Putting Your Life Insurance on the Block

In recent years, a new option has emerged for older adults who own life-insurance policies they no longer want or perhaps can't afford to maintain.

The traditional process for cash-value policies involved surrendering the policy to the insurance company and receiving the accumulated savings component. Today, investors will buy that policy for considerably more, although less than the benefit payable upon death. They on occasion also will buy "term" policies that pay a death benefit but don't have a savings component.

When such deals -- known as life settlements -- work as advertised, they can free up substantial amounts of money that potentially can be used however the policy owner sees fit. One example: investing for higher returns than are typically available from an insurance policy.

Watch for Pitfalls

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That said, life settlements have significant potential pitfalls. The most serious is that it's extremely difficult for sellers of a policy to know whether they're getting the best deal possible. As a result, life settlements have been drawing the attention of regulators who allege backroom dealings and predatory sales tactics.

There are a host of other issues to consider. The payout from a life settlement can lead to a big tax bill and affect Medicaid eligibility. (In contrast, at a policyholder's death, life-insurance benefits paid to heirs aren't subject to income tax.) Your medical history can be widely shared with many parties.

In the end, there may be other more attractive options, such as exchanging your policy for another insurance offering that can potentially earn higher returns.

The pitch is "free money," says Glenn Daily, a fee-only insurance consultant in New York who provides independent evaluations of life-settlement proposals. And while it can be a good strategy under certain circumstances, "it doesn't mean you shouldn't ask a long series of questions."

Life settlements usually are aimed at policies with a death benefit of at least $250,000, although sometimes policies with death benefits as low as $100,000 will be considered. Policyholders need to be at least 65 years old and have a life expectancy at the time of the purchase of at least two years but no more than 12 to 15 years, depending on the buyer's criteria.

The buyers are mainly investment firms that, after purchasing the policies, continue to pay the premiums and collect the benefit when the original holder dies.

Obviously, it's in the investors' interest to keep the purchase price down. They also would prefer if you died sooner rather than later; a policy from a holder who is in declining health, or, say, is an active smoker, could be worth more than a comparable policy from someone who is healthy.

Acting as a go-between between the policyholder and the investor are brokers. Ideally the broker, who is supposed to act in the seller's best interest, will submit the policy to different potential buyers who might make a bid.

Factors affecting the purchase price offered include your age, medical condition and resulting life expectancy, the type of policy and the premiums involved in keeping the policy in force. It's possible to get widely differing bids.

From this purchase price a number of fees are deducted, the largest of which is usually the broker's commission.

The problem is "there's no transparency -- you're reliant on your broker to shop your policy around," says Mary Schapiro, chairman of the National Association of Securities Dealers, which published an "Investor Alert" on life settlements last month (available at nasd.com).

Ask the broker for a full accounting of what bids were received and what steps were taken to shop it around, the NASD suggests. In addition, it's important to ask if the broker is affiliated with a particular life-settlement company and thus may only be getting a bid from that one firm.

A Percentage of What?

Sellers should ask about commissions and any other charges.

Standard brokers' commissions have been 6%, but there may be subtle differences that can cost you big money. For example, some brokers charge commissions based on the purchase price, but others charge based on the policy's face value, a bigger figure -- which results in substantially less money in your pocket.

"If it's 6% of face value, that could be 20% or more of the purchase price," says Mr. Daily, who adds that policyholders shouldn't be afraid to haggle. "Commissions are negotiable."

Meanwhile, questions have been raised about collusion among buyers and brokers. Last October, former New York Attorney General Eliot Spitzer filed suit against one of the largest life-settlement buyers, Coventry First, accusing the firm of bid-rigging with one of its competitors that significantly short-changed investors.

In this alleged scheme, Coventry would make payments to brokers in exchange for them tilting the bidding process to ensure that Coventry was able to purchase the policies at lower prices. Emails presented as evidence showed Coventry officials haggling with brokers over what Coventry would have to pay to win the auctions. In one instance, Coventry is alleged to have paid a broker $200,000 in exchange for not presenting to the policyholder a bid that would have topped Coventry's bid on a $10 million policy by $425,000.

Coventry denies in court filings that the firm did anything wrong, saying it didn't have to disclose the payments to policyholders.

Other Routes to Consider

There may be other options that should be considered. If it's a question of not being able to afford the policy premiums, you can ask if dividends or the cash value from the policy can help with the payments. You also can ask a family member to contribute.

If there's a concern that the policy is earning subpar returns, under certain circumstances it can be exchanged tax-free for another insurance policy or an annuity -- if losing the death benefit isn't a major concern.

John Skar, chief risk officer at Massachusetts Mutual Life Insurance, and a vocal critic of life settlements, says policyholders should keep in mind that sophisticated investors believe they are getting good value in the policies they buy. But once commissions and taxes are taken into consideration, most policyholders who sell are going to have a hard time matching what they have given up, he argues.