Tapping Life Insurance Before You Die Can Be Unwise

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.

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.