What it means
Most people who stop paying for a life policy either let it lapse or surrender it to the insurer for its cash value. A life settlement offers a third option, which is to sell the policy to an investor who thinks it is worth more.
The investor judges value from the insured person's age, health, the size of the death benefit and the premiums still due. The shorter the expected life, the more the policy is worth to a buyer, since the death benefit will be paid sooner.
Settlements are usually arranged through brokers or providers, and the seller should ask how much commission is charged. The price may be a small fraction of the death benefit, so competing bids can matter.
There are trade-offs for the seller. The proceeds may be taxable in whole or in part, a sale may affect eligibility for means-tested benefits, and the family loses the death benefit that the policy would have paid to them.
Rules differ widely by country and region, including licensing of providers and cooling-off periods. Anyone considering a sale should take independent tax and financial advice and compare the offer with other options such as reducing the cover or keeping the policy.
For investors the key risk is longevity, meaning the insured living longer than predicted. Every extra year adds premium cost and delays the return, which can turn an attractive deal into a poor one.
In practice
Real-world examples.
Example
A 78-year-old retired architect holds a $500,000 policy she no longer needs because her children are financially independent. A broker obtains bids, and she sells for $110,000 compared with a surrender value of $40,000. She uses the cash to fund home care costs.
Example
A business owner has a $2,000,000 policy that protected a business loan which has now been repaid. The premiums of $45,000 a year are no longer worthwhile. He sells the policy and uses the proceeds to invest in a new venture.
Example
A specialist fund buys a portfolio of 50 policies with a combined death benefit of $60,000,000. It models the life expectancy of each person and prices accordingly. The fund's return depends on how closely actual lifespans match its forecasts.
Formula
Calculation
Buyer's net gain = Death benefit - Purchase price - Premiums paid until death
Suppose a policy has a $1,000,000 death benefit and an $80,000 cash surrender value. An investor buys it for $250,000 and then pays $20,000 a year in premiums. If the insured dies after 8 years, the premiums total 8 x 20,000 = $160,000 and the net gain is 1,000,000 - 250,000 - 160,000 = $590,000. The seller received $250,000, which is $170,000 more than the surrender value of $80,000. The buyer's gain is only realised if the insured dies in time. If the insured lives 20 years instead of 8, premiums rise to 20 x 20,000 = $400,000 and the net gain falls to 1,000,000 - 250,000 - 400,000 = $350,000, while the money was tied up for much longer.Case study
Seen in the real world.
Cedar Point Capital is an illustrative, fictional fund that buys life policies. It purchases a $1,000,000 policy for $250,000 and expects to pay $20,000 a year in premiums. Its model predicts the insured will live about eight years.
The insured lives 14 years, so premiums total 14 x 20,000 = $280,000 and the fund's net gain is 1,000,000 - 250,000 - 280,000 = $470,000. That is still a gain, but the return on the money invested is much lower than the fund forecast because the cash was tied up for longer. The numbers are invented.
The fund's managers now use a range of life expectancy estimates from two independent medical underwriters and set aside cash to pay premiums for longer than forecast. They also hold a spread of 50 or more policies, so that one long-lived insured does not decide the result.
Watch out
Common mistakes.
- Assuming the offer equals the death benefit. Buyers pay only a fraction because they must wait and pay premiums.
- Ignoring tax. Part of the proceeds can be taxable, depending on the jurisdiction. The tax treatment of the proceeds should be checked with an adviser before accepting an offer.
- Not comparing offers. Prices can differ widely between providers. Seeking at least three quotes from licensed providers is a sensible habit.
Questions
People also ask.
What is the difference between a life settlement and a surrender?
A surrender returns the cash value to the insurer, while a settlement sells the policy to a third party, usually for more.
Who typically sells?
Older policyholders or those with health problems whose cover is no longer needed or too costly.
What happens to the beneficiaries?
They lose the death benefit, since the new owner collects it when the insured dies. Families should discuss a sale before it happens, because it changes what they will receive.
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