Personal
Editor:
Financial Planning
Life Settlements
Advisers are constantly looking for
ways to supplement the depleted finances
of their clients. For seniors, one option that
has become more popular is the secondary
market for life insurance or life settlements.
Several articles have recently been pub-
lished on this topic, and many have tried
to portray this industry as the “next sub-
prime crisis” waiting to happen but gloss
over the underlying fact that the use of life
settlements has uncovered vast amounts of
hidden value from existing life insurance
policies. Over the past 10 years, owners of
life insurance policies who have chosen to
sell have received approximately $6–7 bil-
lion more than their cash surrender value
(CSV) (Thomas, “LISA Pans Article,” Life
and Health Insurance News (September
14, 2009), www.lifeandhealthinsurance
news.com/News/2009/9/Pages/LISA-Pans-
Article.aspx).
1 4 0 the tax adviser February 2010
Michael David Schulman, CPA/PFS
It is not uncommon for the settlement
amount to be three to five times the CSV,
and the policy owner is relieved of all
future premium payments on the policy.
All types of policies are eligible for a life
settlement, including term, universal
life, whole life, variable universal, and
second-to-die policies. The general rule
of thumb in today’s market is that the in-
sured should be over age 70 with a mini-
mum of $250,000 of insurance.
The tax treatment of life settlement
proceeds has been unclear until recently.
However, the IRS issued guidance during
2009 that clarifies when and to what ex-
tent policyholders must recognize capital
gain when they sell a life insurance policy.
Background
The definition of a life settlement is the sale
of an existing life insurance policy from
the current policy owner to a third party
via the secondary institutional market in
exchange for an immediate one-time cash
payment that is less than the policy’s face
value but more than the policy’s CSV.
There are many reasons a policy owner
could come to the conclusion that he or she
no longer needs or wants a policy: Own-
ing an underperforming policy, retirement
of an executive or sale of a business, di-
vorce or death of a spouse or beneficiary,
estate size growth or reduction, changes in
health, and economic hardship or bank-
ruptcy are just a few examples that can
Author:
Amy Gavartin
cause policy owners to cancel or surrender
their life insurance. All these changing cir-
cumstances lead to an overwhelming out-
come: 88% of universal life policies and
95% of term policies never pay a death
claim (Kadlec, “Extra Value,” Time (Octo-
ber 22, 2006), www.time.com/time/maga
zine/article/0,9171,1549320,00.html).
The hard numbers are staggering: Ac-
cording to the American Council of Life
Insurers, in 2006 $2.22 trillion worth of
life insurance policies lapsed or were sur-
rendered, a total that increases by ap-
proximately 4% per year (American
Council of Life Insurers, Life Insurers Fact
Book 2006, www.acli/com/ACLI/Tools/
Industry+Facts/Life+Insurers+Fact+Book/
FB06.htm). Yet only an estimated $15–$20
billion of life insurance policies were sold
to the secondary market in 2007 (Breus,
“Virtues and Evils of Life Settlement,”
Journal of Accountancy (June 2008)).
The research firm Conning and Company
reports that seniors have approximately
$500 billion of life insurance in force, and
policyholders will contemplate canceling
about $125 billion of those policies (Stern,
“Life Settlements: The Legitimacy of a
Long-Term Care Funding Source,” Case
in Point (June–July 2009), www.snapfor
seniors.com/tabid/973/Default.aspx).
There lies the opportunity.
The legal and historical underpinnings
of life settlements are deep. In 1899, New
York’s highest court held that policy
owners have property rights in life in-
surance and as such can “go to the best
market [they] can find, either to sell it
or borrow money on it” (Steinback v.
Diepenbrock, 52 N.E. 662, 664 (1899)).
The Supreme Court laid the groundwork
for today’s life settlement marketplace in
1911, when it established the policy own-
er’s right to transfer an insurance policy
(Grigsby v. Russell, 222 U.S. 149 (1911)).
Misconceptions
Given the statistics, why are more people
not taking advantage of this option? The
primary reasons are (1) industry miscon-
ceptions and (2) policy owners and/or
their advisers do not realize that this alter-
native exists.
One of the most widely held miscon-
ceptions is that life settlements are viatical
settlements. The viatical settlement market
became popular in the late 1980s due to
the AIDS epidemic. The industry had vir-
tually no regulation, and there were many
incidents of questionable business prac-
tices. In addition, because of advances in
medical treatment for people that were
HIV positive, the death rate drastically
slowed and a significant number of inves-
tors lost money when policies did not ma-
ture as expected. These factors tainted the
reputation of the market and led insurance
carriers to implement accelerated benefit
riders for the terminally ill.
Although a life settlement transaction
is similar to a viatical settlement in that
the insured is selling his or her policy to
an outside investor, they are different in
two important ways. Viaticals are almost
always sold to an individual or a group of
private investors. The inherent risk is ob-
vious: The buyer knows the insured and
has a financial interest in the insured’s
death. Viaticals are also only for people
who are terminally ill.
Life settlements, however, are exclu-
sively for those insureds with more than
three years of life expectancy who have a
change in financial needs rather than an
overwhelming change in health. In addi-
tion, almost universally, institutional in-
vestors purchase the policies.
The other large misconception is that
life settlements and stranger-originated life
insurance (STOLI) are one and the same.
A STOLI policy is one created for the
purpose of selling at some future point in
time. In addition, these policies are initi-
ated by some outside third party and are
often accompanied by a financial induce-
ment. Although the intent of a STOLI
policy is for the policyholder to sell it via a
life settlement, the policy itself is not a life
settlement.
Taxation of Life Settlements
Another confusing issue is the taxation of
settlement proceeds. Until last year, the
IRS was silent about the taxation of the
proceeds of life settlements, and advisers
had varying opinions about what to do.
Rev. Rul. 2009-13, which went into effect
August 25, 2009, clarified the tax treat-
ment, even though many opinions still
differ. The ruling explains that for calcu-
lating the gain on the policy sold, the cost
basis consists of the cumulative premiums
paid into the contract less the cumulative
cost of insurance. This calculated cost
basis reduces the taxable gain on the sale
if paid for with after-tax dollars.
With respect to the character of the
gain, if the current CSV is greater than
the calculated cost basis, the difference is
treated as ordinary income. Any proceeds
received above the CSV are considered
capital gains. In the case of term life
insurance, the ruling states that the entire
amount of premiums paid is cost of
insurance, so there is no cost basis; since
there is no CSV with term insurance, all
the settlement proceeds are treated as
capital gain. (For more on this revenue
ruling, see McGivney, “Two Recent
Revenue Rulings Clarify Tax Treatment
of Life Settlements,” Tax Clinic, 40 The
Tax Adviser 516 (August 2009).)
Regulation of Life Settlements
Currently, 39 states and Puerto Rico regu-
late life settlements, and the National As-
sociation of Insurance Commissioners
(NAIC) recognizes them as a viable solution
(NAIC, “NAIC Adopts Viatical Settlements
Model Act Revisions,” News Release (June
4, 2007), www.naic.org/Releases/2007_
docs/viatical_settlements_model.htm). One
of the most recent states to institute regu-
lations is Rhode Island, which enacted life
settlement legislation in November (to take
t h e ta x a d v i s e r
effect July 1, 2010) (RI Gen. Laws §§27-
72-1 through 27-72-18).
In addition, three states—Maine, Or-
egon, and Washington—have new laws
that ensure policy owners are notified
about the opportunity of life settlements
and have reliable information when mak-
ing decisions about lapsing or surrender-
ing their policies (ME Rev. Stat. tit. 24-A,
§6812-A; OR Rev. Stat. §744.358; WA
Laws of 2009, ch. 104). It is expected that
several other states will adopt similar laws
in the near future.
Because the life settlement industry is
not regulated by any one nationally recog-
nized governing authority and is currently
regulated on the state level by state insur-
ance commissioners, policy owners should
exercise caution and good judgment when
choosing a broker (see “Choosing a Bro-
ker,” below). It is important to note that
the SEC and the Financial Industry Regu-
lation Authority have both pledged to
take a look at the life settlement industry
(see Schapiro, “Address Before the So-
lutions Forum on Fraud” (October 22,
2009), available at www.sec.gov/news/
speech/2009/spch102209mls.htm).
Advantages
There are many situations that would
make a life settlement beneficial. A com-
mon example is when a policyholder has
an underperforming policy but still needs
coverage.
Example: H and W, a married couple
aged 78 and 76, have a $10 million sec-
ond-to-die policy (taken out for estate
tax purposes) that costs them $385,000
per year. After meeting with their CPA,
they agree that due to the losses they
have incurred in the stock and housing
markets, they need only $5 million in
coverage. Because their existing policy
is underperforming, they look into a life
settlement for the $10 million policy,
wanting to use the proceeds to pay for
a new, more efficient $5 million policy.
The current policy has a $426,000 sur-
render value, but the top settlement offer
is $1,324,000—a 211% increase above
surrender. They then compare a Sec.
1035 exchange to selling the policy. A
1035 exchange would leave them with
F e b r u a ry  2 0 1 0 1 4 1
PersonalFinancialPlanning
annual premiums of $212,000 per year,
but by using the settlement proceeds to
fund the new policy, the premiums total
$165,000 per year for a $47,000 annual
savings, and a $220,000 annual savings
versus keeping the larger policy.
Another example of the versatility of
life settlements is in the distressed cor-
porate markets. The proceeds from a life
settlement can free up cashflow to pay
off creditors and help businesses stay out
of bankruptcy. Many corporations have
corporate-owned key executive policies
that they originated to fund buy-sell agree-
ments or nonqualified deferred compensa-
tion plans. Buy-sell agreements are often
protected with term insurance that usually
has an option to convert into a perma-
nent cash value policy. Corporations often
overlook the policies as assets because,
since they have no current value, they are
usually not on the financial statements.
Some advisers like to throw a philan-
thropic twist into the settlement equation
to offset any potential capital gains tax.
The following scenarios can achieve this
objective:
• Gift the policy to a charity and receive a
current tax deduction.
• Gift the policy to a charity, receive a
current tax deduction, and make addi-
tional yearly gifts to the charity to cover
the annual premiums to receive future
deductions.
• Sell the policy and donate a portion of
the proceeds to offset any capital gains
incurred from the sale.
• Sell the policy and donate all the pro-
ceeds to be able to take a deduction.
• Set up a charitable remainder unitrust
(CRUT) and gift the policy to the trust,
allowing the CRUT to sell the policy and
take the deduction based on the policy’s
true market value. This would also allow
for the annual income stream from the
trust to go to the insured for life, and the
remainder funds in the trust after the in-
sured died would go to as many charities
as the trust designated.
Life Settlement Process
The marketplace is always changing so it is
important to know what the current land-
scape looks like and what to expect from
1 4 2 the tax adviser February 2010
the sale of a policy. Institutional investors
analyze and price policies using a multitude
of factors. Policy type, age, gender, life ex-
pectancy, face amount, insurance carrier
rating, projected annual premiums, and
state of residency are just a few of the many
variables buyers consider. Future cost to
carry and life expectancy weigh most heav-
ily in determining price. Hence, individual
medical records are necessary for each in-
sured and should be analyzed by multiple
life expectancy reporting agencies.
The life settlement process usually
takes four to six months from start to
finish, and this is an important factor
to consider when starting the process.
After a general application is filled out,
a life settlement broker begins by order-
ing medical records from the insured’s
physicians and/or hospitals. Simultane-
ously, all illustrations are run, and trust
documents, copies of policies, and any
applicable supporting documents such as
loan documents are collected. The next
step is ordering life expectancy reports.
These are normally obtained within two
to three weeks. At this point, the broker
compiles and submits a complete package
to the marketplace of institutional buyers.
A policy’s desirability will determine how
rapidly the offers come in. Typically all of-
fers and declinations are received within
two to six weeks.
Practice tip: Because life expectancies
can vary by as much as two to eight years
from one life expectancy company to an-
other, ordering multiple life expectancies
is the best business practice.
Upon receiving the highest offer, pre-
senting it to the policy owner, and ac-
cepting it (around one week), closing
documents are prepared and sent out for
signatures. It is not uncommon for clos-
ing documents to be 70–90 pages long (it
is, after all, a contract to sell an asset) and
require the signatures of insured, owner,
beneficiary, spouse, personal physician,
and notary. This process of receiving
documents, getting signatures, and having
a legal review by the purchaser’s counsel
usually takes three to four weeks. The
final part of the process is that escrow is
opened, funds are deposited, and docu-
ments are submitted to the insurance car-
rier so it can make the changes of owner-
ship. Most carriers complete the changes
within two weeks, but some take as long
as 30 days. After the changes are com-
plete and verified by the escrow agent, the
agent releases the funds to the seller.
Choosing a Broker
Because of the many moving parts in-
volved in a life settlement transaction, it is
important that the policy be shopped and
represented properly in the marketplace.
To ensure this, a policyholder desiring a
life settlement should always use the ser-
vices of a reputable and seasoned life set-
tlement broker. A strong broker will:
• Act as a fiduciary to the policy owner
and his or her adviser;
• Not work with private individual
buyers;
• Submit cases to at least 30 institution-
ally owned funding sources;
• Not purchase policies for his or her
own investment;
• Offer full transparency on offers, in-
cluding funding source;
• Be willing to provide a list of all state
licenses;
• Have at least three years of industry
experience;
• Mandate a rescission period for all sold
policies; and
• Use a third-party escrow service com-
pany to complete transactions.
Cautions
Advisers and policy owners commonly
make the mistake of shopping a policy
through multiple brokers because of their
desire to have maximum exposure to the
funders. Most reputable brokers shop cases
to many of the same buyers. If multiple
brokers submit the same case to a funding
source, they dilute the market efficiencies
and create a lack of interest from potential
buyers. Many buyers will simply decline
or ignore these cases because no particular
broker is in control. In addition, one broker
may hurt the potential bids of another by
not sending the lowest combination of life
expectancies, basically polluting the file.
Another important consideration for
clients selling their insurance policies is
that the first policy remains in effect, even
though they are no longer the owners, and
therefore counts against their insurance
capacity (i.e., the total amount of life in-
surance they can purchase). Selling a pol-
icy may thus limit the amount of coverage
they are eligible for in the future if they
should need additional coverage.

Conclusion
At the end of the day, a successful life set-
tlement transaction results in more money
going to policy owners in exchange for
their unwanted or unneeded life insurance
policy than would have been received if the
policy was lapsed or surrendered. When a
policyholder no longer wants or needs a
particular life insurance policy—for ex-
ample, the policyholder can no longer af-
ford the insurance premiums or is willing
to give up or replace the coverage—life
settlements can make a lot of sense. This
powerful asset recovery, estate planning,
and charitable giving tool should be in
every financial professional’s repertoire
when dealing with senior clients.

This article is for informational purposes

only. Although the information in this
article is believed to be reliable, Melville
Capital and its affiliates do not warrant
the accuracy or completeness and accept
no liability for any direct or consequential
loss arising from its use. Past performance
is not a guarantee of future results. Nei-
ther Melville Capital nor any of its af-
filiates provide tax or legal advice. People
should consult independent counsel/tax
advisers in connection with matters cov-
ered in this article.

tta

EditorNotes
Michael David Schulman is the
owner of Schulman CPA, an
Accountancy Professional Cor-
poration, in New York, NY. Amy
Gavartin is director of advanced
markets at Melville Capital in
New York, NY. For further infor-
mation about this column, con-
tact Ms. Gavartin at agavartin@
melvillecapital.com.