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The Life Settlement Transaction: An Alternative Estate-Planning Tool

These transactions are now being extended to healthy seniors, where they can enhance the financial and estate planning flexibility for some affluent seniors.

By Jack V. Sinclair

A life settlement is the sale of an existing life insurance policy for immediate funds that represents a percentage of its net death benefit In the past, these transactions, commonly known as viatical settlement agreements, were almost exclusively used with terminally ill policyholders. However they have been extended to healthy seniors, where they can enhance the financial and estate planning flexibility for some affluent seniors.

How a life settlement works
The overall concept of a life settlement is relatively simple: a policy owner agrees to sell his or her policy for an agreed upon sum of money to a third-party funding company, who then becomes the new owner and beneficiary of the policy and assumes all future premium obligations. Several factors play into the determination of the fair market value of a policy. These are (1) the net death benefit of the policy; (2) the age and health condition of the insured; (3) the amount of the policy premiums; and (4) the rating of the insurance carrier.

To receive policy appraisals, the policy owner completes a brief questionnaire consisting of pertinent personal and policy questions.

When the funding company has all the pertinent information, it will then determine the value of the policy as a life settlement and make an offer to the policy owner. After the funding company receives the necessary signed documents, it will forward the change of ownership and change of beneficiary forms to the insurance company. When the funding company receives verification from the insurer, it will pay the seller the agreed amount.

Qualifying factors
Generally, policyholders over the age of 70 will be considered for life settlement transactions. Individuals as young as 65 may also be considered when they have significant health concerns. Life insurance policies of many types will be appropriate for a life settlement including term, universal, variable life, group and survivorship life. Individuals, trusts or corporations may own these policies. The policies must be beyond the contestable period, over two years old, and have a minimum face amount of $100,000.

There are many circumstances in which the sale of an existing life insurance policy would be of interest to the policy owner. One of these is when a client wants to eliminate the proceeds of a life insurance policy from their gross estate. Of course, payments received from the life settlement would still be part of their estate, but assuming the insurance policy was owned by the insured at their death, the estate taxes would be reduced because the estate would be smaller. Settlement proceeds are often gifted at maximum rates to lower the estate size. A client may consider selling a life insurance policy to replace highly appreciated assets that were donated to charity. In another situation, a client may have a need for long-term care or long-term care insurance, and an existing policy may be sold to fund these new needs. Considerations relating to Medicaid eligibility and tax-exempt funds must, however, be considered.

Removing a policy from an estate
Under some circumstances, a life settlement may be the only means by which an insurance policy may be removed from an individual's estate without the total loss of the value of the policy. A life settlement can be a means of avoiding the three-year rule, thereby maximizing the proceeds to be transferred to the insured's family or other beneficiaries and reducing estate taxes by removing the death benefit from the estate. Because a life settlement is a &quo;sale for value,&quo; the three-year rule does not apply. Of course, proceeds from the sale of the policy will still be included in the estate of the policyholder. However, this amount will be greatly discounted from the amount of the death benefit.

Tax issues
Tax consequences from the transaction vary, but generally all life settlement funds up to the tax basis are received tax-free, all funds received in excess of basis up to cash surrender value (CSV) are treated as ordinary income, and funds in excess of CSV are treated as long-term capital gain. If the policyholder is terminally ill or chronically ill as defined in Code Secs. 101(g)(4)(B) and 7702B(c)(2), the proceeds of these settlements may be tax-free.

Conning & Company, in a 1999 strategic research study of the settlement industry, researched the market of individual life insurance policies owned by the age 65 and older population. They have calculated the settlement market to be $108 billion over the next decade. With extended life expectancies, it can be expected that this group will provide continued demand for financial services that provide flexibility during retirement.

Jack V. Sinclair is a veteran financial planner and a partner in The Heritage Group, a licensed settlement broker. He can be reached at 405 753-9100 or at


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