A life settlement, also known as a viatical settlement, is a lump sum payment that purchases a person’s life insurance contract from them and makes the life settlement company the new beneficiary. These have become more regulated in last 20 years due to the questionable moral dilemma that this presents.

They tend to only work for permanent life insurance products like whole life and universal life, since the viatical company will know that it will get a return on its investment. Life insurance companies have some of the most impressive returns, in a risk-adjusted perspective, on the money in their general account.

This is partially due to the fact that actuarial science can estimate with some accuracy when the average person with a certain risk profile will pass away. The companies have a strong cash flow due to premiums coming in.

On term life policies, 99% of them will never result in a death claim, and the term will expire, allowing the life company to keep the money. Life settlement companies attempt to capitalize on the returns that are possible by tapping into the general account of life insurers, and they can get an even better return than the average by taking advantage of a sick person’s need for cash.

Even if it’s a financially strained person who isn’t sick, statistically a poorer, stressed person will have a shorter life expectancy than a wealthy person. Life settlement companies offer a lump sum settlement to a person which will be greater than the cash value in their permanent policy but less than the death benefit, after which the settlement company will take over any remaining premiums and will become the beneficiary that receives the death benefit amount.

For example, if a person had a whole life policy with a $50,000 cash value and a death benefit of $100,000, the life settlement company might pay the insured person, say, $65,000 in a lump sum to take over the contract. The IRS issued new rules regarding the taxation of Life Settlement transactions in 2009 (Rev. Ruls. 2009-13, 2009-14), and you should check to see what the current laws and tax regulations are to make sure.

Basically the basis on the policy is not as favorable if a person sells to a life settlement company as opposed to surrendering the contract with their issuing life insurance company for the cash value, but, as stated above, the settlement company will pay more. The settlement company will be taxed at capital gains on any profit above their purchase price.

Pools of such settlements can be securitized and sold in the second market. After the settlement, the contract might be known as third-party owned life insurance or stranger-owned life insurance (STOLI).

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