A New Life For Unwanted Life Insurance Policies
Reprinted with permission of Accounting Today
Do you have clients who no longer want to maintain their life insurance policies? In the past, their only alternatives were “lapse” or “surrender.” Lapse a policy and you get nothing. Surrender it and receive only the net cash surrender value.
New options affecting life insurance may mean that your clients can do better — a whole lot better. A potential option, life settlements, now exists which may enrich policy owners with significantly greater funds.
As an accountant, you have a responsibility to apprise your clients of this option.
You may have heard of life settlements before, which are also sometimes referred to as senior settlements, viatical settlements or high net worth transactions. A rose by any other name would smell as sweet. Life settlements are the result of a secondary market for life insurance policies and may provide an exciting opportunity to be taken advantage of by some of your clients.
A few major players and many smaller investors are interested in purchasing life insurance policies that might otherwise lapse or be surrendered.
Which policies have potential for sale in this market? Those belonging to an insured party with a life expectancy of 12 years or less.
Potential buyers are primarily interested in policies covering insured parties who are in their mid-to-late 60s or older and have a reduced life expectancy due to health conditions. The ideal policy insures someone who has had a change in health since the policy was purchased. It has a net death benefit of at least $250,000. Any policy, including term that is beyond the contestable period, is fair game.
If an accountant has any clients who may be interested in life settlements, it is best to deal with reputable financial organizations. This ensures personal and medical data remain confidential.
Changing Needs, New Strategies
Individuals purchase life insurance to address a variety of financial concerns. They may be concerned about covering estate taxes or they may want to protect themselves against individual or business risks. When the reasons that prompted their initial investment no longer exist, they may no longer want or need to maintain policies.
Retirement, health problems, fluctuation in estate size or the sale of a business are all events that may impact on a decision to sell.
Situations where life settlements come into play include:
• Key person insurance — The insured party retires or leaves a business and insurance is no longer necessary.
• First to die to second to die estate planning — A single life policy purchased years earlier for estate planning purposes becomes obsolete when clients decide to buy survivorship insurance.
• Change in personal finances — The policy owner can no longer afford the policy or income replacement coverage becomes a nonissue.
• Purchase of a co‑owner’s business interest — Cash flow considerations of the purchase force the new sole owner to seek relief from costly premium payments on the seller’s life policy.
• Discount planning — A trustee of an irrevocable life insurance trust prefers to acquire a minority, lack of marketability interest in an entity that the insured party owns which may prove to be a superior investment.
• Potential elimination of federal estate taxes — There has been talk of a repeal of the federal estate and gift tax, which could precipitate a mad dash by those paying large life insurance premiums to transact a life settlement.
Without question, a life settlement can be a tremendous boon to an owner who qualifies and wants to dispose of a life insurance policy. Liquidity springs from a dormant asset. The owner saves on cash expenditures for premiums and is able to avoid gift and generation-skipping taxes. At the same time, annual exclusions and unified credits are available for other gifts. An owner who takes advantage of a life settlement has increased funds to use personally. There is also the opportunity to help family members and pursue philanthropic endeavors.
Example: How It Works
John Smith, who is 70 years old, has an irrevocable life insurance trust (ILIT) which owns a $25 million policy on his life. The annual premium on the policy is $1 million. Each year $550,000 in gift taxes must be paid. The policy has a $3.5 million cash surrender value. John has a four-year life expectancy. The ILIT decides to sell the policy for $14 million through a life settlement.
Q: Why did the trustee sell this policy when John was expected to die in four years? A: To acquire an interest in a closely held business owned by the insured party.
Because the ILIT was designed to be an intentionally defective grantor trust (as to income taxes, not estate taxes), the entire $14 million was available for purchase. The insured party's lawyers determined the trustee could use the $14 million life settlement proceeds to purchase an interest that had an underlying value of $22 million (due to discounts permitted in the valuation of the asset).
The business had posted annual growth between 18 percent and 23 percent for seven consecutive years. Assuming continued 20 percent yearly growth for the next four years, John will have, in effect, removed a $46 million asset from his estate. In addition, $4 million in premiums and $2.2 million in gift taxes will be saved.
The proceeds of a true viatical settlement where the insured party is expected to die within 24 months are not generally subject to federal income tax.
However, there are exclusions to the general rule when the owner is someone other than the insured party. If that owner has an insurable interest because the insured party is an employee, officer or director, proceeds are taxed as though the policy is a life settlement. The same tax implications exist if the owner has a financial interest in the insured party.
Nonetheless, tax treatment of a life settlement is very favorable. While there is no official interpretation of tax treatment for life settlements, one national accounting firm has interpreted the tax code such that proceeds up to basis generate no tax exposure. Ordinary income tax liability exists on the difference between the owner’s income tax basis and the cash surrender value.
Moreover, capital gain treatment applies for proceeds in excess of the greater of tax basis or cash surrender value. Potentially, the IRS could interpret the tax code such that excess gain would be taxed as ordinary income — a worst case scenario that most sellers are willing to live with. What the client will want to know is whether he or she will realize a higher net after tax sum through a sale, surrender or lapse. The life settlement is a vehicle that has the potential to deliver higher profitability.
Here’s an example of a life settlement and its tax implications. Let’s suppose the insured party has a policy for which the cash surrender value is $500,000. A life settlement for that policy pays $1 million. The insured party’s income tax basis is $300,000. Under this scenario, tax implications are as follows:
• $300,000 is a return of basis;
• $200,000 is taxed as ordinary income; and
• $500,000 is taxed as a capital gain.
If capital gain taxes are due, the seller receives $400,000 more than if the policy is surrendered. If the $500,000 is taxed as ordinary income, the seller still realizes approximately $300,000 more than if the policy is surrendered. A tidy profit indeed.
Making It Happen
The process to underwrite a life settlement requires an application, a copy of the policy and an in‑force illustration assuming a zero cash surrender value at 95. The elements of the underwriting process include an annual policy statement, executed medical authorization forms, medical records for the previous two years and a family health history. No medical examinations or blood samples are required.
The insured party can expect that the price of the policy will escalate as his or her life expectancy decreases. The lower the ratio of premium to face amount, the higher the purchase price.
The underwriting process can take up to eight weeks. The escrow process following policy owner acceptance takes approximately five to 10 days. The seller can elect to have the purchase price wired or expressed.
Life settlements are part of a new secondary market. They present an excellent opportunity for a limited segment of the population.
Accountants can strengthen their advisory position and help clients who are potential prospects for life settlements by making sure they are informed. Accountants should then select an expert who has access to the major players in this specialized market to ensure that the client gets top dollar when it comes to selling. The expert will ensure an auction environment where the highest bidder wins.
And when the highest bidder wins, so does the accountant and the client.
Bio: John E. Mayer is president of BFA® Family
Wealth Planners, a registered investment advisor firm with offices in