Sometimes, when a client is in old age and in need of funds, it makes sense to help them cash out of an unnecessary life insurance policy.
The secondary market for existing life insurance policies, in which sales are known as life settlements, has been around since at least the 1980s. In that market, individuals and companies purchase existing insurance contracts from policyholders at a discount to face value, hoping they‚Äôll turn a profit when the insured dies and they can collect the death benefit.
While the policyholder ends up selling the policy at a discount, these transactions can still make sense for some clients who no longer need a policy. Some relevant examples include when a spouse has passed away, a client can no longer afford to pay premiums, or he or she is suffering from a terminal illness and as a result, his or her life expectancy has suddenly narrowed.
Now, recent tax laws and improving life-expectancy estimates may make selling a life insurance policy an even more attractive option for some clients in these situations.
Whereas ‚Äúconcerns over the accuracy of life expectancy estimates‚ÄĚ had led to a lower volume of life settlements in recent years, life expectancy providers have since improved their methods, reports Scott Hawkins, director, insurance research, at Conning, an investment management firm in Hartford, Connecticut. The market bounced a bit in 2016 and Hawkins expects to find a further increase for 2017, when Conning publishes those figures later this year.
An additional boost to the market may come from the Tax Cuts and Jobs Act of 2017. Among its many provisions, the new tax law overrode IRS Rev. Rul. 2009-13, making the life settlement process simpler and less expensive, tax-wise, for sellers.
Under the tax code, a sale of a life insurance policy when the insured individual has a life expectancy under two years is considered a viatical settlement, a tax-free advance of the death benefit. Sellers with longer life expectancy ‚ÄĒ possibly anxious about running short of money over a long retirement ‚ÄĒ don‚Äôt qualify for this tax exemption.
Instead, a nonviatical life settlement can be taxed as a capital gain if the proceeds exceed the seller‚Äôs basis in the policy.
The old tax law, which was in place for nearly a decade, required life-policy sellers to reduce their basis (the cost for tax purposes) by the cost of acquiring insurance. That lower basis resulted in a higher taxable gain for the seller.
Now, under the new tax law, the seller‚Äôs basis is equal to the premiums paid, with no reduction for the cost of insurance.
Raising the basis reduces the taxable gain, providing more net dollars from a life settlement.
The more after-tax dollars, the merrier
Pocketing more after-tax dollars, and perhaps reducing outlays for no-longer-needed insurance premiums, may ease clients‚Äô financial burden at the end of their life. Leo LaGrotte, founder, president and CEO of Life Settlement Advisors, in Carmel, Indiana, tells of a 73-year-old man whose life was insured for $500,000.
‚ÄúHis wife passed away a few years ago and he no longer needs his term life insurance policy,‚ÄĚ LaGrotte says. ‚ÄúHe had planned to let the term policy lapse until his financial advisor told him he might be able to sell it. He sold his policy for $78,000 and made his retirement a little bit more comfortable.‚ÄĚ
LaGrotte notes that the term life policy was convertible to a permanent life policy, which is a requirement for such a sale. After a conversion, the buyer can pay ongoing premiums to keep the policy in force and eventually collect the death benefit.
When it comes to raising cash, Barry Flagg, CFP, managing principal at Triangulum Financial Partners in Tampa, Florida, asserts that a financial planner‚Äôs role can go well beyond soliciting offers that are greater than the policy‚Äôs cash surrender value. One of his clients, for example, was offered $500,000 for a $4-million policy with $400,000 in cash surrender value. Even though the offer was 20% more than the cash surrender, he advised the client to reject it because it was considerably less than the independently calculated fair market value.
‚ÄúBy following a specific process, we eventually sold that policy to a different buyer for $1.25 million,‚ÄĚ he says.
Flagg, who also is the founder of Veralytic, a life insurance research company, explains that the fair market value of a life settlement can be estimated in the same way as the value of a zero-coupon bond is calculated. ‚ÄúIt‚Äôs the present value of the death benefit at life expectancy, less the present value of the premiums required to maintain the death benefit,‚ÄĚ he says. ‚ÄúIn both cases, using the target yield the buyer is seeking as the present value discount rate.‚ÄĚ
The specific process Flagg mentions includes getting two or three life expectancy reports. ‚ÄúDifferent providers can produce dramatically different life expectancy calculations,‚ÄĚ he says. ‚ÄúThe shorter the life expectancy, the shorter the buyer expects to have to hold the policy before getting a return on investment, and thus the higher the purchase offer.‚ÄĚ
Some companies that provide these estimates include AVS Group, ITM TwentyFirst Services, Fasano Associates, Predictive Resources, Longevity Services and ISC Services.
It pays to look back, too
The new tax law not only reduces the tax burden on policyholders who decide to sell their life insurance contracts in the future ‚ÄĒ it also can deliver tax savings to some sellers, years after the fact, too.
Lee Slavutin, a principal of Stern Slavutin 2, a life insurance and estate planning firm in New York, points out that this provision is retroactive to 2009. ‚ÄúClients who have sold policies and paid tax under the revenue ruling may be able to get a tax refund,‚ÄĚ he says.
The sellers could recalculate their taxable gain, without reducing basis for the cost of insurance. ‚ÄúPeople with open tax returns might consider reporting the gain with a higher basis, on an amended return,‚ÄĚ says Slavutin. ‚ÄúThe difference could be thousands, even tens of thousands of dollars, depending on the size of the life settlement.‚ÄĚ
Regardless of whether a client has this refund opportunity, advisors might go over current life insurance with older clients, to discover if the coverage is still necessary. ‚ÄúA policy may have little surrender value but would bring more from a sale,‚ÄĚ Slavutin says.
Assuming that clients don‚Äôt mind allowing an investor or group of investors to profit from their death, they could wind up with more nuggets for their golden years.