Life & Viatical Settlements
Chapter 3
Life & Viatical Benefits
Traditionally, life insurance policy owners were limited to just two options when they wanted to get out of their insurance policy:
They could allow their policy to lapse, often receiving nothing, or
They could surrender their policy receiving its net cash value.
In the past few years, however, secondary markets for life insurance policies have created another option for terminally ill life insurance policyholders: viatical settlements (sometimes also referred to as “life settlements” or “senior settlements”). Life or viatical settlements allow life insurance policyholders to obtain substantially more than they might ordinarily have received under the two previous options.
An informal secondary market in life insurance policies has actually existed for a long time in the sense that it was not uncommon for terminally ill policyholders to borrow money from relatives or friends, using their life insurance policies as collateral on the loan. In some cases, policies were even sold outright to third parties with no insurable interest. No one in authority took notice since it was not done frequently enough to be considered dangerous to the industry.
This secondary market became significantly more formalized with the development of the viatical settlement industry in the late 1980s, at a time when the Acquired Immune Deficiency Syndrome (AIDS) outbreak seemed to be quickly approaching epidemic proportions. At that time, some AIDS victims found themselves in a situation where they had very high medical costs, very few assets other than a life insurance policy, and a very short life expectancy. In response to the financial needs of this particular population, viatical settlement companies stepped forward and offered some financial relief when no other industry was willing to.
In late 1996 researchers at the World AIDS Conference presented information showing that the use of protease inhibitors and other modern pharmaceutical medications were having a significant impact on the ability to prolong the lives of many AIDS patients. As a result, viatical settlement investors soon began focusing on life insurance policyholders who were terminally or chronically ill with other deadly diseases, such as heart disease, cancer, Alzheimer’s disease, stroke, and sometimes just plain old age. This changed the focus of life and viatical settlement contracts, eventually leading to state regulation when viatical abuses became significant.
Today, the viatical settlement industry has grown considerably. Between 1991 and 2000 viatical settlement contracts increased from $90 million to approximately $1 billion. According to a May 2006 Bernstein Research report titled “Life Insurance – Life Settlement Update – What a difference a year can make”, the life settlement market is expected to become an estimated $160 billion industry. In 2004 the viatical market produced $5 billion in transactions, with that doubling to $10 billion in 2005. It seems to be one of the fastest growing industries.
About the Viatical Industry
It is important that viatical representatives understand the product prior to representing viaticals, just as it is important that policy owners understand what to expect when selling their life insurance policies. Just as we must read contracts prior to signing them, participants in the viatical industry must do the same.
The viatical industry has three participating groups: viators, viatical brokers and viatical providers. Viators (policy owners) deal with the viatical brokers and viatical providers.
Viatical brokers handle all aspects of viatical transactions. Since brokers represent the policy owner, they usually remain in contact with the policy owner throughout the viatical purchase process. Viatical brokers generally provide multiple offers so viators are not burdened with personally having to seek them.
Viatical providers are the companies that represent the institutional funding groups. It is the providers that determine monetary offers and manage the life insurance policy after it is sold, and ownership has been transferred.
Tax Issues
We always hesitate to provide any tax-related information since tax laws change and some laws apply only under specific conditions. Therefore, the reader assumes all responsibility for staying abreast of tax laws; this course is not intended to provide any tax or legal advice. Nor should this course be used in any financial planning capacity. Each person must know their personal state’s laws.
Since proceeds from viatical settlements are considered personal income, another issue that certainly needs to be addressed is the related tax implications. Originally proceeds from viatical settlements were treated as ordinary income and taxed accordingly. However, in the mid-1990’s, Congress changed that.
The federal Health Insurance Portability and Accountability Act (HIPAA), which passed in 1996, allow individuals to exclude most viatical settlement proceeds from gross income. Proceeds from viatical settlements are treated as income received by reason of the insured’s death. However, the exclusion is available only to individuals who are terminally ill from a medical condition that could reasonably lead to their death in 24 months or less. Furthermore, the terminal nature of the condition must be certified by a physician. Likewise, chronically ill individuals also may be able to receive a tax break under HIPAA. A “chronically ill individual” is defined in the Internal Revenue Code as:
Being unable to perform at least two activities of daily living (eating, toileting, transferring, bathing, dressing, and continence) for a period of at least 90 days;
Having a certain level of disability as prescribed in the federal rules by the Secretary of Treasury, in consultation with the Secretary of Health and Human Services; or
Requiring substantial supervision due to severe cognitive impairment. Unlike those who are terminally ill, the health status of the chronically ill individual need only be certified by a licensed health care practitioner (as opposed to a physician).
Conflicts of interest can develop, so it is important that the viator consider all who might be affected prior to considering the sale of their policy. In the beginning, one of the most commonly seen issues in the viatical settlement industry involved health care professionals who worked directly with the viatical settlement companies. Whenever a caregiver becomes financially linked to the viatical settlement industry, there is a concern that a conflict of interest will occur, putting the investor at a disadvantage. Full disclosure of the potential for these types of conflicts of interest is essential in enabling the potential investor to make informed investment decisions. Of course, such relationships could also affect the confidentiality of the insured, since the caretaker would know his or her patient’s identity, medical, and financial situation.
Viators with Less than Two Year Life Expectancy
This course is not intended and does not offer any tax advice. We strongly urge anyone participating in a viatical settlement to seek their personal tax advice from a tax expert. Tax laws may change at any time. Generally, however, any viator who is estimated to have a life expectancy of less than two years receive their viatical settlement proceeds federal tax free. Life expectancy is determined by third party underwriters companies use to determine the insured’s estimated mortality. In many states, such as New Jersey, New York, and California, there are also no state taxes due. Again, the best advice is to seek a tax advisor in the state of domicile to gain information on the specific state requirements and tax laws.
The following example of a viatical settlement shows a typical case:
Death Benefits: $250,000
Cash Surrender Value: None (term policy)
Premiums Paid: $5,000
Settlement Amount: $122,500
Our example policy has no cash values since it is a term life policy so the policy owner would not receive any cash values by surrendering it. The owner received $122,500 instead of letting the life insurance policy lapse. Even if it was a cash value policy, however, the values in the policy may have been less than what could be received by selling the death values and transferring policy ownership. In this case, the entire settlement is received tax free. However, we are not saying that this will always be the case. Each person must know their own state laws.
Two to Five Year Life Expectancy Estimate
There is usually capital gain taxes involved in viatical settlements when the insured individual is estimated to live longer than two years. Since the time of death (policy maturity) is estimated, of course there is no way to guarantee life expectancies, but viatical firms using sound underwriting will come fairly close.
In this example, the cash surrender is less than the premiums paid on the policy. In other words, the insured already paid more into the policy than he or she will receive if the policy is surrendered and the cash values taken. Even though the settlement amount is well below the death benefit, for individuals needing cash and terminally or chronically ill, the amount is likely to be considered as fair.
Death Benefits: $250,000
Cash Surrender Value: $10,000
Premiums Paid: $23,000
Settlement Amount $60,000Settlement Amount: $60,000
Premiums Paid: $23,000Taxable Amount: $37,000 Capital Gain
Although $37,000 of the settlement will be taxed, the policy owner still receives money he or she would not have otherwise had.
Life and Viatical Settlements
While it is very important that viatical and life settlement participants understand the risk involved, these contracts can be beneficial, as AIDS patients discovered in the 1980s.
Many professionals have recommended life and viatical settlements to seniors who apply the transaction proceeds to their financial planning strategies. Selling unwanted and often unneeded life insurance policies have allowed our senior citizens to give to charities, purchase more suitable life insurance coverage (if an insurance need still exists) and pay for specific medical needs, such as nursing home care.
We often think of the terminally ill profiting primarily from life and viatical settlements, but businesses are also using them by selling company-owned life insurance policies. This was previously an untapped market. The policies that are sold are usually ones that were placed on key employees no longer working for the company, due to their advanced age or medical situation. Since life insurance policies often carry a low surrender value, selling the policies typically brings in more immediate cash than would otherwise be available from the policy.
If not terminally ill, life and viatical settlement contracts are not realistic for every policy owner. They are generally most suitable for well-to-do people who are at least 65 years old. So far, the policies have been primarily written on men, with those 72 and older most likely to be the contract sellers. When women sell their policies, they are most likely to be at least 75 years old. Of course, those who are terminally ill may be any age.
Although it depends on the viatical company, the minimum face value that will be accepted is often as high as $250,000. The average policy sold is closer to $2 million. However, viatical companies are increasingly accepting policies with lower face values, perhaps as low as $50,000. Although smaller policies are now being purchased, professionals often feel policy owners receive greater benefits when the face values are higher.
Universal life policies are the most common type of policy that is settled, but all types can be sold. Variable life policies are expected to enter the viatical settlement market in greater numbers as more broker-dealers open life settlements to their security-registered representatives.
While companies vary, most viatical and life settlement firms prefer policies from only highly rated insurance carriers. Each company will have its own guidelines and investors will be wise to check the issuers rating before investing in a life policy. Individuals selling viatical settlements should also know the rating of the company in order to fairly represent the product to investors.
Since viatical settlements developed a bad reputation in the investing community in the 1990s, states have generally adopted some form of regulation for viatical settlements. Now they are also adopting regulation for stranger-owned life insurance, as that form of investing gains substantial growth. Even so, a 2002 study showed that among hospice financial counselors who had experience with viatical settlements, most thought it was a positive experience. There is obviously a place for these contracts as long as they are bought and sold in an appropriate manner. Sellers receive more than the policy’s cash surrender value, so they are generally happy. Buyers pay less than the actual death benefit so they are also happy. Investors may or may not be happy, depending upon the outcome of the investment.
Life or viatical settlements provide a liquidity that would not normally exist on a life insurance policy. Policy owners might otherwise have allowed their policy to lapse, receiving only what cash values happen to exist in their contract.
Client Qualifications
While there may be differences among companies, the basics tend to be universal. Generally, all types of life insurance qualify, including term policies. Any person or business who owns a policy can request an appraisal with the goal of selling the contract, as long as they are the legal owner. It is important to note that usually only the policy owner may sell it. There are basically three general requirements that need to be met in order to receive a policy appraisal, which determines whether or not the viatical firm will purchase the life policy.
Requirement #1:
The life insurance policy must have been purchased no less than two years ago before it can be used in a viatical settlement. That is because insurance companies put a two year contestability period on all life insurance policies. Any reputable funding source in the viatical industry will not purchase a policy during this contestability period. Doing so would put the viatical settlement investors at risk, since the insurer could refuse to pay death proceeds with cause.
Requirement #2:
The life insurance policy must have a face amount that meets the viatical firm’s size requirement. Many are accepting smaller policies, such as $20,000, but it should not be assumed that all companies will do so. The face value is the amount that will be paid by the insurance company upon the insured’s death (the death benefit). There is generally no maximum face value that can be purchased. Viatical funding companies have pricing models fit around fixed returns on purchasing policies.
Requirement #3:
The insured must have some type of life threatening illness, such as AIDS or cancer, or be owned by an individual with advanced age. If the insured has no life threatening illnesses or is still young, the viatical firms cannot determine how many premiums might be needed to have an estimate of when the policy will mature. In viatical settlements the “maturity date” is the date of the insured’s death. This date is vital to obtaining investors.
Illness Creates a Need for Cash
Viatical settlements were initially created to meet the financial need of AIDS victims, but any type of terminal illness may apply to viatical settlement contracts. Generally, the policy owner takes part in a viatical settlement because he or she wants to pay medical or other bills, eliminate debt, enjoy the final months or years of their life, or simply enhance the quality of their remaining life.
How does a terminally or chronically ill person learn of viatical settlement opportunities? In the past health care workers, or even the individual’s attorney, may have informed the insured of their existence. Today, it is likely an advertisement will be the instrument alerting the policy owner to viatical companies.
Once a policy owner becomes interested in viatical settlements, he or she will likely call the company sponsoring the advertisement. The states and other professionals highly recommend individuals interested in participating in a viatical settlement check with multiple companies prior to signing over their life insurance policy. The insured will get a percentage of the death benefit soon after the policy ownership is transferred. While the percentage is less than his or her beneficiaries would have received upon his or her death, at this point the policy owner is more interested in receiving cash than leaving an inheritance. The amount received is typically more than the policy’s surrender value so policy owners are satisfied with the reduced death benefit they receive.
A viatical settlement might be compared to selling an asset that would normally be considered illiquid. Instead of selling their home or car the policy owner sells his or her life insurance policy. Doing so also reduces household expenses by the amount of the premium since the viatical company will take over that cost.
There are more news articles against viatical settlements than for them, but that does not necessarily mean viatical settlements are a poor choice. However, it is important to investigate the quality of those selling the product, underwriting them, and handling the investments. The states either have or soon will be implementing legislation because of past viatical and life settlement abuses.
United Insurance Educators, Inc.