Life Settlement & Viatical Contracts

A life settlement is the sale of a life insurance policy to a third party for a value in excess of the policy’s cash surrender value, but less than its face value, or death benefit. The policy owner receives a cash payment, while the purchaser of the policy assumes payment of future premiums and receives the death benefit upon the death of the insured. A viatical contract is essentially the same thing, but the term is generally used in reference to the sale of life insurance by a terminally ill owner.

The sale of life insurance by a terminally ill policy owner (a viatical contract) is well known and well understood by the public. The idea is that the terminally ill policy owner needs the cash for immediate needs (not for his funeral), and the buyer can expect to get a return on his investment relatively soon.

There can also be many good reasons for the owner of a life insurance policy who is not terminally ill to sell the policy to an investor in a life settlement. For example, things change. If the policy was originally acquired to provide a death benefit, protecting spouse and children in case of an early death, and if the need no longer obtains, then the owner might decide the money would be more useful during life than after death. Or, an unexpected urgent need for cash might arise, for example, from an injury or illness in the family, or from an uninsured family business crisis. Or, what often happens is that premium payments become too burdensome. For example, in many whole life and term life insurance policies, the premium amounts can become un-affordable with limited income, or simply no longer make economic sense.

One of the best available solutions in such cases is for the policy owner to sell the policy to an investor. Depending on the facts, the seller of the policy can get significantly more than the cash value of the policy. Even if there is little or no cash value in a policy, there can still be value for a buyer. For example, a term life insurance policy has no cash value. If the policy is “convertible”, that is, if it can be converted to a “permanent” policy, it might be a good long-term investment for the buyer.

Investors know that sooner or later the insured will die. Based on the age and expected life expectancy of the insured, the policy’s face value (death benefit), and the costs of future premium payments, an investor can make an offer that benefits both buyer and seller.

Life settlement 2.0. Another version of life settlement contracts involves the sale of the cash-value aspect of a permanent policy, while the insured keeps the death benefit. This unique transaction enables the owner of a life insurance policy to keep the death benefit for the rest of his life, yet never again pay a premium to maintain the policy. This could be very useful for a policy owner who can no longer afford premiums, or simply does not want to pay them, but who would also like to keep the death benefit to protect his family or to pass on as a legacy to his heirs or charity. Under circumstances, the investor even pays off policy loans as part of the purchase transaction. Why would an investor buy the cash-value building aspects of a policy, and not the death benefit? It is because a cash-value policy provides steady, reliable, risk-free, no-volatility growth better than bonds, which would otherwise be the alternative for conservative investors. So, the investor is happy to let the seller keep the death benefit.

In any case, no owner of a life insurance policy should surrender a policy, much less allow a policy to lapse, without first having the policy evaluated for a life settlement.

Taxation of Proceeds from Life Settlement and Viatical Contracts. Proceeds of a life settlement are taxed in a manner similar to other investments, that is, a return of basis is not taxed, while gains are taxable. Basis would be the amount of premiums paid in, minus the value of any benefits previously received. In contrast, if a contract meets the definition of a viatical contract, proceeds are treated as a death benefit. A death benefit from life insurance is always received tax-free. The federal definition of a viatical for federal tax purposes may be different than a state definition for state tax purposes. In any case, a general requirement to qualify for treatment as a “viatical” is that the insured is “terminally ill”, that is, is reasonably expected to die within two years.