When trying to determine the value of an unwanted or unneeded life insurance policy, there are many factors to consider. Both policyholders and advisors can use the resources provided by our experienced team members at LISA to help better understand what these factors are and how they might influence the potential payout if the policy is sold in a life settlement transaction.
The Insured’s Age and Health Status
The most important driver of value in a life settlement transaction is the life expectancy of the insured. Age, smoking status, sex and many other factors related to the insured’s health have an influence on life expectancy. For example, the older the insured, the shorter the period of time a buyer will have to wait to collect the policy’s death benefit. Also, since the buyer will have to pay premiums until the insured passes away, the shorter the period during which they have to do this, the more attractive the policy can be. So, since age is a very significant factor with regard to life expectancy, most but not all life settlements involve older age insureds.
Along the same lines, if the insured is in a state of declining health that influences their life expectancy, a policy covering them may be more valuable. Again, the greater the probability that the policy will mature in a somewhat measurable period of time, the more likely the policy’s value will be more attractive to life settlement investors.
The Policy Death Benefit
The death benefit of the policy is a major factor in determining if a life insurance policy is salable. Generally speaking, the policy’s death benefit should be at least $100,000. As you might expect, the greater the death benefit, the more lucrative the life settlement value will be. This is because a policy with a large death benefit pays out more money at maturity, and thus commands a higher price to the seller in a life settlement transaction.
Future Policy Premiums
When a policy is sold and becomes a life settlement, the investor who buys it becomes the policy owner and is responsible for future premium payments. The investor keeps the policy in force until the death benefit is collected. So, the amount paid for the policy plus the premiums paid while it is held are the primary costs associated with buying a life settlement. Premiums can have a significant impact on the return the investor earns when they collect the death benefit.
Of course, not all life insurance premiums cost the same. Depending on when the insured party purchased the policy originally, and what their medical status was at the time, some policies may cost substantially less to maintain and keep active when compared to others.
The Policy’s Cash Value
If the insured has already spent several years building-up cash value in the policy, then this could positively influence the value of the life settlement as well. This is because the cash value of most policies can be used to pay future premiums. So, if a policy with cash value is sold, the amount of money needed by the investor to keep the policy active will be reduced, and that can make the policy more valuable.
The Discount Rate
Like all investments, the buyer’s ultimate objective is to earn a rate of return from purchasing an unwanted policy and paying premiums until the policy matures. However, because the actual return on a policy cannot be known precisely until the death benefit is collected, buyers use a discount rate to estimate the rate of return they hope to achieve by investing. This rate is commonly known as a discount rate. Buyers perform a series of calculations using their chosen discount rate to produce a discounted cash flow analysis. They use this analysis to decide what to pay for a given policy, taking into account all of the variables described above, as well as many others.
While discount rates and interest rates are not the same thing, if interest rates are low, buyers may be willing to use lower discount rates to price policies. Part of this decision is tied to the comparison all investors make between various investments and the rates of return they can earn by investing in different instruments. All investments offer differing degrees of risk and return and interest rates are often used as a means of comparing these returns across different assets.
Putting It All Together – The Rate of Return
While it may be generally understood how each of these factors contributes to the value of a life settlement, the final determination will require performing some calculations. For example, let's assume a policyholder has a policy with a $250,000 death benefit and the average annual premium over the next 10 years is $12,000 per year. And in this example, an investor pays $50,000 to buy the policy and pays $120,000 in premiums ($12,000 per year over 10 years) by the point of collecting the death benefit. In this example, the investor will have invested a total of $170,000 over 10 years to get back $250,000. To compare this investment to any other, the buyer can calculate a rate of return based on these facts and use it to compare with other investments. In this case, the investor's rate of return would be 6%.
Of course, this is just a simple illustration to demonstrate how these factors might influence the value of a policy. The payout to the insured, as well as any commissions, fees, and taxes, will also play a role in the overall investment outcome to the investor, and life settlements, like all investments, bear some risk.
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