Life settlements: Should you sell your life insurance policy?

In 1911, John C. Burchard needed a medical procedure. He couldn’t afford to pay his physician, Dr. Grigsby, so Burchard made a deal to sell his life insurance policy to the doctor for $100. Dr. Grigsby in turn agreed to pay the policy premiums and receive the death benefit when Burchard passed away. These are the details of Grigsby v. Russell, a Supreme Court case that ruled that life insurance is private property and can be legally assigned by its owner.

In what’s become known since as a “life settlement,” the transaction involves a policy owner with a life expectancy of greater than 24 months selling a policy to an unrelated third party for more than its cash surrender value and less than its death benefit. The new owner then pays any remaining premiums and eventually receives the death benefit. The value of the policy is determined by considering how long the insured is expected to live, the annual premium, the death benefit, and various other policy features.

When to consider a life settlement

So, when does a life settlement make sense? Here are a few possible scenarios:

• A person age 65 or older experiences a decline in health from original policy issue. This policy owner needs or desires cash today more than a death benefit for his or her heirs.
• A healthy individual age 65 or older has a term policy that’s going to terminate or lose its ability to convert to a longer lasting policy without underwriting. The temporary need for the term insurance no longer exists. For example, in situations involving the sale of a business, revising a buy/sell agreement, or accumulating enough wealth over time to eliminate the need for the coverage.
• A healthy individual age 70 or older has a policy that’s guaranteed to be in place at his or her passing as long as premiums are paid on time. The policy owner decides to explore the economics of a sale.

Tax treatment of a life settlement

A life insurance death benefit is typically received tax-free by the named beneficiary. The tax treatment of proceeds from a life settlement sale isn’t quite as simple.

Let’s assume the sale of a policy with the following characteristics:

• $1,000,000 death benefit
• $50,000 of cash surrender value
• A sale price of $300,000
• $100,000 of cost basis (meaning the cost of the insurance policy for tax purposes)
• A broker fee of $30,000
• Amount to seller of $270,000 ($300,000 sales price less $30,000 broker fee)
• The cost of the insurance over the lifetime of the policy is $30,000

Prior to the Tax Cuts and Jobs Act (TCJA), the IRS concluded that when a life insurance contract was sold, the seller’s gain was determined based on the amount realized on the sale — so $270,000 in our example. The cost basis was then reduced by the cost of the insurance of $30,000. That meant adjusted cost basis was $70,000 instead of $100,000, and the total gain was $200,000 ($270,000 amount realized less the $70,000 of adjusted basis). The $200,000 was treated as all capital gain since the cash surrender value of $50,000 didn’t exceed the cost basis of $100,000. If the cash surrender value had exceeded the cost basis, then the amount realized above basis would be treated as ordinary income and any additional proceeds would be taxed as capital gains.

In the current TCJA environment, everything remains the same except the basis is no longer reduced by the cost of insurance. Accounting for that change means the total taxable gain in our example would be $170,000 instead of $200,000. In other words, the tax savings associated with selling a life insurance policy today can be substantial.

Potential drawbacks

What are the some of the drawbacks with a life settlement? Key issues include ensuring the policy owner understands how much will be received, how long the process can take, and how to weigh that information against the benefits of keeping the policy. Additional concerns include:

• Finding the right buyer: Some companies may initially offer substantially lower purchase prices than they’d provide in a competitive environment. This is especially important since life settlements tend to occur within an older population when issues such as mental capacity can be involved.
• Determining policy value: The process for determining the value of the life insurance policy can involve gathering medical records on the insured(s) and creating illustrations showing how long the policy could last in various scenarios. Discussing realistic expectations upfront and maintaining the policy appropriately during this process will ensure the owner has information to make good decisions.
• Emotional considerations: Undertaking an honest assessment of the insured’s life expectancy and how paying insurance premiums on that life can affect emotions and family dynamics.

Historically, if you had a policy that you didn’t want, need, or couldn’t afford as premiums increased over time, your choices could be limited to surrendering the policy for cash value, letting it terminate, or making changes to the coverage. In the current environment with investors searching everywhere for yield and tax law changes making life settlements potentially more attractive, selling a policy should be seriously considered as a valid option.

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