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Making Your Money Last

Life Settlements Can Be a Big Risk

Seniors who sell their life insurance policies to investors typically get only a fraction of the value.

A growing number of seniors are looking to sell their life insurance policies to investors. But there is significant risk for older people getting involved in either side of these "life settlement" transactions.

In a life settlement, a policyholder sells his policy in exchange for a lump-sum cash payment. The buyer makes all the future premium payments and gets the death benefit when the insured person dies.

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For seniors who find their policy is no longer needed or affordable, a life settlement can be a better option than letting the policy lapse. But a life settlement will bring the seller just a small fraction of his policy's face value. All too often, insurance experts say, seniors agree to life settlements without exploring alternatives that could bring far greater value to themselves or their beneficiaries.

Life settlements are also a gamble for investors. If the insured lives much longer than expected, the investor's return will plunge. And lawsuits filed in recent months by the Securities and Exchange Commission accuse some investment firms of misleading investors about life settlements' risks. In one case, a firm allegedly told customers that life settlements were "guaranteed" and as safe as certificates of deposit, while in fact life settlements offer no guarantees.

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Although life settlements can make sense in certain situations, for both sellers and investors, "there are so many ways of being taken advantage of," says Glenn Daily, a fee-only insurance adviser in New York City.

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The life-settlement industry says it's providing a better alternative to seniors who often let policies lapse or continue paying premiums they can't afford. Many people "assume the only time a policy is worth something is when the insured passes away," says Darwin Bayston, president and chief executive officer of the Life Insurance Settlement Association.

Starting in the late 1990s, life settlements grew rapidly until investor capital dried up in the financial crisis. But the market has rebounded in the past couple of years, buoyed by investors' increasing appetite for risk and seniors' desire to unload their policies. In some cases, seniors no longer need a policy because their children have grown or a spouse has died. In other cases, they turn to life settlements because they need cash to pay for long-term care or other expenses.

Selling a Policy

If you are over 65 and have a life insurance policy with a death benefit of more than $100,000, you may be a candidate for a life settlement. You can go to a life-settlement broker, who will solicit bids from multiple buyers. Or you can go to a life-settlement "provider," a company that buys policies either for its own investment purposes or to sell to third-party investors. The provider will review your medical records and get life-expectancy estimates before making a bid. You can find licensed brokers and providers at www.lisa.org.

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But before selling a policy, you should understand the costs and complexities of life settlements. The amount of cash you can receive depends on your remaining life expectancy, your policy's annual premiums and death benefit, the rate of return the buyer demands, and other factors. Sellers typically receive more than the policy's cash surrender value but far less than the death benefit. The gross purchase price -- before deducting taxes, commissions and other transaction costs -- is often 10% to 25% of the death benefit.

And transaction costs can consume a big chunk of the gross purchase price -- often 10% to 20%, Daily says. The broker's commission can be as much as 4% to 6% of the policy's face value. The provider also collects a fee, which is generally not disclosed to the seller.

What's more, with a life settlement, "there's a tremendous loss of tax advantage," says Scott Witt, a fee-only insurance adviser in New Berlin, Wis. If you hold on to the policy, your beneficiaries get the death benefit tax-free. In a life settlement, the seller must pay tax on at least a portion of the amount he receives, and the buyer also owes tax on the death benefit -- another factor that pushes the offer price lower.

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Still, life settlements can make sense for some seniors. One of Daily's clients, a 74-year-old woman, has a policy with a face value of about $500,000. Because of her relatively short life expectancy of about five years, Daily estimates that the gross price she can receive in a life settlement is unusually high -- about $250,000. After deducting transaction costs and taxes, she might pocket roughly $180,000. Since the client needs money now, a life settlement makes sense, Daily says.

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To determine whether a life settlement is a good option for you, ask a fee-only insurance adviser to help value your policy (find links to nine advisers at www.glenndaily.com). Also consider alternatives. If your policy has become unaffordable, ask the beneficiaries to take over the premium payments, says John Skar, an actuary who works with Daily. In a life settlement, "it's a valuable family estate asset that you're getting rid of for pennies on the dollar."

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Ask if you can borrow against your policy, or if the policy can be revised so that no future premiums are owed and the death benefit is reduced. People with short remaining life expectancies may be eligible for accelerated death benefits.

If you no longer need the policy, some community foundations and large charitable organizations may be willing to accept donations of life insurance. Also, keep an eye on a new charitable alternative that aims to smooth the process of donating an insurance policy. Insuring a Better World Fund (www.iabwf.org), launched last year, pools all donated policies and pays the premiums. As death benefits roll in, it makes pro rata distributions to the charities named by the donors. The donor receives a tax deduction for the fair market value of the policy.

For older investors who are pitched life settlements as investments, the best policy is to stay away. In some cases, a person invests in a single policy. More often policies are pooled into life-settlement funds. Investors' returns depend on the accuracy of life-expectancy estimates, and "it doesn't take very many [people] who dramatically outlive life expectancy to really put a crimp in your returns," Witt says.

In addition, insurers may refuse to pay death benefits if they suspect that a policy was initiated by an investor, rather than the insured person. In these "stranger-originated life insurance" arrangements, investors pay seniors to buy life insurance and then turn the policies over to investors. Without examining every policy in a fund, it can be hard for investors to be sure they're avoiding such situations.

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