Life settlements are an important financial tool that many consumers and financial advisors know surprisingly little about. When used properly, life settlements can help supercharge underfunded retirement accounts, a common financial woe for baby boomers. This article will give the reader an overview of the product and industry, when one might consider this tool, and how the transaction works in gory detail.
A life settlement is the sale of a life insurance policy to an investor. The insured receives an upfront cash payment in exchange for transferring ownership of the life insurance policy to a third party. The investor then continues to make the annual premium payments, and when the insured passes away, the investor collects the policy's death benefit.
The life settlements market is still relatively young but was born as a result of a number of judicial rulings over the past hundred years. The most notable of them was the US Supreme Court case of Grigsby v. Russell, 222 U.S. 149 in 1911. Justice Homes wrote:
"So far as reasonable safety permits, it is desirable to give to life policies the ordinary characteristics of property. To deny the right to sell except to persons having such an interest is to diminish appreciably the value of the contract in the owner's hands."
This opinion set forth the foundations of the life settlement market: life insurance is a private asset that the owner should be able to sell. If you'd to see how much your policy could be worth, you can get a quick estimate here.
One important distinction to make is the difference between viatical settlements and life settlements. The two are similar because in both cases, the insured is selling their life insurance policy to an investor. However, viatical settlements are arranged for individuals who have a life expectancy of under two years while life settlements are for individuals who have a life expectancy greater than two years.
There are different regulations covering viatical settlements. This article discusses only life settlements and, although some of the information is applicable to viatical settlements, does not aim to cover that topic.
The annual US life insurance lapse rate is 4.5%. This means that out of the $20 trillion of in-force life insurance, roughly $900 billion of insurance lapses annually. Of course, part of this value is term life insurance - which is designed to lapse. But what about permanent life insurance - the type of coverage that is meant to insure a person for their entire life?
According to a study done at Wharton, it turns out that 88% of all universal life insurance never materializes into a claim either. In fact, 76% of universal life insurance purchased by seniors 65 years or older are also never claimed!
This results in a tremendous transfer of economic value from the consumer's pocket to the life insurance companies' bottom line. Often times, there is potential cash value that could be reinvested in other income-earning assets or be used to pay down debt.
The answer to why policies are lapsed is simply because circumstances change. The reasons why someone initially purchased the policy may no longer be relevant 20 years down the road. Here are some examples:
An man purchased a policy while he was working to protect his family. 40 years later, his children are self-sufficient. Sadly, his health has recently declined and he requires medical help. Rather than burdening his kids for money, he is looking for a way to get liquidity from his policy.
A business purchases a key-man policy on the CEO. This year, the CEO is considering retirement and the business needs money to expand. Rather than borrowing from the bank, the company wants to exchange the key-man policy for capital.
A married couple with no kids purchased a policy. However, after a number of years, they divorce and decide that the policy is no longer useful to them.
A working executive purchased a universal life insurance policy in 25 years ago. However, as she's aged the policy's premiums have increased but her income has decreased post-retirement. She is struggling to keep the policy in-force.
This is why life settlements exist. A mature secondary market for life insurance will greatly benefit the consumer in each of these common cases. Life settlements are a way to potentially turn something that was perceived to be illiquid and turning it into a liquid capital. It is also a way to eliminate on-going premium expense if the policy owner is struggling to keep up with the required payments.