Think twice about ditching your life insurance

February 11, 2011

Workers walk outside the London Stock Exchange October 16, 2008. REUTERS/Andrew Winning A controversial way to wring cash out of unwanted or outdated life insurance is quietly making a comeback.

The ability to sell such policies on the secondary market, through a transaction known as a life settlement, provides an alternative to simply letting the policy lapse after many years and thousands of dollars of premium payments.

But for many people, there are better alternatives. “In reality, it is likely that some 95 percent of potential policy sellers should retain them,” says Peter Katt, a fee-only insurance agent in Kalamazoo, Michigan.

The life settlement industry took a big hit in 2008 and 2009 as the investors who buy the policies closed their wallets during the worst of the economic crisis. Now that the economic dust has settled the market “is poised for growth as investors look for alternatives to diversify their risk exposure,” according to a report by the non-profit Insurance Studies Institute.

The transactions are marketed most heavily to people age 65 or older with life expectancies of two to 10 years, and who have policies with a death benefit of $250,000 or more. Typically, they no longer need insurance to cover dependents, mortgage debt, or other obligations and the premiums have become an unwanted and unnecessary burden.

These individuals can cash out by selling the policy for a one-time cash payment, usually through a life settlement broker or insurance agent, to private investors or to companies that specialize in this kind of investment.  The proceeds depend on health, life expectancy, the type of policy, and other factors. While the payment can be several times higher than the cash surrender value, it is usually well below the full death benefit.

The policy buyer continues premium payments and, when the policyholder dies, collects the death benefit.   The sooner the grim reaper comes calling, the higher the investor’s return.

Advocates argue that life settlements provide an alternative to letting policies lapse or accepting a low cash surrender value.  That’s particularly important when the proceeds from the sale are being used for pressing needs such as long-term care, large debts, or unexpected medical bills.

But while selling life insurance for cold, hard cash might seem tempting, especially when times are tough, these transactions are far from simple.

One problem is that policyholders always incur commissions and often must pay taxes when the policy is sold.  Commissions, which can range from 10 percent all the way up to 30 percent or more of the gross sale price, are essentially hidden because they are built into the price.

It’s also difficult to know if you’re getting a fair shake, since there is no transparent secondary market for life insurance policies. And because the life settlement industry “is relatively new and may target seniors in poor health it can be prone to aggressive sales tactics and abuse,” warns a report from the Financial Industry Regulatory Authority (FINRA), a securities industry regulator.

Katt recalls one 80-year-old client in deteriorating health who was offered $525,000 for a $2 million face value policy. After subtracting for commissions and taxes, the client would be left with $350,000. The purchase contract also had a number of vexing provisions, including one that allowed the buyer to contact the seller at least every three months to see if he was still alive.  In some contracts, the seller may even be required to provide updated medical records or a physical exam.

“There are only two situations where selling a policy is the best choice,” says Katt. “One is when cash is desired and a life settlement exceeds the policy’s surrender value. The other is where a policy has heavy surrender charges and is poorly priced, and the insured person is still in good enough health to replace the old policy with a better one if needed.”

Individuals who no longer need their policies, but who need cash or want to stop paying premiums, can also turn to other options.

If the need for cash is a primary motivator, check your policy or call your insurance agent to see if you are eligible to borrow against it. Some policies may have an accelerated death benefit, which allows someone with a long-term or terminal illness to receive reduced benefits before death.

What if you want to just stop paying premiums but keep the policy? In that case, you could use any cash value that’s built up over the years to pay premiums. If you decide to sell the policy in a few years, you would likely get more for it in a life settlement transaction because you’re older.

If you decide to investigate selling your policy, be sure the agent or broker you’re working with gets more than one quote. Ask for full disclosure of all commissions and fees. And remember that in many states, you can rescind the transaction in 15 to 30 days of receiving the sale proceeds if you change your mind.

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Peter Katt – you make me laugh – only two situations when selling a policy is the best choice? Come on Peter! What happened to your imagination? To name just two more: What if the insured can no longer afford to make the payments and/or doesn’t need the insurance any longer? What if the insured bought it to protect his wife and she dies first?

According to a 2010 study by the Federal Government, insureds receive up to eight times their policies’ cash values when they sell them. Many states have enacted laws REQUIRING life insurance companies to advise their policyholders of the right to sell their policies rather than use the limited choices you espouse.

Selling your life insurance policy was declared legal a century ago. US Supreme Court Chief Justice Oliver Wendall Holmes wrote the decision for the majority in 1911. Guess who argued against his decision.

Me thinks your bias is showing…just a wee bit.

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