Life settlements: selling your life insurance policy

A life settlement is the sale of an existing life insurance policy to a third party for more than its cash surrender value but less than its death benefit. The buyer takes over the premiums and collects the death benefit when the insured dies. It is a regulated transaction in most states, usually involves a licensed provider or broker, and creates tax consequences for the seller, so it is worth comparing against keeping, surrendering or borrowing against the policy.

How a life settlement works

A policy owner who no longer needs, wants or can afford a policy can sell it instead of lapsing or surrendering it. A buyer, often an institutional investor working through a licensed provider, prices the policy mainly on the insured's life expectancy, the death benefit, and the premiums required to keep it in force. A policy is generally more attractive to buyers when the insured is older or in poorer health, because the death benefit is expected sooner.

Buyers vary in what they will consider: policy type (universal life and whole life are common; some term policies can be sold if convertible), face amount, insured's age and health, and the insurer's financial strength. Minimums differ from buyer to buyer, so ask rather than assume.

The usual process:

1. Gather policy information. Current in-force illustration, a statement of cash value and loans, and the owner's and insured's details.
2. Medical records and life expectancy review. The insured authorizes release of medical records; buyers obtain independent life expectancy estimates.
3. Offers. A broker may solicit bids from multiple providers; a provider may make a direct offer.
4. Contract and disclosures. The licensed provider gives required disclosures and the settlement contract, often subject to state approval of the forms.
5. Insurer paperwork. The insurer verifies the transfer of ownership and change of beneficiary. The buyer's payment is often held in escrow with an independent third party until the insurer confirms.
6. Rescission period and funding. The seller can rescind within a period set by state law (below).

Who regulates life settlements

State insurance departments regulate life settlements, and the framework is a patchwork. The NAIC Viatical Settlements Model Act (#697) is the main template. Despite the name, it covers settlements of policies on people who are not terminally ill. A reported survey from 2009 counted 44 states and Puerto Rico with some form of life or viatical settlement regulation, and more have acted since; check your state insurance department for current rules. The National Conference of Insurance Legislators (NCOIL) adopted its own model; states draw on one or both.

Under the NAIC model (July 2009 edition):

• Licensing. A provider or broker must be licensed by the commissioner of its state of residence. Life insurance producers may act as settlement brokers if they meet the model's conditions, and some states require a separate broker license.
• A broker represents the seller. The model deems a viatical settlement broker to represent only the viator (the seller), with a fiduciary duty to the seller, regardless of how the broker is paid.
• Disclosures to the seller. In a signed, separate document, the seller must be told that alternatives exist (including accelerated death benefits and policy loans), that some or all proceeds may be taxable, that proceeds could be subject to creditors' claims, and that receiving proceeds could affect Medicaid or other government benefits.
• Escrow. The model contemplates payment into an independent escrow account before the insurer changes ownership.
• Contact limits. After the sale, the provider may contact the insured about health status only once every three months if life expectancy exceeds a year, and once a month at most if it is a year or less.
• Rescission. The seller may rescind before the earlier of 60 calendar days after all parties sign the contract or 30 days after the proceeds are paid, by giving notice and repaying the proceeds. If the insured dies during that window, the contract is deemed rescinded. States set their own periods, and some are shorter, so read your state's rule and your contract.
• Waiting periods. The model generally prohibits settling a policy within five years of issuance, with exceptions such as terminal or chronic illness, death of a spouse, divorce, retirement, disability, or the owner's bankruptcy. NCOIL's model uses a two-year period instead. See Stranger-originated life insurance (STOLI): what it is and why it is restricted.

Your state's insurance department can confirm whether a company is licensed. See insurance commissioner for how to find yours, and ask any provider or broker for its license number.

How the sale is taxed

Federal tax treatment turns on the seller's basis and the policy's cash value. IRS Revenue Ruling 2009-13 set the framework; Revenue Ruling 2020-5 updated it after the 2017 tax law (Public Law 115-97) amended section 1016(a) to say that a life insurance contract's basis is not reduced for mortality, expense or other reasonable charges.

• Basis is generally the premiums paid, with no reduction for the cost of insurance. Before the change, the IRS had required sellers to reduce basis by cost of insurance charges, which increased taxable gain.
• Gain is the sale price minus basis. Under the ruling's example, an owner sold a policy for $80,000 after paying $64,000 in premiums and recognized $16,000 of income, of which $14,000 was ordinary income and $2,000 was long-term capital gain. The ruling's footnote says the 2017 amendment does not change the character of the income. In general terms, the part of the gain up to the policy's cash surrender value over basis is ordinary income, and gain above that may be capital gain.
• Loss. If the sale price is below basis, the ruling treats a term policy sale as a long-term capital loss, but a personal loss is deductible only in limited cases.
• Reporting. The 2017 law also added information reporting for life settlement transactions (section 6050Y).
• Buyers. A buyer who pays for a policy generally faces income tax on part of the death benefit under the transfer-for-value rule, to the extent it exceeds what the buyer paid plus later premiums.
• Terminally or chronically ill sellers may qualify for exclusion treatment under section 101(g); see viatical settlements for the terminally or chronically ill.

A tax professional should model your case, because partial sales, outstanding loans and prior withdrawals change the numbers.

Costs and trade-offs

• Broker and provider compensation. The model act requires disclosure of compensation; ask what the broker will earn and how the offer compares with others.
• Lost coverage. After a sale, the death benefit goes to the buyer. Your beneficiaries receive nothing from that policy.
• Privacy. Health information is shared with providers, buyers and their agents, subject to the model act's confidentiality rules.
• Benefits and creditors. Proceeds can affect Medicaid or other need-based benefits and may be reachable by creditors; see medicaid eligibility and life insurance cash value.
• Limited market. Many policies, especially those on younger or healthy insureds, may not receive offers above surrender value.

Compare outcomes with the keep, surrender or sell your policy? before accepting an offer. See also surrendering a life insurance policy: what you get and what it costs, accelerated death benefit riders: how they work and how they're taxed, and, for a terminally ill seller, viatical settlements for the terminally or chronically ill.

Key takeaways

• A life settlement sells your policy to a third party for more than its surrender value but less than the death benefit; your beneficiaries lose the coverage.
• Providers and brokers are licensed and regulated by states; confirm the license and your state's rescission period before signing.
• Under the NAIC model, a settlement broker represents the seller, and the seller must receive written disclosures about alternatives, taxes, creditors and benefits.
• Revenue Ruling 2020-5 confirms basis is not reduced by cost-of-insurance charges, but part of the gain can still be ordinary income.
• Get several offers and compare with keeping or surrendering the policy.