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What is a Life Settlement? - Definition & Benefits

Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

In some situations, selling a life insurance policy to a third party is a better option than surrendering the policy. In this lesson, you will learn about life settlements.

What Is a Life Settlement?

Martha is 70 years old and recently retired. She has a life insurance policy that she took out before her children were born. Given that her children are grown up, she wonders if she should continue to pay the premiums to keep her insurance in force. A friend recently told her about life settlements and she wonders if this is a good option for her. Let's see if we can help Martha with this decision.

A life settlement involves a policyholder selling his or her life insurance policy to a third party for a lump-sum cash payment. The payment amount is somewhere between the cash surrender value and the death benefit. The cash surrender value is the amount of cash value that has accumulated in a permanent life insurance policy over the life of the policy. It is available for the policyholder to withdraw if he or she surrenders the policy. The death benefit is the amount payable to the policyholder's beneficiaries when she or he dies.

The most common purchasers of life settlements are institutional investors. When the institutional investor purchases the policy, it becomes the owner of the policy and must pay all future premiums or the costs of the policy. The purchaser of the policy is also entitled to receive the death benefit proceeds when the insured dies.

Let's assume that Martha sells her policy to the ABC Company. She would receive a lump-sum payment from the company and they would become the owner of her policy. When Martha dies, ABC Company will receive the death benefit proceeds from Martha's insurance company.

Policyholder Benefits

If Martha were to sell her policy in a life settlement, she would receive a higher payment amount than if she surrendered her policy for the cash value. A sale in a life settlement would provide her with an amount between the cash surrender value and the death benefit.

Selling her policy gives Martha the opportunity to convert something she no longer wants or needs (her insurance policy) into cash. She receives a lump-sum payment for her policy that she can use for whatever she wants or needs such as travel or paying for her stay in a retirement home.

Policyholder Risks

The policy owner will be selling his or her policy to a stranger who now has a vested interest in his or her death. The purchaser of the policy may change as life settlements can be bought and sold a number of times.

Since the purchaser's profit is the difference between the amount paid and the death benefit, the purchaser could have an incentive to offer a low lump-sum amount to the seller. The seller must also consider that he or she may no longer qualify for life insurance due to age or health.

Purchaser Benefits

The purchaser of a life settlement is hoping to make a return on their investment. The purchaser buys the insurance policy at a price that is less than the death benefit that they will receive when the insured dies. The difference between the death benefit and the purchase price represents profit to the purchaser.

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