Life Insurance and Divorce

Does your divorcing client's Statement of Net Worth reflect the fair market value of the life insurance policies he or she owns? This seems like a simple question, but in certain circumstances it may actually be quite complex.

Traditionally, when reviewing a client's policies, most practitioners have first asked themselves, 'Is this a term or permanent life insurance product (universal life, whole life or variable life)?' If it is a term policy, the practitioner concludes that it is worth no more than the unexpended portion of the last annual premium. This is a fair conclusion in most circumstances, assuming the insured is in reasonably good health, and barring an unfortunate incident. If it is a permanent-type product, the practitioner often concludes the policy is worth no more than its cash surrender value, in lock step with the conventional manner of thinking about this issue. Opposing counsel accepts this logic, in compliance with tradition.

To be sure, the Statement of Net Worth in use today asks the policy owner to list the cash surrender value of the policy. There are times, however, when this bowing to convention could potentially leave a significant number of dollars on the table. If you have a client who is ill, retired or approaching retirement age, the situation may be right for a life settlement transaction, which returns a value greater than a policy's cash surrender value, but less than the net death benefit. (A death benefit is the amount an insurance company pays to a policyholder's beneficiary when the insured dies. The net death benefit is the amount specified in the insurance policy or annuity contract, minus any unpaid premiums that are due and minus any outstanding loan balances. In the case of variable life insurance or variable annuities, investment gains and losses can impact the amount of the death benefit.)

Wise practitioners have long understood that, as the likelihood of a claim increases, the value of being insured is greater. In the past, a practitioner may have dealt with this on an as-, if- and when-paid basis, accompanied by some provision for sharing the burden of premium payments until the date of death. Today, however, there is another option.

Life Settlements

Many individuals surrender their policies or allow them to lapse because the premiums become unaffordable, but allowing a client's policy to terminate without first getting a valuation in the life settlement market could constitute a lost opportunity. When the situation is right, you can add value to your role as a trusted adviser by recognizing what could be one of your client's larger assets: a life insurance policy worth more than its cash surrender value.

Previously, the owner of a life insurance policy who no longer wanted it or could not afford to keep it in force was generally considered to have only two options: 1) to let it lapse; or 2) surrender it to the issuer for its cash surrender value. (Lapse refers to the termination of an insurance policy when an individual fails to pay his or her premiums. Cash surrender value is based on the cash or investment value accumulated in the policy over time, which is tax-deferred savings, minus outstanding loan balances and/or surrender charges.)

The emergence of a secondary market for existing life insurance policies since the 1980s provides a third alternative: to sell the policy to a third party for less than the net death benefit, but more than the cash surrender value. Such transactions are typically referred to as life settlements.

There is an expanding number of companies whose only business is purchasing policies through life settlements. (This is not the viatical market; viaticals involve the purchase of policies of the terminally ill who usually have a life expectancy of less than two years.) The life settlement market emerged as an offshoot of the viatical settlement industry that developed in the 1980s as a source of liquidity for AIDS patients and other terminally ill policyholders with life expectancies of less than two years. Unlike viaticals, however, life settlements involve policyholders who are not terminally ill and have longer life expectancies. They also tend to involve policies with higher net death benefits than viaticals.

The purchasers of life settlements ' sometimes called life settlement companies or life settlement providers ' generally are institutions that either hold the policies to maturity and collect the net death benefits or resell policies (or interests in multiple bundled policies) to hedge funds or other investors. In exchange for the contract assignment, the policyholder receives a lump sum payment. The life settlements market is one of the fastest growing markets today. Buyer's in the sizable secondary market for life insurance policies include organizations such as AIG, Credit Suisse, MapleLife Financial, Inc., Life Settlement Solutions, Inc., and even a publicly traded firm devoted to life settlements ' Life Exchange (ticker symbol: LFXG), which has developed an electronic trading platform for the secondary life insurance market and whose shares are traded on the Over The Counter Bulletin Board (OTCBB).

The amount received in the secondary market depends on a range of factors, including the insured's age, health, and the terms and conditions of the policy. When a policyholder sells a life insurance policy, the buyer is acquiring a financial interest in the insured's death. In addition to paying a lump sum for the policy, the buyer agrees to pay any additional premiums that might be required to support the cost of the policy for as long as the insured lives. In exchange, the buyer receives the net death benefit when the insured dies. For these reasons, in most states, both life settlement providers and life settlement brokers are subject to licensing and other requirements.

Who Is a Good Candidate?

The types of insurance policies that are saleable in the life settlement market are universal life, variable life, whole life and convertible term life. Life settlements frequently involve the purchase of policies of people aged 65 or older, or those nearing retirement, who may have a life expectancy of about 15 years, depending on the status of their health and any changes in their health since the policy was issued.

A client with immediate financial needs is a good candidate for this option. There are also a number of situations in which a client's life insurance policies, or corporately owned life insurance (COLI) policies inside a closely held entity, may no longer be needed. Such situations may occur when a specific risk or need the policy was purchased to cover no longer exists, where the intended beneficiary has predeceased the insured, or where changes in the size of an estate or tax laws makes policies acquired for estate planning reasons unnecessary. For example, when the circumstances are correct, properly planning a life settlement transaction could allow a client to purchase a single-premium policy with the same face value as a variable or universal life policy and free up cash proceeds to spend or invest elsewhere.

Mike Lovell, of L&L Consulting, has been working with life settlements from his Louisiana office since the early 1990s. When asked who might be a good candidate for a life settlement transaction, he answered, 'Different buyers have different parameter sets, but the preference is for clients 69 years of age or older and a policy with a face amount of $250,000 or more. The larger the face amount, the more interest in the policy. The life expectancy of the clients should also generally fall within the 15-year window.'

Beyond the salability question, your client's needs are certainly going to be his (and your) paramount concern. As Lovell pointed out, 'If the original reason for the insurance is still a viable need, then it makes sense to continue paying the premiums. But keep in mind that when the client is dead he or she cannot enjoy the net benefit paid when a claim is filed. In other words, if the need for the insurance no longer exists and the client can use that money more productively for long-term care needs, retirement concerns, tying up loose ends of his or her estate, or just a great vacation, then selling the policy makes sense.'

Getting Started

There are two types of companies operating in the life settlements industry, namely providers and brokers. Providers purchase the policies. Brokers take the policies to market and work with many providers. Because life insurance policies can be very complex, a skilled broker may be able to use his or her expert knowledge to structure a proposal so that it receives attractive offers from providers.

To obtain a life settlement, the policyholder completes an application that includes policy-related information, medical information release forms and verification of coverage from the underwriter. The broker then sends the package to providers and, if any of them are interested, he accepts their competing bids. 'The type of policy determines the amount of interest from our buyers,' says Lovell. 'When a policy is submitted to our office for valuation, we check several things to determine if we can get a good bid. The annual premium to face amount ratio should be 4% or less. A life expectancy of 12 years or less is preferred. It is also important that ownership can be transferred without penalty.' The broker's commission is paid by the buyer and not the seller of the policy rights. The seller is generally quoted the bid amounts less the broker's commission.

When a bid is made there is no obligation to accept. When a bid is accepted, the proceeds from sale are held in escrow until transfer of the ownership of the policy and changes in beneficiary designations are completed. The purchaser is responsible for making any remaining premium payments and the seller receives a lump sum.

In general, the lump sum payment is tax-free up to the basis of the policy, and then is taxed as ordinary income from basis up to cash surrender value, with any excess beyond cash surrender value taxed as a capital gain. A tax professional should always be consulted when obtaining a life settlement.

What can your client expect to receive in payment for his or her policy? Says Lovell, 'That is a difficult question to answer, considering the variables involved in pricing out a settlement. Generally speaking, the shorter the life expectancy of the insured, the higher the amount of the life settlement transaction.' That being said, he noted that there is a big difference between a viatical settlement (life expectancy of 24 months or less) and life settlement (life expectancy of more than 24 months). 'States have different requirements concerning these two transactions and many life settlement companies do not involve themselves with viaticals. A rule of thumb would be this: Viaticals can settle for as much as 40% of the face value, or more, while the life settlement should go for from 18% to 35% of the face amount.' For example, said Lovell, a $1 million universal life policy might be salable at about $325,000, and a $700,000 term policy (after converting to a universal life policy) might be salable for $144,000, depending on the specific facts and circumstances. 'Again, it is impossible to state anything with absolute certainty due to the variables involved in each individual case,' he advises.

The National Association of Securities Dealers (NASD), whose rules apply to variable life insurance products, which are considered securities transactions, recognizes that life settlements can be a valuable source of liquidity for those who would otherwise surrender their policies or allow them to lapse, or for individual's whose life insurance needs have changed. But the NASD also warns that they are not for everyone. Life settlements can have high transaction costs and unintended consequences. It can also be difficult for a policyholder to determine if they are receiving a fair price.

The NASD has issued Investor Alerts to highlight the questions that policyholder's should ask and the factors they should consider before entering into a life settlement. It has also issued Notices to Members reminding them of their obligations under NASD rules, including considerations of the suitability of the transaction for their customer, due diligence regarding the terms and conditions of the contracts, and a member's participation in the marketing and sale of life settlements.

Conclusion

In today's environment, when the facts and circumstances indicate that a life settlement may produce an amount greater than surrender value, practitioners should investigate the prices that may be available in the secondary market. Although a life settlement or viatical settlement option may apply only to a handful of your high net worth cases involving older or ill clients, it is source of liquidity that should not be overlooked, since to do so could result in a significant undervaluation of the marital estate. The number of cases where such settlements apply may expand in future years as more baby boomers in strained marriages become empty nesters, reach retirement age and decide that divorce is their best bet for ensuring peace and happiness in their final years.

Capturing the potential value that may be obscured by a life insurance contract is especially important where a boomer's retirement planning has fallen by the wayside. For purposes of equitable distribution, if the titled spouse or non-titled spouse considers the sale of a life insurance policy to a third party a viable alternative, you can help your client by familiarizing yourself with the existing policy so that you fully understand the available options, becoming fully informed about life settlements, dealing only with licensed buyers and brokers, and shopping around for the best offer. When this level of due professional care is taken the additional liquidity afforded by a life settlement may be just what the doctor prescribed to settle your matrimonial action.

Thomas A. Hutson, CPA/ABV, CFP, is a partner at BST Valuation & Litigation Advisors LLC. He is a Certified Public Accountant, Accredited in Business Valuation by the American Institute of Certified Public Accountants, and a Certified Financial Planner.

Does your divorcing client's Statement of Net Worth reflect the fair market value of the life insurance policies he or she owns? This seems like a simple question, but in certain circumstances it may actually be quite complex.

Traditionally, when reviewing a client's policies, most practitioners have first asked themselves, 'Is this a term or permanent life insurance product (universal life, whole life or variable life)?' If it is a term policy, the practitioner concludes that it is worth no more than the unexpended portion of the last annual premium. This is a fair conclusion in most circumstances, assuming the insured is in reasonably good health, and barring an unfortunate incident. If it is a permanent-type product, the practitioner often concludes the policy is worth no more than its cash surrender value, in lock step with the conventional manner of thinking about this issue. Opposing counsel accepts this logic, in compliance with tradition.

To be sure, the Statement of Net Worth in use today asks the policy owner to list the cash surrender value of the policy. There are times, however, when this bowing to convention could potentially leave a significant number of dollars on the table. If you have a client who is ill, retired or approaching retirement age, the situation may be right for a life settlement transaction, which returns a value greater than a policy's cash surrender value, but less than the net death benefit. (A death benefit is the amount an insurance company pays to a policyholder's beneficiary when the insured dies. The net death benefit is the amount specified in the insurance policy or annuity contract, minus any unpaid premiums that are due and minus any outstanding loan balances. In the case of variable life insurance or variable annuities, investment gains and losses can impact the amount of the death benefit.)

Wise practitioners have long understood that, as the likelihood of a claim increases, the value of being insured is greater. In the past, a practitioner may have dealt with this on an as-, if- and when-paid basis, accompanied by some provision for sharing the burden of premium payments until the date of death. Today, however, there is another option.

Life Settlements

Many individuals surrender their policies or allow them to lapse because the premiums become unaffordable, but allowing a client's policy to terminate without first getting a valuation in the life settlement market could constitute a lost opportunity. When the situation is right, you can add value to your role as a trusted adviser by recognizing what could be one of your client's larger assets: a life insurance policy worth more than its cash surrender value.

Previously, the owner of a life insurance policy who no longer wanted it or could not afford to keep it in force was generally considered to have only two options: 1) to let it lapse; or 2) surrender it to the issuer for its cash surrender value. (Lapse refers to the termination of an insurance policy when an individual fails to pay his or her premiums. Cash surrender value is based on the cash or investment value accumulated in the policy over time, which is tax-deferred savings, minus outstanding loan balances and/or surrender charges.)

The emergence of a secondary market for existing life insurance policies since the 1980s provides a third alternative: to sell the policy to a third party for less than the net death benefit, but more than the cash surrender value. Such transactions are typically referred to as life settlements.

There is an expanding number of companies whose only business is purchasing policies through life settlements. (This is not the viatical market; viaticals involve the purchase of policies of the terminally ill who usually have a life expectancy of less than two years.) The life settlement market emerged as an offshoot of the viatical settlement industry that developed in the 1980s as a source of liquidity for AIDS patients and other terminally ill policyholders with life expectancies of less than two years. Unlike viaticals, however, life settlements involve policyholders who are not terminally ill and have longer life expectancies. They also tend to involve policies with higher net death benefits than viaticals.

The purchasers of life settlements ' sometimes called life settlement companies or life settlement providers ' generally are institutions that either hold the policies to maturity and collect the net death benefits or resell policies (or interests in multiple bundled policies) to hedge funds or other investors. In exchange for the contract assignment, the policyholder receives a lump sum payment. The life settlements market is one of the fastest growing markets today. Buyer's in the sizable secondary market for life insurance policies include organizations such as AIG, Credit Suisse, MapleLife Financial, Inc., Life Settlement Solutions, Inc., and even a publicly traded firm devoted to life settlements ' Life Exchange (ticker symbol: LFXG), which has developed an electronic trading platform for the secondary life insurance market and whose shares are traded on the Over The Counter Bulletin Board (OTCBB).

The amount received in the secondary market depends on a range of factors, including the insured's age, health, and the terms and conditions of the policy. When a policyholder sells a life insurance policy, the buyer is acquiring a financial interest in the insured's death. In addition to paying a lump sum for the policy, the buyer agrees to pay any additional premiums that might be required to support the cost of the policy for as long as the insured lives. In exchange, the buyer receives the net death benefit when the insured dies. For these reasons, in most states, both life settlement providers and life settlement brokers are subject to licensing and other requirements.

Who Is a Good Candidate?

The types of insurance policies that are saleable in the life settlement market are universal life, variable life, whole life and convertible term life. Life settlements frequently involve the purchase of policies of people aged 65 or older, or those nearing retirement, who may have a life expectancy of about 15 years, depending on the status of their health and any changes in their health since the policy was issued.

A client with immediate financial needs is a good candidate for this option. There are also a number of situations in which a client's life insurance policies, or corporately owned life insurance (COLI) policies inside a closely held entity, may no longer be needed. Such situations may occur when a specific risk or need the policy was purchased to cover no longer exists, where the intended beneficiary has predeceased the insured, or where changes in the size of an estate or tax laws makes policies acquired for estate planning reasons unnecessary. For example, when the circumstances are correct, properly planning a life settlement transaction could allow a client to purchase a single-premium policy with the same face value as a variable or universal life policy and free up cash proceeds to spend or invest elsewhere.

Mike Lovell, of L&L Consulting, has been working with life settlements from his Louisiana office since the early 1990s. When asked who might be a good candidate for a life settlement transaction, he answered, 'Different buyers have different parameter sets, but the preference is for clients 69 years of age or older and a policy with a face amount of $250,000 or more. The larger the face amount, the more interest in the policy. The life expectancy of the clients should also generally fall within the 15-year window.'

Beyond the salability question, your client's needs are certainly going to be his (and your) paramount concern. As Lovell pointed out, 'If the original reason for the insurance is still a viable need, then it makes sense to continue paying the premiums. But keep in mind that when the client is dead he or she cannot enjoy the net benefit paid when a claim is filed. In other words, if the need for the insurance no longer exists and the client can use that money more productively for long-term care needs, retirement concerns, tying up loose ends of his or her estate, or just a great vacation, then selling the policy makes sense.'

Getting Started

There are two types of companies operating in the life settlements industry, namely providers and brokers. Providers purchase the policies. Brokers take the policies to market and work with many providers. Because life insurance policies can be very complex, a skilled broker may be able to use his or her expert knowledge to structure a proposal so that it receives attractive offers from providers.

To obtain a life settlement, the policyholder completes an application that includes policy-related information, medical information release forms and verification of coverage from the underwriter. The broker then sends the package to providers and, if any of them are interested, he accepts their competing bids. 'The type of policy determines the amount of interest from our buyers,' says Lovell. 'When a policy is submitted to our office for valuation, we check several things to determine if we can get a good bid. The annual premium to face amount ratio should be 4% or less. A life expectancy of 12 years or less is preferred. It is also important that ownership can be transferred without penalty.' The broker's commission is paid by the buyer and not the seller of the policy rights. The seller is generally quoted the bid amounts less the broker's commission.

When a bid is made there is no obligation to accept. When a bid is accepted, the proceeds from sale are held in escrow until transfer of the ownership of the policy and changes in beneficiary designations are completed. The purchaser is responsible for making any remaining premium payments and the seller receives a lump sum.

In general, the lump sum payment is tax-free up to the basis of the policy, and then is taxed as ordinary income from basis up to cash surrender value, with any excess beyond cash surrender value taxed as a capital gain. A tax professional should always be consulted when obtaining a life settlement.

What can your client expect to receive in payment for his or her policy? Says Lovell, 'That is a difficult question to answer, considering the variables involved in pricing out a settlement. Generally speaking, the shorter the life expectancy of the insured, the higher the amount of the life settlement transaction.' That being said, he noted that there is a big difference between a viatical settlement (life expectancy of 24 months or less) and life settlement (life expectancy of more than 24 months). 'States have different requirements concerning these two transactions and many life settlement companies do not involve themselves with viaticals. A rule of thumb would be this: Viaticals can settle for as much as 40% of the face value, or more, while the life settlement should go for from 18% to 35% of the face amount.' For example, said Lovell, a $1 million universal life policy might be salable at about $325,000, and a $700,000 term policy (after converting to a universal life policy) might be salable for $144,000, depending on the specific facts and circumstances. 'Again, it is impossible to state anything with absolute certainty due to the variables involved in each individual case,' he advises.

The National Association of Securities Dealers (NASD), whose rules apply to variable life insurance products, which are considered securities transactions, recognizes that life settlements can be a valuable source of liquidity for those who would otherwise surrender their policies or allow them to lapse, or for individual's whose life insurance needs have changed. But the NASD also warns that they are not for everyone. Life settlements can have high transaction costs and unintended consequences. It can also be difficult for a policyholder to determine if they are receiving a fair price.

The NASD has issued Investor Alerts to highlight the questions that policyholder's should ask and the factors they should consider before entering into a life settlement. It has also issued Notices to Members reminding them of their obligations under NASD rules, including considerations of the suitability of the transaction for their customer, due diligence regarding the terms and conditions of the contracts, and a member's participation in the marketing and sale of life settlements.

Conclusion

In today's environment, when the facts and circumstances indicate that a life settlement may produce an amount greater than surrender value, practitioners should investigate the prices that may be available in the secondary market. Although a life settlement or viatical settlement option may apply only to a handful of your high net worth cases involving older or ill clients, it is source of liquidity that should not be overlooked, since to do so could result in a significant undervaluation of the marital estate. The number of cases where such settlements apply may expand in future years as more baby boomers in strained marriages become empty nesters, reach retirement age and decide that divorce is their best bet for ensuring peace and happiness in their final years.

Capturing the potential value that may be obscured by a life insurance contract is especially important where a boomer's retirement planning has fallen by the wayside. For purposes of equitable distribution, if the titled spouse or non-titled spouse considers the sale of a life insurance policy to a third party a viable alternative, you can help your client by familiarizing yourself with the existing policy so that you fully understand the available options, becoming fully informed about life settlements, dealing only with licensed buyers and brokers, and shopping around for the best offer. When this level of due professional care is taken the additional liquidity afforded by a life settlement may be just what the doctor prescribed to settle your matrimonial action.

Thomas A. Hutson, CPA/ABV, CFP, is a partner at BST Valuation & Litigation Advisors LLC. He is a Certified Public Accountant, Accredited in Business Valuation by the American Institute of Certified Public Accountants, and a Certified Financial Planner.