Life settlements

What a life settlement is

A life settlement is the sale of an existing life insurance policy by its owner to a third party for a cash payment that is more than the policy's cash surrender value but less than its death benefit. At closing, ownership and beneficiary rights transfer to the buyer. The buyer then keeps the policy in force by paying the remaining premiums and collects the face amount when the insured dies. Nothing about the insurer's promise changes -- only who owns the contract and who gets paid.

Who is involved

• Policy owner / insured -- sells a policy that is no longer needed, no longer affordable, or worth more sold than surrendered.
• Life settlement broker -- shops the policy to multiple buyers on the owner's behalf; state law makes brokers licensable and holds them to a duty to act for the owner (Tex. Ins. Code Title 7).
• Life settlement provider -- the licensed buyer that contracts with the owner and takes ownership of the policy.
• Investors / funders -- supply the capital behind the provider and receive the eventual death benefit.
• Insurer -- not a party to the settlement, but it verifies coverage and records the change of owner and beneficiary.

Viatical settlement vs. life settlement

A viatical settlement involves an insured who is terminally or chronically ill, so life expectancy is short and the offer is closer to the face amount. A life settlement typically involves an older insured who is not necessarily ill; because life expectancy is longer, the buyer must fund more premiums and the offer is a smaller share of the face amount.

Consumer protections to expect

State law regulating settlements requires licensing of providers and brokers, written disclosures before the owner signs, a rescission window after closing, confidentiality of the insured's health and identifying information, and limits on stranger-originated coverage and on settling a very recently issued policy except in specified circumstances (Tex. Ins. Code Title 7). Required disclosures point the owner back to alternatives: accelerated death benefit riders, policy loans, surrender, or simply keeping the coverage. Proceeds can also be reachable by creditors and can affect eligibility for needs-based public assistance.

Tax treatment

• Death benefits paid to a beneficiary are generally excluded from gross income (26 U.S.C. Sec. 101(a)).
• If the insured is terminally ill, amounts received on the sale or assignment of the policy to a viatical settlement provider are treated as paid by reason of death and are generally excludable; for a chronically ill insured the exclusion applies subject to statutory limits (26 U.S.C. Sec. 101(g)).
• For an ordinary life settlement, proceeds above the seller's investment in the contract are taxable; premiums paid create that basis, and for a sale the basis is not reduced by the cost of insurance (26 U.S.C. Sec. 1016).
• On the buyer's side, the transfer-for-value rule can make part of the death benefit taxable, and a reportable policy sale triggers both a narrowed exclusion and information reporting (26 U.S.C. Sec. 101(a)(2)-(3), Sec. 6050Y).

Exam framing: the settlement amount always sits between cash surrender value and face amount, the broker works for the owner, and health status is what separates a viatical from a life settlement.