LIVING ON A

fixed income and ever-mounting expenses, many retirees are reaching for an unexpected source of cash: their life insurance policies.

But rather than tapping its cash value, an increasing number of insured folks in their 70s and beyond are choosing a relatively new option: selling their insurance to investors through what is known as a life insurance settlement.

It sounds like a win-win situation for all parties involved. The insured who sells the policy, the investor who buys it, and the life settlement broker who facilitates the deal. Here's how it works: The insured gets an immediate payout that is higher than the policy's cash value. Still, the settlement payout is lower than the total face value of the insurance, which the investor will receive once the owner dies. How much lower? That depends on his or her age, health condition and the policy's premiums, which the investor continues to pay until the seller's death, says Craig Campbell, a licensed broker with Life Insurance Settlements, a brokerage. "We've sold policies for less than 10% of the face value to over 70%," he says. The broker, of course, collects a generous commission.

Life insurance settlements are a spinoff of the so-called viatical settlements, which back in the 1980s allowed AIDS patients to get much-needed cash to cover expensive medication by selling their policies to investors. But as new medication prolonged the lives of AIDS victims, viatical settlements became less popular. Life settlements, which target elderly individuals with 12 or fewer years to live based on life expectancy charts, claimed the majority of the market.

As bleak as it all sounds, it's a fast-growing market. Although no official statistics exist, Doug Head, executive director of the Life Insurance Settlement Association (LISA), the industry's trade group, estimates investors purchased polices worth between $10 billion and $15 billion in face value last year alone, compared with only $500 million five years ago. He also notes that the association's membership has ballooned from 16 companies in 2000 to 136 today.

But are all the people selling their policies getting a fair deal?

Take this typical scenario: You're retired, with adult children no longer dependent on your income, and a spouse with Social Security and a nest egg to draw on if you pass away. Your health has been diminishing and medical expenses are on the rise. Yet, you still have to pay insurance premiums on a policy no one really needs.

A life settlement broker then shows up with the attractive proposition of finding an investor who will pay you more than the policy's cash value (that's assuming a whole life policy, but term life can also be sold). You're getting a better deal than cashing in and definitely a better deal than simply letting the policy lapse. Selling sounds smart.

But in most cases, it isn't the smartest financial choice, says Herbert Karl Daroff, a certified financial planner (CFP) in Boston. "Unless you're in dire need for food, clothing and shelter, you ought to ask the question, why would someone pay me this much money for my policy?" he says. After all, given the significant discount at which you'll be selling that policy, it's worthwhile to consider whether you could still hold onto it, so that one day the ones who really benefit from it are your loved ones, not a stranger.

Indeed, life settlements come with so many potential traps that the National Association of Securities Dealers (NASD) last week issued an investor alert about them. Here's what you need to know.

1. Shop around first

So a life settlement broker has offered what sounds like a good deal but how do you know if you're getting the best deal? "Unlike the stock market, there isn't one web site where you can go and see what life settlements are trading for," explains John Gannon, senior vice president for investor education at the NASD. "That's why we urge people to get more than one quote."

The good news is, if you're a desirable candidate for selling your insurance there'll be plenty of candidates to buy it, says Sally Hurme, a lawyer with AARP's financial-security division. "There's fairly stiff competition out there," she notes.

Some states are actually working to make the marketplace transparent. Maryland, for example, has a law requiring brokers to disclose to the client all offers for his or her insurance policy within 48 hours of receiving the offer. For now, it's the only state with such a requirement, according to LISA's Head.

2. Fat commissions

There's nothing wrong with brokers getting paid. But life settlement commissions can run as high as 30%, according to the NASD. With such high commissions at play, a broker could go with an investor who offers a higher commission versus another one with a lower commission.

3. Know the tax consequences

Selling your policy is a taxable event. Just how it's taxed isn't crystal clear because this is still a relatively new way of using life insurance. Here's life settlement brokers' version: Say you have a policy with a $40,000 accumulated cash value. So far, you have paid $30,000 worth of premiums. The life settlement broker offers a $60,000 payout. Taxes: You don't get taxed on the first $30,000, and pay income tax on $10,000, or the difference between the cash value and your premiums paid to date. The rest ($20,000 in this case), will be treated as capital gains (at the generally much lower 15% or even 5% long-term capital gains rate).

But the IRS may disagree, Daroff says. "There's not a whole lot of IRS guidance on how life settlements are actually taxed," he notes. "Life insurance has never been looked at as an investment or capital gains asset, so while selling it and expecting capital gains treatment seems logical, that's not to say the IRS won't come back and tax it [as ordinary income] in the future." (The IRS tax code does clarify that the entire payout of a viatical settlement received by terminally ill patients those expected to die within 24 months or less are fully excluded from tax.)

Bottom line? Be sure to consult with a tax specialist beforehand.

4. Weigh the alternatives

Don't sell your policy before exploring all alternatives, Daroff warns. You may just find one that's better for you.

If you're thinking of selling because you simply can't afford the premium payments, you may ask your insurer about converting to a "paid-up" policy, AARP's Hurme suggests. You'll stop paying premiums and the insurance company will use your built-up cash value as a premium for reduced coverage (as much as it will buy).

Finally, if you have children, consider keeping the policy, Daroff says. If you can't afford the payments, maybe the kids can help.

5. Avoid questionable offers

The life insurance industry has good reason to dislike life settlements; they prevent people from letting their policies lapse. When that happens, insurers' bottom line suffers, as they owe more payouts.

But while the industry can't discard the secondary life insurance market altogether, it does have a problem with so-called stranger-originated life insurance. That's when an investor lends you money so you can buy a large life insurance policy, which the investor will buy from you after two years. You keep the difference between the life insurance settlement payout and the loan the investor gave you. When you pass away, the investor collects the total value of the insurance.

Sounds like easy money, but the National Association of Insurance Commissioners (NAIC) says you'll be in a legally gray area. After all, you're misrepresenting the fact that you're purchasing life insurance for yourself, while you're actually planning to use it as an investment. "What that does is create a commodity that can be sold," says Julie McPeak, the insurance commissioner for Kentucky. "That's a bad thing. It skews actuarial assumptions." (In other words, insurers' underwriting assumptions including a certain lapse rate will be wrong if individuals start buying and selling policies as an investment.)

NAIC is currently at the last stages of extending the required hold period for policies from two to five years, which it hopes will discourage investors from engaging in this practice.