Using a life settlement vehicle to tackle term insurance challenges
Realising the cash value on term insurance policies can often prove difficult. Col Fullagar explains why employing a life settlement vehicle can help your clients address this problem.
The appeal of term insurance has always been the belief that it would provide access to low-cost, affordable life insurance protection.
Coming out of the 1970s when a $500,000 whole of life policy was costing around $8,000 annually for a 40-year-old male, term insurance at just over $500 for an equivalent benefit amount was affordability nirvana – even a smoker would only pay around $1,000.
Sadly, the 40-year-old non-smoker is now a 70 year old paying in the order of $15,500 annually for his $500,000 term policy ($23,000 for the smoker).
Sadder still, he has paid almost $135,000 into his term insurance over the years.
His need for cover has diminished, as has his health, and he is thinking of cancelling his insurance for a net return of nil.
This is not to denigrate term insurance. It was likely the correct recommendation, but for the client there may be a temptation, with the wisdom of hindsight, to question the investment of that amount of money just for peace of mind. If only there was some alternative.
In the past, when applying for life insurance, unless on an own-life basis, it was necessary for the applicant to have an insurable interest in the life insured. According to the Life Insurance Act, England, 1774, an insurable interest is:
- an interest based upon a reasonable expectation of pecuniary advantage through the continued life, health and bodily safety of another person and, consequently, loss by reason of their death or disability; and
- a substantial interest engendered by love and affection if closely related by blood or law.
The legislative requirement for there to be an insurance interest when applying for life insurance arose in response to early insurance being used as a form of gambling.
A notorious case occurred in Pennsylvania in the late 1800s when six men took out an insurance policy on an elderly gentleman who then proceeded to live longer than expected.
As the premiums rose ever higher, the men, in their frustration, murdered the old man, and were then hanged for their trouble.
Within Australia, the need for an insurable interest was removed from legislation in 1995, however, underwriters are likely to be hesitant still about approving an application where there is no insurable interest.
Importantly, any issues about an insurable interest only exist at the time of application.
Thus, for example, a husband and wife who hold insurance on each of their lives could separate but still continue to retain the insurances in force.
Similarly, the owner of a policy could transfer the ownership to another party either with or without the payment of remuneration for the transfer.
It is this aspect of life insurance that provides the opportunity for the owner of a term insurance policy to realise a cash value from it in certain circumstances.
The vehicle used is what is called a ‘life settlement’. Life settlement generally refers to the sale to a third party of a life insurance policy by a policy owner for less than the face value but more than the cash-surrender value (which is nil in the case of term insurance).
The third party 'investor' plans to profit when the life insured dies by collecting more in death benefits than they have paid out in the original purchase price, plus premiums plus expenses and interest.
This type of transaction has been available in the United States since 1911, where in the last financial year it was reported that almost $20 billion dollars of sums insured were traded.
The practice started in Australia in mid 2009 with the establishment of Australian Life Settlements (ALS).
How do life settlements work?
Firstly, the life insured would need to be able to satisfy the following criteria:
- Is their insurance issued by an Australian life insurer?
- Has the policy been in force for longer than two years?
- Is the benefit amount between $50,000 and $5 million?
- Is the life insured over age 65?
- Does the life insured have health impairments that are likely to reduce their life expectancy to 12 years or less?
Once ALS is advised of eligible insurance policies by way of a completed application form, not dissimilar to the health questions in an insurance application form, ALS contacts the insurer to obtain the necessary basic policy details for their records.
ALS then calculates a cash value based on the actuarially calculated future life expectancy of the insured, with the cash value being: “The anticipated future policy payout less the present value of future premiums that are likely to be paid less the profit return rate to ALS.”
For example: A 70 year old holding a $500,000 term life insurance policy with a future life expectancy of eight years might receive a cash payment of around $62,500 (figures provided by ALS).
If acceptable, the client assigns ownership of the policy to ALS and receives payment in exchange.
The advantages to the client is a cash return on their term insurance that would not have been available otherwise, which might be particularly important if the life insured is ill but not terminally ill.
For a client who is not yet eligible for a life settlement payment, the knowledge that one may be available in the future might encourage them to retain their insurance in force longer than they would have otherwise.
Their adviser can assist here by obtaining details of the possible future cash value and assessing this against future premiums to the date of any life settlement.
This improved persistency is good news for the client, the adviser and the insurer.
Because ALS retains the policy in force, the adviser continues to receive servicing commission.
There may be perception issues associated with this (ie, receiving a commission but not providing ongoing service), so an alternative available is for the client to authorise the payment of up to 2 per cent of the cash value to the adviser by way of a fee for assistance in arranging the life settlement.
Questions
Questions that may arise include:
(i) What is the tax position of the cash value paid to the client?
Tax advice obtained by ALS is that the payment would not be taxed as it would be treated the same as the payment of a death benefit.
If it was taxed, it would be on the basis of the cost base being the total of premiums paid which, in most cases, would be greater than the cash payment. Of course, clients should obtain their own tax advice in regards to this.
(ii) What would be the position if the insurance was held within a superannuation fund?
If the policy is suitable for a life settlement transaction, ALS advises it would be necessary for the member to convert it to non-superannuation, with he or she as the policy owner.
They would then be entitled to sell the policy and use the cash value to supplement their retirement savings. Once again, however, the client should obtain their own tax advice in this regard.
(iii) Is there a moral issue surrounding the purchasing of an insurance policy by an unrelated third party?
Some people may not feel totally comfortable with this concept but on the other hand, the advantages for the client set out above are such that perhaps the focus should be in that area rather than elsewhere.
(iv) What is the position of life insurers to the life settlement business?
From the insurer’s perspective, the insurance is retained in force and premiums continue to be paid. In one sense, it may be advantageous for the insurer if the policy had been cancelled prior to a claim, but it is more likely the insurer will look at the positive aspects of:
- improved persistency;
- potentially greater take up of term insurance on the basis that a cash value can be realised in the future; and
- maintenance of their normal profit margin on their term insurance book of business.
(v) What is the position of advisers?
The role of the adviser is, in part, to assist the client by providing appropriate financial advice.
If the client has access to a previously unknown valuable asset, it is contingent on the adviser to make this known to the client in such a way as to enable the client to make an informed decision.
The purpose of this article is not to provide an endorsement or otherwise of the life settlement market. It is intended to put before the adviser information about the market to assist the adviser in making their own enquiries, so they can in turn assist their clients.
Col Fullagar is national manager at Risk Insurance.
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