Life Settlement
A Life Settlement is the sale of an existing life insurance policy by the policyholder to a third-party investor for a lump sum greater than the cash surrender value but less than the death benefit.
Life settlements emerged as a recognized market in the early 1990s and have grown into a multi-billion-dollar secondary market for life insurance. The fundamental insight is that an unwanted or unaffordable insurance policy has value that exceeds what the issuing insurer will return as a cash surrender value.
The mechanics are straightforward. The original policyholder sells ownership and premium-paying responsibility to a life settlement company or institutional investor. The buyer continues paying premiums until the insured dies, at which point the buyer collects the full death benefit. The spread between the purchase price (plus cumulative premiums paid) and the death benefit represents the investor's return, which is a function of how long the insured lives.
Life settlements are most commonly pursued by seniors over age 65 with policies of $100,000 or more in face value. Common motivating circumstances include premium unaffordability, a change in estate planning needs, the lapse of business continuity needs (such as key-person insurance), or simply a preference for liquidity during one's lifetime over a posthumous benefit.
Regulation varies by state. Most states require life settlement brokers and providers to be licensed, and some impose waiting periods between policy issuance and settlement to prevent the practice of stranger-originated life insurance (STOLI), in which a policy is purchased specifically with intent to sell it.
Tax treatment is nuanced. The gain above the adjusted cost basis of the policy (premiums paid minus dividends received) is taxed as ordinary income; gains above the cash surrender value may be taxed as capital gains. Policyholders considering a life settlement should obtain professional tax guidance before proceeding.