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Whole-life insurance can turn quickly from a financial asset to a financial burden. The premiums are high and there's no flexibility to skip or miss payments unless the policy is paid up. A deteriorating financial situation that prevents your client from paying premiums puts the policy at risk of lapse.
A lapse leaves your client with no coverage, cash, and in some scenarios, a 1099 and a huge tax bill. That's a troubling set of outcomes, especially if your client has invested in premium payments for years.
Fortunately, there are better options for clients who cannot fund their life insurance. Read on for a review of four ways to generate cash from an expensive whole-life insurance policy.
Cancel, sell, or loan
Four options that can alleviate a client's cash-flow shortfall are:
1. Canceling the policy
Your client would contact the insurance company and request an immediate cancellation. A cancellation ends coverage immediately. The insurer would pay any surrender balance to the client in lieu of using those funds to cover the premiums.
2. Selling the policy
You and your client would work with a life-settlement company to sell the policy to an investor. The client receives a cash payment and the policy transfers to a new owner.
3. Borrowing against the policy through the insurer
Your client can take a loan from the insurance carrier. This strategy can be counterproductive if your client can't make the premium payments, however. The accrued interest on the loan usually raises the premium burden. If the policy lapses while the loan is outstanding, the client may owe income taxes on the balance.
4. Borrowing against the policy with a collateralized broker loan
Your client can borrow up to 95% of the policy's cash value from a participating broker. Once the loan funds, the broker takes over the premium payments. The broker also repays the loan and accrued interest from the death benefit.
Policy cancellations
An immediate policy cancellation eliminates all future premium payments and may provide a cash payment to your client. That's the good news.
The bad news is that your client may incur high fees in the process. Upon cancellation, the insurer will pay your client the policy's cash value less any loans and surrender fees. These fees can be significant, depending on how long the policy has been in force. While surrender fee tables vary, these costs often start out high when the policy is young, and then gradually reduce over time.
Also, in some cases, a policy cancellation is taxable. This can happen when the surrender payout is more than the policyholder's cumulative investment in premiums.
This last point is obvious but worth mentioning: A policy cancellation voids the death benefit immediately.
Policy settlements
A second option is to sell the policy outright for cash, in what's called a “life settlement.” A life settlement produces similar outcomes to a policy cancellation, with one major exception. The life settlement generates far more cash than a cancellation. Some policies are worth up to 60% of the death benefit on the secondary market.
Once the life settlement closes, the policy will belong to someone else. That means your client will have no access to the cash value and no right to the death benefit. The new owner also pays all future premiums.
Life settlements can be taxable. If your client makes a profit on the life settlement, the IRS taxes part of the gain as ordinary income and the remainder as capital gains.
Policy loans
The third option is a loan against the whole-life policy. Your client can borrow directly from the insurer or from a third-party participating broker.
Insurer loans
The insurer loan probably isn't the right solution when your client can't afford the policy's premium payments. This is because the policyholder's out-of-pocket expenses can rise after the loan funds.
Unpaid interest on an insurer loan is added to the loan balance. That causes the interest expense to rise over time. Eventually, it can rise high enough to exceed the dividend income produced by the policy.
When that happens, the policyholder may have to pay in more to protect the policy's solvency. Meanwhile, the policyholder must also continue funding premium payments. Should the policy lapse for any reason, any outstanding loan balance exceeding the policyholder's cost basis becomes taxable as ordinary income.
Broker loans
A broker loan is usually better for a cash-strapped policyholder than an insurer loan. The policyholder comes away with a tax-free cash payment, elimination of future premium payments, no required loan repayments, and a guaranteed death benefit for beneficiaries.
The broker uses the entire policy, including the death benefit, as collateral for the loan. Since the broker relies on the death benefit for repayment, the broker will take over the premiums to keep the policy in force. That prevents an accidental policy lapse and any related tax consequences.
Repayment is optional. If your client makes no repayments, the broker will repay the balance plus accrued interest from the death benefit. There is a guaranteed minimum death benefit, which applies no matter how long the loan is outstanding or how much interest accrues.
Maximize value from an unwanted whole-life policy
Your clients can and should pull value from their unwanted whole-life policies. The right way to liquidate depends on your client's immediate needs and priorities. For maximum cash, a life settlement may be ideal. For a tax-free cash payment plus the retention of a death benefit, your client may prefer a broker loan.
Talk through these options and guide your client to the solution that moves them closer to their financial goals.
Lucas Siegel is CEO of Harbor Life Settlements, an Austin, TX-based firm that advises seniors in how to dispose of life insurance policies.
Read more articles by Lucas Siegel
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
