June 30, 2005 Copyright © 2005, Greenwich Financial Management Inc., a registered investment advisor.  Securities offered exclusively through Purshe Kaplan Sterling Investments of 18 Corporate Woods Blvd., Albany, NY 12211, Member NASD/SIPC.

Uncovering Hidden Value in Your Life Insurance:
Life Settlements

            We discussed last week a large opportunity in obtaining new life insurance for eligible people aged 70 to 95, at ultra-low cost and with equity upside.  (See "A Major Opportunity in Life Insurance for Seniors," www.greenwichfinancial.com -I've never before had so much reader response as to this piece.)  There is a related opportunity to sell existing life insurance policies.

            Under what conditions might you potentially want to sell an existing policy and stop paying the premiums?  Here are a few: ability to obtain a better priced policy, based on changes in mortality tables; changes in the estate tax law; decline in estate size, for example, after transferring wealth to children; change in health condition, whereby cash is needed to pay for long-term care; divorce; retirement; bankruptcy; desire to use proceeds to purchase an annuity with monthly income; use of a family trust to carry out wealth transfer. 

            You may not be aware that your life insurance policy may be worth more, even astronomically more, than your insurance company would pay you if you were to surrender it.  If you are elderly, you might let a policy lapse because of the huge premiums you need to pay each year--not knowing that an investor group might pay tens or even hundreds of thousands for your policy.  This investor market sometimes provides a compelling alternative to surrender. 

            What kind of life insurance do you have?  There are two basic types: permanent and term.  Here's the difference. Whole life (permanent) is designed, in its classic form, to have level annual premiums.  You pay the same every year for the rest of your life, or until "fully paid up."  In term insurance, your annual payment will start to rise at some point (usually, one to twenty years), and after that, it will ramp up in cost exponentially as you get older, until it seems frightfully expensive. There is a hybrid type of insurance, "universal life," which is permanent insurance but in which the annual premiums may vary to some degree, depending on the experienced cost of mortality and administration and (in variable universal life) the performance of investments you choose. See "What You and Your Family Need to Know About Personal Insurance," http://www.greenwichfinancial.com/wm12.htm , a comprehensive summary.  

            To obtain a level schedule of permanent insurance premiums, the insured pays much more in the early years than for term life; the excess goes into something called "cash value."  Your insurance company invests this excess in the hope that it will defray the cost of your mortality later on and support the level payment schedule. 

            In the past, if you wanted to extract money from your insurance policy while still alive, you had to go to your insurance company.  If you had a term policy, you were out of luck: it develops no cash value.  The insurer owes you no part of your death benefit , the so-called "face amount" of the policy.  With permanent life, you can borrow from your cash value, up to the total amount of premiums paid in the past.  But if you surrender your policy, the return of your cash value may lead to treatment of your gains (beyond premiums paid) as ordinary income, taxable at the maximum federal marginal income tax rates.  There is an exception for certain "accelerated death benefits," where the insured has a life expectancy of two years or less; many insurance companies will offer a settlement in such cases, which is income tax free under a special provision of the tax law.

            What has made possible an alternative to lapse or surrender is the development of a secondary market for pools of life insurance policies reassigned by their original owners to institutional investors.  Major insurance companies such as Berkshire Hathaway and AIG became active investors.  This new market also opened up the terms under which insured persons can turn their insurance assets into money while still alive.  For example, expected life span no longer needed to be limited to two years; it could be as much as 20-25 years.  This new market came to be known as "life settlements."  

            I'm going to give two recent cases.  These were handled by a major life settlement company with whom I have a consulting relationship.

            1.  A major public company had taken out $10 MM face amount of key man life insurance, the beneficiary being the company itself.  When the policy was initiated, the executive was 68 years old.  When he retired at age 70, the company no longer needed the policy and was going to abandon it, as it had no cash value.  The company heard about the possibility of selling the policy and contacted the life settlement company.  The policy was sold in the secondary market, with proceeds after brokerage charges (5% of face amount) of $3 million.  The company had a benefit of $3 million dollars (minus capital gains tax of 15%, with cost basis being the premiums already paid), versus the alternative of surrender for zero dollars.

            2.  A married couple had taken out a universal life policy from ING America with a "second to die" provision (i.e. the death benefit would be paid out to the beneficiaries) after both spouses were deceased.  Families typically use this kind of policy to provide for eventual payment of estate taxes.  The death benefit was $5 million, and the cash surrender value was $500,000.   The policy had been in force for eight years, and the husband was now 84, while his wife was 77.  Annual premiums were $150,000.  This policy was sold in the secondary market for $800,000 net proceeds for the couple.  The couple then used the proceeds to purchase a policy from Jefferson Pilot Life (rated "AAA" for credit quality by Standard & Poor's, versus the still solid but lesser "AA" for ING America).  The new policy was based on a 2001 mortality table (as mortality has been declining, this is favorable to the insurance consumer).  The $800,000 in proceeds was enough to prepay fully the policy until the surviving spouse reached 100 years old.  There was a net savings of $150,000 per year ongoing.

            As commentators have noted [see, for example, "Your Hidden Asset," in the June issue of Worth magazine], the life settlement business provides a valuable alternative valuation to life insurance policies, often larger than what the originating insurance company must contractually pay.  There is a good argument that attorneys and accountants who advise trusts and estates have a fiduciary duty to inform their client of the potential hidden value of their life insurance assets in the secondary market.  Certainly, everyone holding a life insurance policy should keep in mind this potential opportunity.  If you are in the age bracket of 70 to ninety years old, or approaching 70, never let a policy lapse or surrender it for cash without checking its "outside" value as a life settlement.

 

Andy Szabo, CFA, is Managing Director of Greenwich Financial Management Inc., a Registered Investment Advisor, which advises individuals and companies on investments, insurance and employee benefits.  Questions or comments welcome by phone at 203-531-2877 or e-mail: Szabo@GreenwichFinancial.com.