At a time when retirement nest eggs have shrunk, home equity has disappeared and bank loans are hard to get, more and more people are selling their life insurance policies to get cash.
"People may chose to sell their life insurance if they no longer want or need the coverage, or if they are struggling to afford the premiums," explains John Yaker, president of Quantum Life Settlements.
In these transactions, called life settlements, a third party buys the policies, taking over the premiums and then collecting the money when the insured person dies.
But while the lump-sum payment these life settlements offer might appear to be a godsend for a cash-strapped senior citizen, critics say life settlements are unethical or immoral -- and some say they could even provide an incentive for murder.
"It's the wild, wild West, generally an unregulated marketplace," says Byron Udell, founder of AccuQuote, a provider of term-life-insurance quotes.
That lack of regulation and oversight, in a market that has grown quickly in the last decade, has raised concerns from the Securities and Exchange Commission. One study estimated that existing policies with a collective face value of $11.8 billion were sold by policyholders to investors in 2008.
In a report in July, an SEC task force described the inconsistent regulation of participants in the market, including those who arrange for the buying and selling of policies and those who provide estimates of an insured person's life expectancy. In addition, the report noted that life-settlement investors would benefit from a set of standards.
The task force recommended that life settlements be clearly defined as securities so that investors in these transactions are protected under the federal securities laws. In 2009, the Financial Industry Regulatory Authority issued an alert warning seniors about life settlements.
To understand why there's so much fuss about these deals, it helps to understand their history. Before life settlements, if you owned a life insurance policy that you no longer wanted or needed, you had two choices: surrender the policy for its cash value or allow it to lapse. Then a third option developed: Sell your policy -- or the right to receive the death benefit -- to someone other than the insurance company that issued the policy, a transaction known as a life settlement.
The purchasers of life settlements, sometimes called life-settlement companies or life-settlement providers, pay off the policy holder in a lump sum and then typically either hold the policies to maturity -- i.e. to the death -- and collect the benefits themselves, or sell interests in a pool of policies to hedge funds or other investors.
The amount of the settlement varies depending on factors such as the insured person's age and health, as well as the terms and conditions of the policy. But typically, the seller will get more than the policy's cash-surrender value and less than the net death benefit. "Policy owners can net up to eight times more in a life settlement than if they surrendered their policy back to the insurance company," Yaker says.
But when you sell your life insurance policy, whoever buys it acquires a financial interest in your death. In addition to paying
you a lump sum for your policy, the buyer pays any additional premiums as long as you live.
That's one reason many financial experts say a life settlement should be the last stop -- and not the first -- during a desperate hunt for cash. "In a financial transaction where one person (the buyer) has a financial incentive for another (the insured) to die, there are massive ethical implications, says Bruce Fenton, managing director of Atlantic Financial. "Additionally, the industry itself has been plagued with unethical behavior, fraud, low quality providers and other issues." He adds: "I would avoid them at almost all costs, as both a seller and an investor."
Investors shouldn't be speculating on other people's lives, argues AccuQuote's Udell. "When a stranger has a vested interest in your death, it can be an incentive for murder," he says. "I predict five years from now there'll be a 60 Minutes story about people who died that they trace back to life settlements. Many of these policies are for more than $1 million. People will die before they should so someone will get millions. You will have to look over your shoulder the rest of your life."
There are plenty of other downsides. For starters, selling your life insurance means you disinherit your beneficiaries. You also likely will have to pay taxes on the payment you receive. And if you change your mind, chaos ensues. "If you sell a policy thinking you do not need insurance and later you do, but your health has changed or premiums are cost prohibitive, insurance is not an option," explains Brian McDowell, chief investment officer for FBR Wealth Management Group.
You also end up paying very high -- and, some argue, unjustifiable -- fees. Let's say a person who owns a $1 million policy with $200,000 in cash-surrender value receives an offer of $300,000 from a life-settlement provider. Assuming 5% commission on the $1 million policy, the cost -- usually paid by the seller -- would come to $50,000. That takes 17% off the offer price, leaving the seller with only $250,000. "Some see this amount of fees as unacceptable no matter the situation; others feel the fees may be warranted on a situational basis," McDowell says.
Buyers also take a big risk: The insured person could easily live longer than expected. "There are much better investments for the average investor," says Amy Danise, senior managing editor at Insure.com. "Plenty of investors got burned and didn't get the returns they expected because the person lived longer than expected. Every time they pay premiums, it cuts into their profits."
Furthermore, in the case of term-life-insurance policies, if the insured person outlives the term of the policy, the investor may end up having to pay for a new policy, which would be more expensive because the insured person would be older than when the expired policy was issued, says Richard McGrath, president of McGrath Insurance, who refuses to sell life settlements because he considers them unethical.
No doubt, there are times when a life settlement makes sense. One 54-year-old man, who's terminally ill with bone-marrow cancer, says he sold his $400,000 policy for $200,000. He wanted money to pay down some of his debt and live a little more comfortably during his remaining time with his wife and grown children. The family took a long-hoped-for trip to San Francisco.
He kept a bigger life insurance policy. "I wouldn't have sold the smaller one if it was all that I had, because I wouldn't leave my wife in a lurch." For him, selling was a good thing. "They'll make money off me, but it's also been very helpful to us."
It might also make sense to sell a policy that isn't performing as expected, says Bryan Freeman, president of Habersham Funding. In some cases, a bankruptcy, the purchase or sale of a business or any change that removes the need for the policy could drive a sound sale, he adds.
Despite all the warnings and the controversy, many more people will likely continue to sell and buy these settlements in the tough economic times. If you're planning to get involved on either side of one of these transactions, here are some tips that may help you avoid getting burned.
Deal only with a settlement entity licensed in your state. This provides safeguards for all involved and may even provide you with advantageous tax treatment, Freeman says.
Know the facts. A death benefit may be tax free, but a policy that's cashed out isn't. If you're selling your policy, make sure to include the taxes, as well as all other fees, in your calculations. The offer price will be well below the value of the policy. "When all is said and done, my experience is that the seller usually receives about 50 cents for each dollar of 'intrinsic' value in a sold policy," says Scott Witt, a fee-only life-insurance advisor.
Get multiple offers from reputable settlement companies. With so much money at stake, shopping around is as important as ever. Never agree to a settlement without a written offer from the buyer.
Take your time and seek professional help. Make sure to select a financial professional who has experience with life settlements and who can explain all the ramifications of the deal, advises Stan Lewandowski, a wealth preservation specialist with Sagemark Consulting. Know too that the sale of the policy is irrevocable and should not be taken lightly.
Consider all your options. If you are considering selling your life-insurance policy for cash, you may have other options. "There are other ways to get money out of your policy. What's the cash value, can you get a loan?" asks Danise. If you have a long-term, catastrophic or terminal illness, you may also be eligible for what's called "accelerated" death benefits, which allow an insured person to receive benefits in advance of his or her death. If you're considering a sale because you can't keep up your premiums, it may make sense to reduce the death benefit -- and thereby lower the premiums.