One of the most important aspects of advanced estate planning is the secondary life insurance market. 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 could normally lapse or be terminated. Life settlements are now being used with other strategies to provide equity 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 receive 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 assessor 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 assessor consulted the real estate agent every year. We would feel undervalued, to say the least, if we had to sell real estate for its appraised value instead of its fair market value. Our heritage 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 arrangements have been around in one form or another for years. They are usually associated with the capital investment 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 is seeking 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 variable or universal 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 surrender value for the same reason 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 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 more accurate at the time of issuance. This benefits consumers in the same way that early settlements do by taking a more individual approach to evaluating 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 subscription is never reviewed. This approach to pricing life insurance policies serves the 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 buy back 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 issue. 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 history by authorizing the review of a copy of their medical records. This is where the most accurate and timely information on the health status of the insured is used to assess life expectancy. The third piece of critical information that is reviewed 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 product of the settlement once the changes in the carrier have been registered. Any amount, up to the cost basis, is a tax-free return of premium. Anything over that, up to the cash surrender 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 shift from recognizing life settlements as a sophisticated financial planning technique. Many clients who are life settlement candidates would probably never buy investments without knowing all the facts and having a solid exit strategy. Now is the time to determine the usefulness 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 hidden value for the benefit of the consumer.