One of the most important aspects of advanced estate planning is the secondary market for life insurance. But, like any other financial planning strategy, it’s not for everyone. The life settlement has traditionally been used as an exit strategy for unwanted or unnecessary life insurance that might normally lapse or be terminated. Now life settlements are being used with other strategies to provide wealth liquidity using alternative financing methods, such as premium financing.
Trusted advisors have a fiduciary responsibility to inform their clients of all of their options when reviewing their estate plan. The fair market value of the life insurance must be the basis. Anyone who has bought or sold real estate knows the importance of fair market value. In recent years, our access to real estate has kept our economy from grinding to a halt.
Most of us probably breathe a sigh of relief every time we get our tax returns in the mail and look at the assessed value. We know that the tax is a percentage of the value assessed by a county appraiser and we are grateful that it is not based on fair market value. But, we would probably see the biggest act of civil disobedience since the Boston Tea Party if the county appraiser consulted the real estate agent every year. We would feel slighted, to say the least, if we were to sell real estate for its appraised value instead of its fair market value. Our wealth is based on a more accurate valuation, which takes into account supply and demand imbalances, among other things, and leaves us with more opportunities.
Now another widely owned asset offers the same opportunity for a more accurate assessment of fair market value. The asset is life insurance. The secondary life insurance market is nothing new. Viatical settlements have been around in one form or another for years. They are usually associated with the investment of capital in a fractional part of a policy in which the insured has a terminal illness. Generally, the insured has a life expectancy of less than 24 months and seeks a tax-free portion of the death benefit to meet an immediate cash need.
Life settlements involve the sale of a policy by someone over the age of 65 who no longer needs, wants or can afford the policy. The life settlement is often used as an exit strategy for underperforming universal or variable life policies where “disappearing premiums” have reappeared or the death benefit is no longer guaranteed. These agreements are negotiated in all types of individual and survivor policies, including term policies. Settlement amounts always exceed any cash salvage value for the same reason that real estate is largely bought and sold for more than its appraised value.
Traditionally, before a life insurance policy is issued, an underwriter reviews the insured’s medical records and makes an offer based on the accepted findings. Unless the case is rejected, different offers could be made, including preferential, preferential plus, standard, table 2 and table 3, etc.
Companies that use the term “clinical underwriting” to assess mortality risks on an individual basis imply that their underwriting is most accurate at the time of issuance. This benefits consumers in the same way early-stage settlements do by taking a more individual approach to assessing an applicant’s medical history. Because of this, an occasional smoker may still be seen as a “non-smoker” risk and may be offered more affordable coverage.
Once the policy is in force, the customer’s underwriting is never reviewed. This approach to pricing life insurance policies works well for insurance companies, but does little for the consumer when the insured’s circumstances change. In fact, it only strengthens the power of the bearers. The ability to repurchase an insured’s life insurance policy is limited to the company that issued it in the first place. Your offer is the cash surrender value of the policy, which is based on the medical underwriting at the time of issuance. Any change in expected mortality that would increase the value of the policy can only be captured in the secondary market when the medical underwriting is reviewed, allowing for a more accurate assessment of the asset.
A typical settlement request includes very important information, which is used for the appraisal. The basic questions are about the type of policy, the insurance company, and when the policy was issued. The insured signs a Health Insurance Portability and Accountability Act (HIPAA) form. Under HIPAA, the insured can share their medical records by authorizing a copy of their medical records to be reviewed. This is where the most accurate and timely information about the health status of the insured is used to assess life expectancy. The third piece of critical information to review is a current illustration of the life insurance policy. It will show the estimated cost to carry the policy to maturity. The non-binding offer can be given to the client once these variables are known.
If the offer is accepted, the policyholder and beneficiary switch to the institution making the offer, which assumes all premium obligations. The insured obtains the settlement product once the changes have been registered with the carrier. Any amount, up to the cost basis, is a tax-free return of premium. The amount above that, up to the cash redemption value, is taxed as ordinary income. Finally, the amount above the cash surrender value, up to the settlement amount, is generally taxed as long-term gain, since the policy must be at least two years old. (This tax opinion was issued in 1997 by KPMG Peat Marwick.)
Life Agreements as Conventional Wisdom
The idea of using the secondary market to evaluate life insurance is slowly becoming conventional wisdom for many reasons. Most importantly, household names such as The Bank of New York, GE Capital, and Lloyd’s of London have committed billions of dollars to this market. This builds credibility with regulators and the public as perceptions of recognizing life settlements as a sophisticated financial planning technique change. Many clients who are candidates for life settlements would probably never buy investments without knowing all the facts and having a solid exit strategy. The time has come to determine the utility of life insurance, especially if the premiums have become a financial burden on the policyholder. The liquidity provided by the secondary market can only improve the value of life insurance by increasing demand in the primary market. Furthermore, a more accurate valuation of the asset is the key to unlocking the hidden value for the benefit of the consumer.