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Here's how a viatical settlement works.

A viatical settlement is some grim business. It allows the holder of a life insurance policy to sell it for more than its purchase price, but less than its face value. If you are in the market to sell one, you have our sympathies. However, if you find yourself in that situation, there are a few things you should know before making a sale.

What Is A Viatical Settlement?

In a viatical settlement, you buy either all or part of a life insurance policy from the policy’s current owner. The buyer of a viatical settlement pays more than the cash surrender value of the policy (if any) but less than the final payout of the policy. They also pay all applicable premiums. In exchange the buyer receives the policy payment once it matures (typically upon the policyholder’s death).

For example, assume that Robert has a life insurance policy that will pay $100,000 upon his death. The policy has a surrender value of $50,000. Steven could buy Robert’s policy in a viatical settlement for $75,000. Robert receives more than he would by cashing in his policy and Steven will make a $25,000 profit upon Robert’s death.

A viatical settlement can either be in whole or in part. In a partial viatical settlement, the buyer receives a percentage of the final payment in proportion to his investment and pays that same proportion of the premiums. In our example above, Steven could have paid $37,500 for half of Robert’s life insurance policy. Here, upon Robert’s death Steven would receive half of the value of the policy (here, $50,000).

Risks and Returns On A Viatical Settlement

Here's how a viatical settlement works.

The profile of a viatical settlement differs for the buyer vs. the seller.

Seller Risks and Returns

At a future date the life insurance policy will be worth its full payment value. However that payout is at an undetermined point in the future, and the priorities of the policyholder may have changed. As a result, the seller takes a lump sum amount of money now in the belief that they will not need that insurance policy again and/or that the value of the lesser amount today outweighs the greater amount in the future.

For example, as a parent you might purchase life insurance to protect young children in case of an untimely death. As time passes and your children start their careers, you might feel this s no longer necessary.

Or you may have taken out a life insurance policy while healthy but now have a critical illness. You need the payment less than you need cash to cover your bills.

In either case a viatical settlement might be an option worth considering.

However you are taking a risk. If one of your adult children loses their job, for example, or if you grow concerned about the financial future of your grandchildren, you might regret not keeping this insurance policy. Older policyholders have the most valuable policies to sell, because the buyer won’t have to wait for 50 years. But they are also tougher to re-insure if their priorities change.

Buyer Risks and Returns

The chief risk of buying a life insurance payment is longevity.

A viatical settlement is based on the remaining life expectancy of the policyholder. If the seller dies earlier than expected, you will see higher than anticipated returns.

For example, in our example above Robert holds a life insurance policy worth $100,000. Steven enters a viatical settlement with him for $75,000. Let’s assume that Steven made this offer expecting that Robert would live another 20 years.

In this case, no matter when Robert dies Steven will receive $25,000. This is the fixed death benefit of the insurance policy. However $25,000 in 10 years is worth more than that same amount of money in 20 years. This gives Steven an extra decade to invest and grow his income.

However the risk is that Robert will outlive his life expectancy. In this case, time value will erode Steven’s returns. Say that Robert lives for 30 more years. This means that Steven will get his money a full decade later than expected, and will lose a decade’s worth of investment and growth.

Worst still is if the buyer enters a viatical settlement with premiums left to pay. If the policy has current premiums, or if the policyholder lives long enough that the plan begins to charge premiums again, the buyer has to pay. This will steadily erode their profits.

Purpose of a Viatical Settlement

A viatical settlement is designed for terminally ill patients. It is not designed for people to speculate on aging or death by natural causes.

While this is not specifically forbidden, you may struggle to find buyers for a viatical settlement on any basis other than critical illness. This is particularly due to the unpredictable nature of death by aging or other causes. Morbid as it is, critical illness makes a viatical settlement a much less speculative investment. (Readers should note that the specific legality and conditions of a viatical settlement may vary by state, as insurance is a highly jurisdictionally-specific market.)

The policyholder generally will use a viatical settlement as a way to access cash during a critical illness. They will typically do this to help fund medical expenses or other needs. For this reason the IRS does not consider viatical settlements taxable for income purposes. However, given that the agency specifically notes that it considers viatical settlements in the context of terminal illness, readers should consult a financial advisor if they enter one for non-health related purposes.

Viatical Settlements vs. Life Settlements

Here's how a viatical settlement works.

The alternative to a viatical settlement is what’s known as a “life settlement.” This is sometimes referred to as a “senior settlement.”

A life settlement has essentially the same form as a viatical settlement. In it you sell the proceeds of your life insurance policy for cash. The key difference is that a life settlement is not designed for the terminally ill. Instead, the typical life settlement is reserved for senior citizens over the age of 70 looking to liquidate their life insurance policies for cash.

Life settlements typically pay considerably less than viatical settlements, although they will still offer more than a policy’s cash settlement. They also require permanent life policies, since the buyer of the settlement doesn’t want to risk the policy expiring before payment. Finally, a life settlement is considered a taxable by the IRS.

Bottom Line

A viatical settlement is meant for the most dire of circumstances. It can come with substantial risk for those who aren’t facing a worst-case scenario.

If you’re considering a viatical settlement simply because you can use the extra money, look at some of the alternatives mentioned. If you are terminally ill or facing similarly grave circumstances, consult a financial advisor before making a decision.

Life Insurance Tips

Photo credit: ©iStock.com/Piotrekswat, ©iStock.com/jeffbergen, ©iStock.com/takasuu

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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