Life Insurance Settlements: Investors' Profit And Investment Reporting

Life settlements, or the sale of life insurance policies to third-party investors, have become an increasingly popular source of retirement income for aging Americans. This is largely due to the extra retirement income generated by selling a life insurance asset for a good price. For investors, life settlements are an attractive prospect because they are not correlated to stocks, bonds, or the overall performance of the economy, and they deliver strong returns at a low risk. However, investors in life settlements are faced with high transaction costs and uncertain timelines, as the insured's life expectancy is unknown.

Life settlement funds: Pros and cons

A life settlement is the sale of an existing life insurance policy to a third party, such as an investor or provider, in exchange for a one-time cash payment. The payment is typically more than the surrender value of the policy but less than the death benefit. The buyer then assumes payment of the policy's premiums and receives the death benefit when the insured dies.

Pros

• The life settlement payment is higher than the cash surrender value of a policy.
• The cash payout is higher than the accelerated death benefit.
• The cash from a payout can be used however you want.

Cons

• Your beneficiaries won't get a payout when you die (unless you retained a portion of the death benefit).
• The payout might prevent you from qualifying for Medicaid or other assistance programs.
• Proceeds from the sale of a policy are likely to be taxed.

When considering a life settlement, it is important to weigh the pros and cons carefully and ensure that you are getting a fair deal. Here are some additional factors to consider:

• The difficulty of determining a fair price: It can be challenging to know if you are getting a fair price for your life insurance policy. It is recommended to shop around, contact multiple life settlement companies, or use a licensed broker who will shop your policy around on your behalf.
• Impact on your finances: The lump-sum payment received from a life settlement may be taxable and can negatively impact your eligibility for state or federal public assistance, such as Medicaid.
• Impact on your survivors: Consider your current income needs against the future financial needs of your survivors. Even if your survivors do not currently need the proceeds from your insurance policy, their situation may change.
• Privacy concerns: Selling your life insurance policy may require you to disclose personal information, including your health status, which can be shared with the buyer and other entities.
• High transaction costs: Life settlements can have high transaction costs, and brokers who sell them can receive substantial commissions. Be sure to ask about any fees and charges before proceeding.

How to get started as a life settlement investor

Life settlement investing is a growing alternative investment option, where an investor purchases an existing life insurance policy from the original policyholder in exchange for a lump sum of cash. The investor then becomes the beneficiary of the policy and is responsible for paying the premiums. When the insured person passes away, the investor receives the death benefit.

• Understand the life settlement market and its regulations: Life settlements are regulated at the state level, usually by the state's department of insurance. It's important to familiarize yourself with the specific laws and requirements of the state(s) in which you plan to invest.
• Connect with brokers or providers: Life settlement brokers or providers can help you identify and participate in life settlement acquisitions. They can guide you through the process and ensure you are complying with all relevant regulations.
• Carefully analyze each policy before investing: As a life settlement investor, it's crucial to thoroughly evaluate each policy before making an investment decision. Consider factors such as the insured person's age, health, and life expectancy, and the terms and conditions of the policy.
• Consider the risks and returns: Life settlement investments offer strong returns with relatively low risk. The primary risk is longevity risk, as the investor's return depends on the insured person's life expectancy. If the insured person lives longer than expected, the investor may need to pay additional premiums, reducing the overall return.
• Decide on the type of investment: You can choose to directly purchase individual life insurance policies or invest in a life settlement fund, which owns and maintains a portfolio of policies. Direct purchases offer more control and potentially higher returns, while funds provide diversification and lower risk.
• Conduct due diligence: Before finalizing any investment, conduct thorough due diligence on the policy, the insured person, and the broker or provider. Ensure that you have access to all relevant medical and personal information, and be aware of any ongoing health or personal issues that could impact the investment.
• Understand the tax implications: In most cases, the cash payment received by the original policyholder is primarily tax-free. However, as an investor, it's important to understand the potential tax implications for yourself and the policyholder, as well as any impact on public assistance programs such as Medicaid.
• Be aware of privacy considerations: Life settlement investments involve accessing sensitive personal and health information about the insured person. Ensure that you are complying with all relevant privacy laws and regulations, and only share information with authorized parties.
• Monitor the investment over time: Once you have acquired a life insurance policy, it's important to stay updated on the insured person's health and any changes in their life circumstances. This can help you manage your investment and adjust your expectations accordingly.

By following these steps and staying informed about the life settlement market, you can make well-informed investment decisions and potentially achieve strong returns while also providing liquidity to policyholders in need.

Taxation of life settlement investments

Life settlements are taxable to the extent that a profit is made. The IRS considers "profit" to be the difference between the premiums paid and the cash payout received from the sale. Some of this profit is taxed as ordinary income, and some is taxed as capital gains, depending on how the cost of the policy compares to the policy's cash surrender value when sold.

Prior to 2018, the IRS's approach to calculating profit on life settlement contracts was vague, which discouraged many seniors from pursuing the sale of their life insurance policies. The Tax Cuts and Jobs Act of 2017 (TCJA) simplified life settlement taxation. Today, the profit on a life settlement is defined as the difference between the premiums paid and the cash payout received from the sale.

Under the TCJA, whole life settlements and policy surrenders now both use the total premiums paid as the cost basis for the transaction. This streamlines the calculations and lowers the overall tax bill. The three-tier tax structure is as follows:

• Sale proceeds up to the amount of the cost basis are not taxable.
• Sale proceeds above the cost basis and up to the policy's cash surrender value are taxed as ordinary income.
• Any remaining sale proceeds are taxed as long-term capital gains.

State taxes may also apply to life settlement transactions. There are three general scenarios:

• The state taxes capital gains as ordinary income.
• The state offers preferential tax treatment for capital gains.
• The state levies no income taxes or capital gains taxes.

It is important to consult with a tax professional to determine the specific tax consequences of a life settlement, as tax law is complex and individual circumstances may impact the tax treatment.

Life settlement investment risks

Life settlement investments can be risky for investors. Here are some of the key risks to consider:

Regulatory Risk

The rules and regulations surrounding life settlements are constantly changing and vary by state. This means that investors may be exposed to unforeseen risks. For example, the Washington State Securities Division has received inquiries about whether people who are not licensed as securities salespersons or broker-dealers can sell life settlement investments to customers.

Investment Risk

There is a risk that the underlying life insurance policies do not perform as expected. For example, the insured person may live longer than expected, reducing the investor's returns. In this case, the investor may also need to pay additional premiums to maintain the policy.

Longevity Risk

Longevity risk refers to the possibility that the insured person will live longer than expected, reducing the returns on the investment. This is the primary risk faced by investors, as the insured's life expectancy is uncertain.

Credit Risk

Life insurance policies that are sold to investors are often bundled into a pool, and the creditworthiness of this pool will depend on the creditworthiness of the individual policies. If one of the policies in the pool underperforms, it could impact the overall creditworthiness of the pool.

Fraud Risk

There is a risk of fraud in the life settlement industry. For example, policies may be issued or sold fraudulently, or sales agents may not disclose all the relevant information to investors.

Tax Risk

While the cash payment received by the insured person is usually tax-free, a portion of the proceeds from the sale of a life insurance policy may be taxable. This could impact the overall profitability of the investment for the investor.

Impact on Public Assistance

The lump-sum payment received by the policyholder in a life settlement may negatively impact their ability to receive state or federal public assistance, such as Medicaid. This could create financial difficulties for the policyholder and potentially lead to issues for the investor.

Life settlement investment returns

Life settlements can be a profitable investment, with industry experts quoting returns of 7 to 11% annually. However, investors entering the life settlement business often seek returns of 8% to 14% IRR. These higher returns are achievable with a carefully planned strategy for purchasing and maintaining a portfolio. The current market price of a life settlement will impact investment returns, and prices fluctuate due to supply and demand, available capital, and other market conditions.

Several factors influence investment returns:

• Premium: The cost of the premium is a major expense in maintaining a life policy. The premium includes the minimum cost of insurance and other fees to keep the policy active. Typically, investors aim to keep premiums to a minimum to maximise returns.
• Purchase price: The price paid for the life policy significantly affects investment returns. A higher purchase price will likely result in lower returns, while a lower purchase price can increase returns.
• Life expectancy: The life expectancy of the insured person is one of the most critical factors in determining investment returns. If the insured lives longer than expected, investment returns will decrease, and vice versa.
• Face value: The face value is the total payout upon the insured's death. As an investor, you can choose policies with face values that align with your investment goals. However, it's important to consider that some costs associated with life settlement transactions are fixed, regardless of the policy's face value.

It's important to note that life settlement investments carry certain risks and considerations. The timeline of returns is uncertain because the insured's life expectancy is an estimate. Additionally, regulatory requirements may vary across states, adding complexity to the investment process.

Frequently asked questions