EXECUTIVE SUMMARY

WHEN INDIVIDUALS OR BUSINESSES HAVE UNNEEDED life insurance policies they have three options: continue paying the premiums until the insured’s death, surrender the policy for the cash value or find a third party to buy the policy in a life settlement transaction. The last alternative usually is the most attractive if the insured is over 65, has experienced a change in health and has a life expectancy of 2 to 12 years. LIFE SETTLEMENT TRANSACTIONS USUALLY result in higher returns for the policy owner than simply surrendering the policy. The actual settlement depends on the policy’s face amount and cash surrender value, the insured’s health and age and the current policy premium. THE FIRST STEP IS TO SELECT A BROKER TO HELP get the best possible offers for the policy. The broker will help choose an appropriate provider. An institutionally owned and funded provider usually has more cash available to invest in policies and will adhere to high ethical standards. A VARIETY OF SITUATIONS CAN CREATE THE NEED for a life settlement, including a change in the policyholder’s business situation, a need for cash to fund medical or long-term care, changes in the insured’s estate, bankruptcy or divorce. LIFE SETTLEMENT TRANSACTIONS MAY BE SUBJECT to income taxes. The actual amount of taxable income depends on the policy’s cash surrender value, cost basis (total premiums paid) and how much the policy owner receives for the policy. Some of the proceeds may be ordinary income and some may be treated as a capital gain.

JAMES D. WARRING, CPA/PFS, CFP, is in charge of wealth management services for Rubino & McGeehin, Chartered CPAs, of Bethesda, Md., and its affiliate, R&M Wealth Management Services, LLC. His e-mail address is jwarring@rubino.com.

ife insurance planning isn’t always about making sure someone has enough coverage. It’s also about finding solutions for people who have too much. For them, it’s a question of whether it’s better to continue paying premiums in hopes of a gain at maturity or recoup some of that investment immediately by surrendering the policy. High premiums often put policy owners in a difficult position—especially if their insurance needs have changed. Corporate policy owners face similar concerns when dealing with key-person or split-dollar policies insuring departed executives or with insurance purchased to fund an obsolete buy-sell agreement.

In some instances the best alternative is neither to hold the policy nor to surrender it. This article explains how CPAs can use a third option—a life settlement—to help eligible clients and employers dispose of unneeded life insurance policies now for more than the cash value rather than wait for the policy to pay off at the insured’s death.

Life Settlement Facts Seniors own an estimated $500 billion in life insurance policies. Some $100 billion of these policies are eligible for life settlements. Life settlement providers will purchase $10 billion to $15 billion of insurance policies in 2005. Source: “2005 Life Settlement Industry Outlook,” Maple Life Financial, www.maplelifefinancial.com.

LIFE SETTLEMENTS—WHAT THEY ARE AND AREN’T
A life settlement turns insurance assets into cash, giving the original policyholder an amount greater than the cash surrender value in exchange for ownership of the policy. This option creates immediate revenue for companies or individuals holding unprofitable or unneeded policies.

Life settlements are not viatical settlements, which terminally ill policyholders often use to raise quick cash. Rather, the typical life settlement candidate has a life expectancy of between 2 and 12 years. The best prospects for such transactions are age 65 or older, have experienced a change in their health and are insured by a policy with a face amount of at least $100,000.

When an individual or business engages in a life settlement transaction, the amount it recoups is based on the policy’s face amount and cash surrender value as well as other factors, such as the insured’s health, age and the current policy premium.

In a recent survey of accountants, attorneys, estate planners and insurance professionals by Maple Life Financial, a Maryland-based life settlement provider, 45% of respondents had clients over age 65 that had surrendered a life insurance policy for its cash value. Many instead could have qualified for a larger cash payment from a life settlement. Considering that cash surrender values average just 4% of policy face amounts, the decision to recommend a life settlement is an easy one for CPAs advising employers or clients unaware of the potential economic gain from these hidden assets.

When providing financial advice and strategic information to clients or employers, CPAs have a fiduciary responsibility to identify effective ways to eliminate assets that burden the client or employer with unnecessary expenses. For CPAs in public practice, marketing and promoting life settlements can be easy; many accountants have clients that fit the life settlement eligibility profile. Any number of situations can create the need for a settlement, including

A change in interest rates that results in increased policy premiums.
A change in a policyholder’s business situation.
A need for cash to fund medical or long-term care.
Improved estate liquidity, a decrease in estate value or elimination of the federal estate tax, making an existing policy unnecessary.
Bankruptcy.
Divorce.
Departing executives or business owners, making policies redundant.

STEP-BY-STEP
To start the process, select a professional life settlement broker to help get the best possible offers for the policy you wish to dispose of. Look for one with experience in the field and connections to major settlement providers. Exhibit 1, below, lists some questions CPAs should ask a broker in choosing one to represent a client or employer in a life settlement transaction.

It’s important to select a broker who represents institutionally owned and funded settlement providers. These entities typically purchase policies using funds invested by large banks or financial companies as opposed to drawing on cash fronted by a loose organization of private investors. An institutionally owned and funded provider usually has more cash available to invest in policies and will adhere to high ethical standards to protect both consumers and the entity’s broader business interests. They also hold purchased policies in confidential portfolios. Most institutional funders are members of the Life Settlement Institute, a national trade association that represents institutionally funded companies. (See the list of life settlement providers in exhibit 2, below.)

Another factor for CPAs to consider is whether the settlement provider has a strong due diligence and compliance program. Good due diligence will protect everyone’s interests through background checks of all parties involved in the transaction, including the policy owner. A good compliance department will monitor and manage licensure, fraud prevention, broker-dealer issues and consumer privacy and ensure the company follows all federal and state regulations that apply to life settlement transactions.

As part of the process the broker submits the policy to selected providers, who review its terms and make an offer based on their calculation of the insured’s life expectancy and other factors. Before advising clients or employers on whether to accept an offer, remember to discuss with them the commission they will pay the broker, how they should complete the closing package and the tax implications of life settlement transactions (discussed in greater detail below). Once you accept an offer and submit a complete closing package, it will be only a matter of days until your client or employer receives a cash payment for the policy.

A case in point. Let’s look at a scenario involving a 77-year-old female who owns an insurance policy with a $900,000 face amount and a current cash surrender value of $68,296. Karen Jones originally purchased the policy for estate planning purposes. Since both of her children now are married and financially secure, she believes she no longer needs the policy and has no desire to continue paying the premiums. Jones’s CPA suggests she sell the policy to a life settlement provider. After working with her accountant to select a provider she receives $314,735 for the policy—an economic gain of $246,439 over the cash value she would have received from simply surrendering the policy. After setting aside some money to pay the taxes, she uses the policy proceeds to make donations to her two favorite charities.

UNNEEDED BUSINESS POLICIES
With more frequent activity between corporations—mergers, acquisitions, bankruptcies and top executives’ changing jobs—it is becoming more important than ever for CPAs to review corporate insurance portfolios for life settlement candidates. Life settlements involving unneeded key-person or buy-sell policies can provide businesses with increased cash flow to solve immediate financial needs, while transactions concerning split-dollar policies can help facilitate retirement planning and charitable giving. For example, a partner still may own the remaining policy funding a buy-sell agreement after the other parties have retired. A life settlement option allows the surviving partner to earn cash for the policy, which he or she can use to buy a policy better suited to the company’s current needs or reinvest into the business.

Another case in point. Over time the Widget Corp. purchased a combined $6 million in key-person life insurance on its CEO, Walter Smith. After many years of employment with the company, Smith left to pursue other interests. At the time he left the company Smith was age 81 and the policies had a combined cash value of $109,500. Although Widget could have waited until Smith’s death to receive the full policy benefits, its annual premium payments were extremely high. The company’s controller recommended the board of directors consider a life settlement. Widget Corp.—the policyholder in this case—engaged in a life settlement transaction and received $1.2 million—nearly 11 times the cash surrender value.

DON’T FORGET TAXES
Life settlement transactions can be subject to income taxes depending on the amounts involved. While there are no specific Internal Revenue Code provisions pertaining to life settlements, there are some general guidelines CPAs can use to help determine the tax implications.

If the policy has no cash surrender value, or the surrender value is lower than the policy cost basis (the total amount of premiums paid), then the amount of taxable income is the difference between the settlement amount and the cost basis. That amount is treated as a capital gain.

If the cash surrender value is higher than the cost basis, then that difference is treated as ordinary income and taxed at the policy owner’s marginal tax rate. The difference between the settlement amount and the surrender value is a capital gain.

If the policy cost basis is higher than the settlement amount there should be no taxable income from the transaction.

CPAs should advise clients and employers that specific situations may result in different tax consequences. Calculating the projected tax liability always should be part of the decision-making process before agreeing to a life settlement offer.

REGULATORY ISSUES
Many states have adopted laws and regulations covering life settlement transactions and viatical settlements. As of June 2005, 26 states had life settlement laws and 10 more were considering such legislation. Before recommending a life settlement to a client or employer CPAs should check to see what rules apply in their state for licensing requirements (some states may require the CPA to have an insurance license), distribution options, consumer protection and related issues.

SATISFYING SOLUTION
The beauty of life settlement transactions is that every party benefits, resulting in high levels of satisfaction among all links in the chain, including the CPA. Discovering the flexibility and profitability of these opportunities can help CPAs provide the best alternative to clients or employers for dealing with financially burdensome or lapsing life insurance policies. With the possible repeal of the federal estate tax still on the horizon, the number of unneeded policies may increase in the future.