alternatives to settlement

Fortunately, if you have a bad health prognosis and need money, a settlement is not your only option. “The unfortunate few who are dealing with serious medical issues have a couple of other options,” says Barclay.

A death benefit loan

If you have permanent life insurance, you may be able to borrow against the cash value that has accrued in the policy. Such loans have some drawbacks, but they do provide you with cash without requiring you to sell the policy. While the loan would be deducted from your death benefit and subject to interest, it would allow you to leave the remainder of the policy proceeds to your heirs, free from possible seizure by creditors.

Accelerated death benefits

Some permanent life insurance policies allow policyholders who are suffering from a terminal or catastrophic illness or who require long-term care to access a portion of the policy's death benefit while still alive.

According to the AARP, the amount that can be tapped is typically limited to 80 percent of the face value of the policy. Receiving accelerated death benefits also reduces the benefit payout to the policy beneficiary after the policyholder's death. In addition, the policyholder is still responsible for making premium payments on their policy.

To qualify, a person's life expectancy must be 6 months or less, or at most 12 months, according to Barclay. “In some cases, that may be a viable option to consider.”

Deciding how to tap your life insurance

The emotion that can accompany a terminal diagnosis, combined with pressing financial needs, does not make for ideal conditions for making a careful financial decision about what to do with a life insurance policy. Nonetheless, you should exercise caution as you consider whether to sell a policy or access some of its proceeds before dying.

According to the non-profit Women's Institute for a Secure Retirement (WISER), the decision-making process should begin with seeking advice from a financial advisor or an attorney. If a settlement is a strong possibility, shop around among several companies and/or brokers to find the best offer, and check with your state insurance department to ensure that the company or broker you're considering is licensed. Finally, the Institute advises “remembering that you are not required to accept an offer [on your policy] and that you can change your mind” after one is made.

In terms of taxes, the Ashar Group, another company that sells settlements, advises that “it is important to discuss the tax implications with a qualified tax professional to determine whether the funds you receive will be subject to federal income tax.”

Finally, keep in mind that the alternatives to a settlement that provide cash before death are not all-or-nothing deals. According to Dave Simbro, senior vice president of life and annuities at Northwestern Mutual, you "can both take some cash and leave some money behind."