Viatical Settlement vs Life Settlement
When the owner of a life insurance contract decides to sell their policy to a 3rd party investor, this transaction is known as a life settlement. You may have heard a few different terms for this type of transaction, and may be doing a bit of research. We’ll explain the difference between a life settlement vs viatical settlement.
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Viatical Settlement vs Life Settlement
The law which allows for the ownership of a life insurance policy to be transferred to a 3rd party was passed in 1911, but viaticals did not come about until the 1980s during the AIDS epidemic. People who had contracted HIV were given a terminal diagnosis, and if they owned a life insurance policy they could sell it to access cash to help pay for medical treatments and living expenses.
To define viatical, it is the more traditional term in this type of transaction, and refers to a settlement where the insured has a terminal diagnosis of 24 months or less to live.
As we all know, the treatments for HIV have improved dramatically since the 1980s, and people with this diagnosis are living much longer lives. In the 1990s the viatical settlement market cooled off a bit until the early 2000s when it was apparent that seniors with permanent life insurance policies were living longer and having trouble keeping up with their premiums and were lapsing their policies. The market for buying and selling existing life insurance policies was expanding beyond the terminally ill and now included seniors, so the term senior settlement has been used for these types of cases as well. The term, Life Settlement, is actually an all encompassing term that covers both viaticals and senior settlements, but the term viatical is still used in terminal cases.
Life settlements have been viable alternative investments within the U.S. for more than a century, and they can provide diversification and solid returns. Yet awareness of them has only recently started to increase. (2)
Info on Viatical vs Life Settlement
In the early 2000s and onwards, the life settlement market started to take off as investor capital began to enter the marketplace. In the early days, in order to be considered for a case the policy had to have a death benefit of $500k+, and the insured had a life expectancy of 8 years or less. This restricted a lot of policy owners from selling their policy, making the market a bit limited to the more affluent families in America. Since then, however, far more investors have entered the market, and will buy policies as small as $100k and have a life expectancy as long as 20 years when the premiums are still low enough for the investment to make sense.
The standard qualifications to sell a policy these days are the insured is age 65+ and the death benefit is $100k+. Anything smaller becomes too small for investors to spend the time and money on something they might only make a few thousand dollars on. And age wise, for a 65 year old with some health issues and a well priced policy, they may get some offers, but if they’re in great health and the policy is pricey, the investor has to assume that person may live until age 95 or older, which is too long to invest. Age 70 and up tends to be more likely to get offers.
Life Settlement vs Viatical Settlement
Even though the term life settlement is more commonly used today as it is an all encompassing term, the main difference today between life settlement vs viatical is how it is taxed. When we’re talking about a policy where the insured is terminally ill, we still classify it as a viatical. In our industry, terminally ill typically means the insured has less than 24 months to live, and ultimately it is the underwriter and life settlement provider that makes this determination, not the insured or their doctor. Oftentimes a doctor may say things with a diagnosis such as - if this goes untreated you may only have 12 months to live. They're recommending treatment to prolong your life, which may prolong it significantly. The investor has no control over whether or not you take the treatments, and has to assume you will. This is an example of why the underwriter decides if it's a viatical settlement vs life settlement.
Life Settlement Option is a life settlement broker solution, and we are not tax professionals, but part of our licensing education provides basic information on how life settlements are taxed, and I will share my limited knowledge as general information not as legal advice; you must consult with a legal tax professional when filing your taxes.
OK, now that I've disclosed that I'm not a legal tax advisor, the profits made on a life settlement are subject to long term capital gains, and the way that is calculated is by establishing your tax basis and subtracting the life settlement amount. If that leaves you with a positive balance you may owe taxes on it. In the case of a life settlement, your tax basis is your cost of insurance paid to date. If you’ve paid $100k in premiums over the years, and you receive a life settlement for $90k, you should not owe any taxes as you have not profited from the settlement. On the other hand, if you’ve paid $100k in premiums and receive a settlement for $150k, then the additional $50k in profit is considered and taxed as long term capital gains.
Expect to receive a 1099 from the investor who purchased your policy, and request a report from your insurance carrier to show how much you’ve paid in cost of insurance to date. The difference with life settlement vs viatical is that a viatical is a non-taxable event. So even if you end up profiting in the settlement you do not owe taxes on it because you are considered terminally ill. If someone is 98 years old but hasn’t been given a terminal diagnosis, the reality is that this will not be considered a viatical because the insured very well may live to age 103 at this point unless they have specific health conditions that say otherwise.
Death Benefits and Application To You
A lot of life insurance policies today have an accelerated death benefit rider which allows people to access some of their death benefit if they are terminally ill, so you may be wondering why someone would do a viatical settlement instead of leveraging that rider? There’s a couple answers to this, including the fact that many older policies do not have this rider on it. But mainly, the accelerated death benefit rider is typically only accessible with a diagnosis of 12 months or less to live, while the viatical gives them up to 24 months to live. It’s possible they may need money for treatments to stay alive for 24 months, and need cash to help pay for that. They may have bucket list items they wish to experience in their final years, and can live it up with a significant amount of cash to do so. Doing a viatical often yields up to 70% of the death benefit on a policy, which may be worth it if it means the insured will get to take advantage of living benefits.
Options You Might Have
Aside from viaticals, life settlements make sense for many other scenarios. Unfortunately a lot of universal life insurance policies have under performed over the years. The safest type of policy is a Guaranteed Universal Life policy as the premium will be fixed and guaranteed throughout the life of the insured, but they appear to be a lot more expensive than a regular universal life plan when you’re first applying. The traditional universal life plans do not have the same guarantees, meaning it’s possible that your future cost of insurance will be higher than it was projected if outside economic environments such as low interest rates affect insurance companies’ investments, solvency, and profitability. In other words, many policies pre 2008 were over projected and have under performed, and policy owners have had to pay more in premiums than they anticipated, and some may not be able to afford the increases. When they get to a point where the premiums are just too high, even if they have another 5 or 10 years, a life settlement may be their best option to recover some or all of their investment in their policy.
Universal life policies offer a lot of flexibility, which can be great for the consumer, but can also get them into trouble. Traditional universal life policies have a cash value account that earns interest over time. This cash can be borrowed in a loan that does not need to be paid back, and it can also be used to help pay future premiums. Both of these scenarios can present problems to policy owners as these policies have an increasing cost of insurance with age. So the older you get, technically the more expensive your premiums should be. You can structure these plans so that you pay a level premium, increasing the balance on your cash value account to help offset future increases in premiums. Your cash account is there to make up the difference from the premium you pay and your cost of insurance, but if it’s not funded enough, the balance starts to shrink every time you pay your premium until eventually there is nothing left. When your balance is nearly $0 your next premium amount will be significantly more than you’re used to paying, and you may not be able to afford it.
What’s challenging about this scenario is that in a lot of ways it allows policy owners to mismanage their policy and guess how long they’re likely to live. If they’re retired and on fixed income, they may decide to skip paying their premiums entirely because they have cash accumulated in their policy to cover it, and this is totally fine to do, but it also means your cash account will reach that $0 balance even faster. If you’re still living when this occurs you will face a very large premium to keep your policy in force for another year. If they're still paying premiums, maybe they're only paying enough to carry the policy to age 85, but when they're 86 and still living their cash will have run out and they'll have a very large premium to keep the policy in-force.
In summary of these examples, when you’re used to paying $10k a year for the last 20 years because that was the amount necessary to carry your policy to age 100, but the insurance company has under performed on their projections and now needs you to make payments of $20k a year to make up the difference and keep it in-force, many folks just may not be able to afford that, so a life settlement might be their best option.
And in the second scenario, you’re used to paying $10k a year for the last 20 years, and now that you’re age 70 and on fixed income, you have accumulated cash in your policy to cover your premiums so you just skip paying them for a few years. Now you’re 78, you’re out of all that cash, and the insurance company is requiring a premium payment of $30k just to cover this year’s cost of insurance. Again, for most people this number is just too high to cut a check for another year of insurance, and a life settlement not only relieves them of this financial burden, but also provides living benefits for which they may use as they like.
The biggest thing to consider when determining if selling your policy is right for you is whether you need the coverage. If someone needs their life insurance coverage and can afford it, they shouldn’t sell it. Life settlements are for people who either no longer want or need their coverage or simply cannot afford it any longer. (1)
Supplement Your Retirement
A few ways people use the proceeds from a life settlement is to help supplement their retirement. Others use it to afford the long term care that they need. You may also remodel your kitchen, buy a vacation home, get a new car, or distribute wealth while you are still living. The benefits are endless when compared to lapsing your policy or surrendering it for a few thousand dollars.
Considering a life settlement offer can be an emotional process. After all, you’ve been paying into a policy with a certain death benefit for years. For example, let’s say the death benefit is $500k, and your current premium is $25k a year, and you’re aged 75 and in average health.
The underwriter believes you are likely to live until age 85, another 10 years, so an investor is going to see right away that they’re likely going to pay $250k in premiums over the next 10 years. They make you an offer for $50k, which sounds almost insulting at first when compared to $500k and they must be getting rich off of you.
Many policy owners think only of the death benefit amount and not how much it costs before it is paid. If you hold onto the policy for another 10 years, based on a zero balance today, your profit on this policy will be $250k, not $500k because you will likely spend another $250k in premiums to get $500k. In essence you are doubling your money, but it will cost another $250k to do that.
If you keep the policy instead of selling it for $50k you will have $25k less in your savings this year from paying the premium. If you accept the $50k, technically by comparison you just increased your savings this year by $75k because you will not be making that $25k payment. Add in next year’s premium and now you have $100k more than if you had held onto the policy and continued paying the premium. Fast forward 10 years and if you’re still living you will have $300k more in your savings than you would have if you kept the policy at this point. Yes, if you still had the policy you’d still be looking at that $500k payout for your loved ones so you would get back that $250k you paid in premiums plus another $250k in profit on the policy, but the alternative of selling it actually yields a lot more money in your pocket than just the purchase price because they are also relieving you of your financial obligation to pay the premiums.
To recap, in one scenario you’re likely going to spend another $250k over 10 years to double your money. In the other scenario of selling it, you have $300k more in your savings account than you would have if you kept it and are still living. No, you won’t double your money, but you will have a lot more liquidity over the next 10 years.
If you have significant liquidity and don’t have a problem writing a $25k check every year, maybe you’re better off keeping it, but for most families a $25k annual premium is a pretty big expense on their annual budget. You may also decide that you don't need the coverage anymore and would rather invest that money in something you have more control over. Keep these concepts in mind when reviewing your offers. We are willing and able to help answer any other questions you might have, a common question we get refers to what does liquidity refer to in a life insurance policy? Check out our other resources or give us a call!
Zack Taylor
4 years in life settlements