Portfolio shrinkage. Lack of real estate liquidity. Job losses. As the economic slowdown drags on, there are many reasons that hard-pressed individuals might want to sell no-longer-needed life insurance policies. "Anecdotally, I've heard that more people are showing interest in life settlements," says Scott Hawkins, an analyst at Conning Research & Consulting in Hartford, Conn.
Darwin Bayston, executive director of the Life Insurance Settlement Association in Orlando, Fla., reports that calls from consumers are on the increase, another indicator that insured individuals may be looking for cash today rather than beneficiary enrichment tomorrow.
There may be more interest from would-be sellers, but that hasn't generated a boom in life settlements - sales of life insurance policies to buyers who will eventually collect the death benefits. Instead, an earlier boom has turned to a bust. "In 2007 and 2008," Hawkins says, "life settlements reached a peak of around $12 billion per year in face value of the policies. That number declined in the next two years, falling to $3.8 billion in 2010," a drop of nearly 70% in the size of the market.
Hawkins declined to provide numbers for 2011. Conning's report for 2010 wasn't released until October 2011, so last year's figures are still being tabulated. Hawkins did state, however, that the 2011 report probably wouldn't show a major upswing. "What had been a seller's market back in 2007 and 2008 has turned into a buyer's market, and that probably will continue to be the case for a while. Relatively few investors are active now, and those buyers are more picky."
In reality, the slump in life settlements might be even more severe than the numbers indicate. "Based on some of the information I've seen," Hawkins says, "nearly half of today's life settlement business might be in the tertiary market, not the secondary market." That is, investors who bought policies during the peak years may be unloading now, trying to recoup some of their investment. Thus, it's possible that only a modest portion of today's life settlement business involves first-time sales of policies by insured individuals.
The bottom line, then, is that a financial planner may find it difficult today to help a client sell a life insurance policy at an appealing price. Nevertheless, some policies are being sold, so planners might want to consider exploring the possibility with clients who are likely candidates.
Only some clients will fall into the "likely" category. Some people are not comfortable knowing that a stranger will profit from their death, even if the buyer is a hedge fund that presumably is acquiring a pool of insurance policies. "There is a 'creepy' factor of knowing that someone else owns an insurance policy on your life," says Tom Orecchio, a principal and wealth manager at Modera Wealth Management in Westwood, N.J. "That just doesn't sit well with many people."
Assuming a client is willing to sell, would a buyer be interested? "Typically," says Lee Slavutin, a partner at Stern Slavutin-2 Inc., a life insurance agency in New York, "buyers want policies where the insured individual has a life expectancy of about 12 years or less. That means sellers usually are in their mid-70s or older. Policies on the lives of younger sellers may interest buyers if the insured individual has a medical condition. A healthy 65-year-old probably will not be able to sell a policy for a significant price."
Even if clients have the "right" life expectancy, they might not have the right type of insurance policy. "Buyers usually prefer universal life," Slavutin says. "Those policies have some flexibility, so buyers can reduce the premiums they pay while they wait for a payoff. Whole life policies have less premium flexibility, while there can be regulatory issues with variable life and variable universal life."
Christian Evulich, vice president of business development at Amrita Financial, a life settlement broker in Oceanside, Calif., adds that convertible term insurance may be salable, especially if it can be converted to a desirable permanent life policy.
Sellers who meet all of the above criteria must still decide whether the price they're getting is attractive. The key to the life settlement business, after all, is that sellers wind up with more money than they would receive by surrendering a policy for its cash value. Now that a seller's market has been transformed to a buyer's market, policyholders may receive low bids.
What is causing a softness in pricing? If more policies are being offered for sale by sellers eager for liquidity, the increase in supply will obviously bring down prices. For the most part, though, it has been buyers' reluctance that has led to lower prices.
"Capital remains skittish," Hawkins notes. With life settlements, investors pay a substantial amount upfront (to the seller) and smaller amounts thereafter (premiums to maintain the policy) until cashing in. There may be little or no return for years, and the environment of the past few years has not encouraged such speculative investments.
What's more, the Society of Actuaries published a new "valuation basic table" in 2008, supplanting a table from 2001. "This change increased life expectancies by 20% to 25%," says Scott Kirby, co-president of Advanced Settlements, a life settlements broker in Orlando. An individual who would have been given a 12-year life expectancy a few years ago might now have a 14- or 15-year life expectancy. The longer life expectancy makes that seller's insurance policy less attractive, so bids would be lower.
Underwriting may be more rigorous, too, with buyers wanting to see proof of a seller's failing health. The process has also become more sophisticated, according to Evulich. "For example, if a patient is on statins," he says, referring to commonly used medication for high cholesterol, "medical underwriters may not shorten the seller's life expectancy. Therefore, buyers won't be as interested."
While buyers' caution has depressed the prices that policy sellers may be offered, an IRS change has reduced the amount the sellers will retain, after taxes, in many situations. As a result of Revenue Ruling 2009-13, a policy seller's cost basis may be lower now, which would result in larger gains, more taxes owed and less after-tax cash for the seller.
If John Smith sells his life insurance policy for an amount in excess of his cost basis, he will have a taxable gain. Historically, the cost basis usually was the amount paid in premiums, assuming no policy loans or distributions. If John had paid $300,000 in premiums over several years and sold the policy for $800,000, he would have had a $500,000 gain.
The IRS ruling introduced the concept of adjusted basis on life settlements, according to Slavutin. "You have to reduce your basis by the cost of insurance," he says, "which is the portion of the premiums that were related to mortality coverage." This cost is comparable to the premiums that would be paid for term insurance, Slavutin explains, and is generally spelled out on annual statements to universal life policyholders.
In the above example, if John had paid $100,000 for mortality coverage over the years, his cost basis would be adjusted down from $300,000 to $200,000 and his taxable gain would raised to $600,000 from $500,000. Thus, this IRS ruling makes selling a policy more taxing and relatively less appealing.
There is a silver lining, though. The extra tax is assessed at favorable rates. When a policy is sold in a life settlement, the so-called "inside buildup" is highly taxed ordinary income while other taxable amounts get bargain long-term capital gains rates after a one-year holding period.
Say that John Smith had $475,000 of cash value when he sold his policy. The $175,000 gap between premiums paid ($300,000) and the policy's cash value ($475,000) is taxed as ordinary income, at rates up to 35% in 2012. The remaining $425,000 of John's profit ($600,000 total gain minus the $175,000 taxed as ordinary income) is taxed at only 15% this year. The $100,000 basis adjustment increases John's long-term gain, costing him $15,000 in tax.
Closing the sale
Altogether, would-be policy sellers are fighting the headwinds of a perfect storm of cautious buyers, longer life expectancies and higher taxes. Nevertheless, there may be times when selling is a good alternative. Slavutin tells of a woman who came to him after her husband had suffered a severe head injury in a skiing accident, so the couple couldn't afford to maintain a $1 million term life policy. "It was convertible," Slavutin says, "so we managed to get $100,000 for the policy, which the couple needed."
An injury or illness is not always needed to trigger a life settlement. Orecchio recalls a client who was in "decent" health at 76 years old. "This client had a $1.6 million universal life policy with a $1.6 million face value," he says. "The annual premium was about $46,000, and it looked as if he would need to pay in for at least eight more years."
The client owned a key man policy, previously taken out for his electrical contracting business. "The client no longer needed the coverage," Orecchio says. "The cash value was about $250,000, which the client would have received from surrendering the policy. However, this client contacted his life insurance agent and wound up selling the policy instead." The policy was sold for around $430,000, more than 25% of the face value and much more than a surrender would have generated.
As Orecchio's example indicates, for life settlement investors elderly clients may have the most desirable policies, and an aging client base is likely to generate an increase in possible sellers. In one case, a business owner in his 70s was about to sell his company, relates Daniel Cotter, a principal and director of risk management at the Westlake, Ohio, office of Rehmann Financial. "He had two life insurance policies that he was going to include as assets for the buyer to acquire," Cotter says. "Instead, he looked into life settlements and discovered he could wind up with a lot more cash selling the policies."
Kirby's examples include an 80-year-old woman with a $1.5 million policy who was still paying over $36,000 a year in premiums. "This client's estate had decreased," he says, "and it had become very difficult for her to pay her premiums. She needed to sell the policy or it was going to lapse - her policy had no cash value. She tested the market and was thrilled to receive an offer of $234,000, in a life settlement."
An even older (age 82) policyholder was paying over $65,000 a year for a $1.85 million policy. "He no longer needed the policy," Kirby says, "which was originally purchased for estate tax purposes. He received a bid of $410,000, which allowed him to recoup some of the premiums he had paid into the policy over the years."
As these case histories illustrate, some clients may receive more cash from a life settlement than from a policy surrender. It's true that there are other ways to obtain funds from life insurance, like policy loans and withdrawals. Those tactics, if taken to excess, can result in tax consequences and erode the policy, Cotter points out. "If the person is older," he says, "it might be better to consider a life settlement of the policy, thus providing more cash with none of the withdrawal issues that can come from large loans."
If selling a life insurance policy seems like an appealing option, caution is called for. Cotter advises sellers to work with a team of professionals experienced in insurance, taxes and other legal issues.
Financial planners can play a role, for example, by looking into a bidder's background. "The more reputable a buyer," Slavutin says, "the more likely a client's privacy will be respected." Orecchio suggests getting multiple bids in order to make sure that a client is getting a fair price for putting his or her life on the line.
Donald Jay Korn is a contributing writer at Financial Planning. His latest novel, In for a Pounding, is available on Kindle and Nook.
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