Life Settlements

By Amy Gavartin

Editor: Michael David Schulman, CPA/PFS

Advisers are constantly looking for ways to supplement the depleted finances of their clients. For seniors, one option that has become more popular is the secondary market for life insurance or life settlements. Several articles have recently been published on this topic, and many have tried to portray this industry as the “next sub-prime crisis” waiting to happen but gloss over the underlying fact that the use of life settlements has uncovered vast amounts of hidden value from existing life insurance policies. Over the past 10 years, owners of life insurance policies who have chosen to sell have received approximately $6–7 billion more than their cash surrender value (CSV) (Thomas, “LISA Pans Article,” Life and Health Insurance News (September 14, 2009)).

It is not uncommon for the settlement amount to be three to five times the CSV, and the policy owner is relieved of all future premium payments on the policy. All types of policies are eligible for a life settlement, including term, universal life, whole life, variable universal, and second-to-die policies. The general rule of thumb in today’s market is that the insured should be over age 70 with a minimum of $250,000 of insurance.

The tax treatment of life settlement proceeds has been unclear until recently. However, the IRS issued guidance during 2009 that clarifies when and to what extent policyholders must recognize capital gain when they sell a life insurance policy.


The definition of a life settlement is the sale of an existing life insurance policy from the current policy owner to a third party via the secondary institutional market in exchange for an immediate one-time cash payment that is less than the policy’s face value but more than the policy’s CSV. There are many reasons a policy owner could come to the conclusion that he or she no longer needs or wants a policy: Owning an underperforming policy, retirement of an executive or sale of a business, divorce or death of a spouse or beneficiary, estate size growth or reduction, changes in health, and economic hardship or bankruptcy are just a few examples that can cause policy owners to cancel or surrender their life insurance. All these changing circumstances lead to an overwhelming outcome: 88% of universal life policies and 95% of term policies never pay a death claim (Kadlec, “Extra Value,” Time (October 22, 2006)).

The hard numbers are staggering: According to the American Council of Life Insurers, in 2006 $2.22 trillion worth of life insurance policies lapsed or were surrendered, a total that increases by approximately 4% per year (American Council of Life Insurers, Life Insurers Fact Book 2006). Yet only an estimated $15–$20 billion of life insurance policies were sold to the secondary market in 2007 (Breus, “Virtues and Evils of Life Settlement,” Journal of Accountancy (June 2008)). The research firm Conning and Company reports that seniors have approximately $500 billion of life insurance in force, and policyholders will contemplate canceling about $125 billion of those policies (Stern, “Life Settlements: The Legitimacy of a Long-Term Care Funding Source,” Case in Point (June–July 2009)). There lies the opportunity.

The legal and historical underpinnings of life settlements are deep. In 1899, New York’s highest court held that policy owners have property rights in life insurance and as such can “go to the best market [they] can find, either to sell it or borrow money on it” (Steinback v. Diepenbrock, 52 N.E. 662, 664 (1899)). The Supreme Court laid the groundwork for today’s life settlement marketplace in 1911, when it established the policy owner’s right to transfer an insurance policy (Grigsby v. Russell, 222 U.S. 149 (1911)).


Given the statistics, why are more people not taking advantage of this option? The primary reasons are (1) industry misconceptions and (2) policy owners and/or their advisers do not realize that this alternative exists.

One of the most widely held misconceptions is that life settlements are viatical settlements. The viatical settlement market became popular in the late 1980s due to the AIDS epidemic. The industry had virtually no regulation, and there were many incidents of questionable business practices. In addition, because of advances in medical treatment for people that were HIV positive, the death rate drastically slowed and a significant number of investors lost money when policies did not mature as expected. These factors tainted the reputation of the market and led insurance carriers to implement accelerated benefit riders for the terminally ill.

Although a life settlement transaction is similar to a viatical settlement in that the insured is selling his or her policy to an outside investor, they are different in two important ways. Viaticals are almost always sold to an individual or a group of private investors. The inherent risk is obvious: The buyer knows the insured and has a financial interest in the insured’s death. Viaticals are also only for people who are terminally ill.

Life settlements, however, are exclusively for those insureds with more than three years of life expectancy who have a change in financial needs rather than an overwhelming change in health. In addition, almost universally, institutional investors purchase the policies.

The other large misconception is that life settlements and stranger-originated life insurance (STOLI) are one and the same.

A STOLI policy is one created for the purpose of selling at some future point in time. In addition, these policies are initiated by some outside third party and are often accompanied by a financial inducement. Although the intent of a STOLI policy is for the policyholder to sell it via a life settlement, the policy itself is not a life settlement.

Taxation of Life Settlements

Another confusing issue is the taxation of settlement proceeds. Until last year, the IRS was silent about the taxation of the proceeds of life settlements, and advisers had varying opinions about what to do. Rev. Rul. 2009-13, which went into effect August 25, 2009, clarified the tax treatment, even though many opinions still differ. The ruling explains that for calculating the gain on the policy sold, the cost basis consists of the cumulative premiums paid into the contract less the cumulative cost of insurance. This calculated cost basis reduces the taxable gain on the sale if paid for with after-tax dollars.

With respect to the character of the gain, if the current CSV is greater than the calculated cost basis, the difference is treated as ordinary income. Any proceeds received above the CSV are considered capital gains. In the case of term life insurance, the ruling states that the entire amount of premiums paid is cost of insurance, so there is no cost basis; since there is no CSV with term insurance, all the settlement proceeds are treated as capital gain. (For more on this revenue ruling, see McGivney, “Two Recent Revenue Rulings Clarify Tax Treatment of Life Settlements,” Tax Clinic, 40 The Tax Adviser 516 (August 2009).)

Regulation of Life Settlements

Currently, 39 states and Puerto Rico regulate life settlements, and the National Association of Insurance Commissioners (NAIC) recognizes them as a viable solution (NAIC, “NAIC Adopts Viatical Settlements Model Act Revisions,” News Release (June 4, 2007)). One of the most recent states to institute regulations is Rhode Island, which enacted life settlement legislation in November (to take effect July 1, 2010) (RI Gen. Laws §§2772-1 through 27-72-18).

In addition, three states—Maine, Oregon, and Washington—have new laws that ensure policy owners are notified about the opportunity of life settlements and have reliable information when making decisions about lapsing or surrendering their policies (ME Rev. Stat. tit. 24-A, §6812-A; OR Rev. Stat. §744.358; WA Laws of 2009, ch. 104). It is expected that several other states will adopt similar laws in the near future.

Because the life settlement industry is not regulated by any one nationally recognized governing authority and is currently regulated on the state level by state insurance commissioners, policy owners should exercise caution and good judgment when choosing a broker (see “Choosing a Broker,” below). It is important to note that the SEC and the Financial Industry Regulation Authority have both pledged to take a look at the life settlement industry (see Schapiro, “Address Before the Solutions Forum on Fraud” (October 22, 2009)).


There are many situations that would make a life settlement beneficial. A common example is when a policyholder has an underperforming policy but still needs coverage.

Example: H and W, a married couple aged 78 and 76, have a $10 million second-to-die policy (taken out for estate tax purposes) that costs them $385,000 per year. After meeting with their CPA, they agree that due to the losses they have incurred in the stock and housing markets, they need only $5 million in coverage. Because their existing policy is underperforming, they look into a life settlement for the $10 million policy, wanting to use the proceeds to pay for a new, more efficient $5 million policy. The current policy has a $426,000 surrender value, but the top settlement offer is $1,324,000—a 211% increase above surrender. They then compare a Sec. 1035 exchange to selling the policy. A 1035 exchange would leave them with annual premiums of $212,000 per year, but by using the settlement proceeds to fund the new policy, the premiums total $165,000 per year for a $47,000 annual savings, and a $220,000 annual savings versus keeping the larger policy.

Another example of the versatility of life settlements is in the distressed corporate markets. The proceeds from a life settlement can free up cashflow to pay off creditors and help businesses stay out of bankruptcy. Many corporations have corporate-owned key executive policies that they originated to fund buy-sell agreements or nonqualified deferred compensation plans. Buy-sell agreements are often protected with term insurance that usually has an option to convert into a permanent cash value policy. Corporations often overlook the policies as assets because, since they have no current value, they are usually not on the financial statements.

Some advisers like to throw a philanthropic twist into the settlement equation to offset any potential capital gains tax. The following scenarios can achieve this objective:

  • Gift the policy to a charity and receive a current tax deduction.
  • Gift the policy to a charity, receive a current tax deduction, and make additional yearly gifts to the charity to cover the annual premiums to receive future deductions.
  • Sell the policy and donate a portion of the proceeds to offset any capital gains incurred from the sale.
  • Sell the policy and donate all the proceeds to be able to take a deduction.
  • Set up a charitable remainder unitrust (CRUT) and gift the policy to the trust, allowing the CRUT to sell the policy and take the deduction based on the policy’s true market value. This would also allow for the annual income stream from the trust to go to the insured for life, and the remainder funds in the trust after the insured died would go to as many charities as the trust designated.

Life Settlement Process

The marketplace is always changing so it is important to know what the current landscape looks like and what to expect from the sale of a policy. Institutional investors analyze and price policies using a multitude of factors. Policy type, age, gender, life expectancy, face amount, insurance carrier rating, projected annual premiums, and state of residency are just a few of the many variables buyers consider. Future cost to carry and life expectancy weigh most heavily in determining price. Hence, individual medical records are necessary for each insured and should be analyzed by multiple life expectancy reporting agencies.

The life settlement process usually takes four to six months from start to finish, and this is an important factor to consider when starting the process. After a general application is filled out, a life settlement broker begins by ordering medical records from the insured’s physicians and/or hospitals. Simultaneously, all illustrations are run, and trust documents, copies of policies, and any applicable supporting documents such as loan documents are collected. The next step is ordering life expectancy reports. These are normally obtained within two to three weeks. At this point, the broker compiles and submits a complete package to the marketplace of institutional buyers. A policy’s desirability will determine how rapidly the offers come in. Typically all offers and declinations are received within two to six weeks.

Practice tip: Because life expectancies can vary by as much as two to eight years from one life expectancy company to another, ordering multiple life expectancies is the best business practice.

Upon receiving the highest offer, presenting it to the policy owner, and accepting it (around one week), closing documents are prepared and sent out for signatures. It is not uncommon for closing documents to be 70–90 pages long (it is, after all, a contract to sell an asset) and require the signatures of insured, owner, beneficiary, spouse, personal physician, and notary. This process of receiving documents, getting signatures, and having a legal review by the purchaser’s counsel usually takes three to four weeks. The final part of the process is that escrow is opened, funds are deposited, and documents are submitted to the insurance carrier so it can make the changes of ownership. Most carriers complete the changes within two weeks, but some take as long as 30 days. After the changes are complete and verified by the escrow agent, the agent releases the funds to the seller.

Choosing a Broker

Because of the many moving parts involved in a life settlement transaction, it is important that the policy be shopped and represented properly in the marketplace. To ensure this, a policyholder desiring a life settlement should always use the services of a reputable and seasoned life settlement broker. A strong broker will:

  • Act as a fiduciary to the policy owner and his or her adviser;
  • Not work with private individual buyers;
  • Submit cases to at least 30 institutionally owned funding sources;
  • Not purchase policies for his or her own investment;
  • Offer full transparency on offers, including funding source;
  • Be willing to provide a list of all state licenses;
  • Have at least three years of industry experience;
  • Mandate a rescission period for all sold policies; and
  • Use a third-party escrow service company to complete transactions.


Advisers and policy owners commonly make the mistake of shopping a policy through multiple brokers because of their desire to have maximum exposure to the funders. Most reputable brokers shop cases to many of the same buyers. If multiple brokers submit the same case to a funding source, they dilute the market efficiencies and create a lack of interest from potential buyers. Many buyers will simply decline or ignore these cases because no particular broker is in control. In addition, one broker may hurt the potential bids of another by not sending the lowest combination of life expectancies, basically polluting the file.

Another important consideration for clients selling their insurance policies is that the first policy remains in effect, even though they are no longer the owners, and therefore counts against their insurance capacity (i.e., the total amount of life insurance they can purchase). Selling a policy may thus limit the amount of coverage they are eligible for in the future if they should need additional coverage.


At the end of the day, a successful life settlement transaction results in more money going to policy owners in exchange for their unwanted or unneeded life insurance policy than would have been received if the policy was lapsed or surrendered. When a policyholder no longer wants or needs a particular life insurance policy—for example, the policyholder can no longer afford the insurance premiums or is willing to give up or replace the coverage—life settlements can make a lot of sense. This powerful asset recovery, estate planning, and charitable giving tool should be in every financial professional’s repertoire when dealing with senior clients.

This article is for informational purposes only. Although the information in this article is believed to be reliable, Melville Capital and its affiliates do not warrant the accuracy or completeness and accept no liability for any direct or consequential loss arising from its use. Past performance is not a guarantee of future results. Nei ther Melville Capital nor any of its af filiates provide tax or legal advice. People should consult independent counsel/tax advisers in connection with matters cov ered in this article.


Michael David Schulman is the owner of Schulman CPA, an Accountancy Professional Corporation, in New York, NY. Amy Gavartin is director of advanced markets at Melville Capital in New York, NY. For further infor-mation about this column, contact Ms. Gavartin at agavartin@

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