Chapter 3 — Prospects for Lifetime Settlements

Businesses often insure the lives of key executives, owners, or revenue-generating employees against the financial loss that would result from their death. When the insured executive retires, departs, or the business is sold, the key person policy may no longer serve its original function.

Rather than surrendering the policy to the insurer for its cash value, the business may be able to settle the policy for a significantly higher amount — particularly if the insured’s health has declined since the policy was issued. The settlement proceeds can be redirected to fund operations, retire debt, or be distributed to shareholders.

Life insurance is commonly used to fund buy-sell agreements between business partners or co-stockholders. Each partner typically owns a policy on the other, so that if one dies, the surviving partner can use the death benefit to purchase the deceased’s business interest from the estate.

A life settlement opportunity arises when:

› A co-owner predeceases the insured, making the coverage on the surviving owner unnecessary
› The business is sold to a third party, eliminating the need for the buy-sell arrangement
› The buy-sell agreement is restructured or dissolved
› The partners mutually agree to terminate the arrangement

In any of these situations, policies that would otherwise be surrendered for their cash values may command significantly higher proceeds on the secondary market.

Split-dollar arrangements divide the costs and benefits of a life insurance policy between an employer and an employee (or between a business and another party). These arrangements were commonly used as executive compensation vehicles. When a split-dollar plan is terminated or unwound, the policies involved may be candidates for settlement — particularly if the insured executive is older and in impaired health.

Settlement of split-dollar policies requires careful analysis of the ownership structure and the rights of each party under the arrangement. Legal and tax counsel should always be involved.

Corporate-owned life insurance — policies owned by a corporation on the lives of employees, officers, or directors — has been used as a tax-advantaged financing vehicle. COLI policies accumulate cash value on a tax-deferred basis, and death benefits have historically been received income-tax-free by the corporation.

Congress addressed perceived abuses in the COLI market through IRC §101(j), enacted as part of the Pension Protection Act of 2006. Under these rules, a corporation may only receive death benefits income-tax-free if the insured employee:

› Was notified in writing that the corporation intended to insure their life and the maximum face amount of coverage
› Provided written consent to being insured and to the corporation being the beneficiary
› Was an employee, officer, or director within the 12 months before death — or a highly compensated employee or director at the time the policy was issued

Death benefits paid in excess of the corporation’s cost basis that do not meet these requirements are taxable as ordinary income. When COLI policies become excess or unwanted, a life settlement may offer more than the policy’s cash value.

Charitable organizations are frequently named as beneficiaries of life insurance policies or receive donated policies from supporters. While waiting for the death benefit can be appropriate in some cases, charities may have more immediate funding needs.

A life settlement allows a charity to:

› Convert a donated policy into immediate operating cash rather than waiting years or decades for the insured to die
› Eliminate ongoing premium obligations on policies where the charity is responsible for paying premiums
› Redirect resources away from insurance premium payments toward mission-critical programs

For charities that receive donated policies they lack the expertise or resources to manage, a settlement is often the most practical option. The charity receives cash immediately, avoids the complexity of managing an insurance asset, and can put the funds to work right away.