Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

What to Do About That Old Life Insurance Policy

Thinking about canceling your old life insurance policy? Make sure you have good reason to act, because you could come out the loser.

People cancel life insurance policies for all sorts of reasons, good and bad. Life insurers not only know this but count on it; check out the rates for term life insurance and you'll find they're lower than they were even five years ago -- in part because people live longer, and in part because every person who cancels a life insurance policy allows the insurer to pocket all those premiums that would otherwise pay a death benefit. Insurers call this a “mortality credit” when calculating the payouts on annuities. You can call it money your beneficiaries won't get because you let your policy expire before you did.

Most people cancel their policies because they don't need them anymore or because they can't afford the premiums in hard times. There are, however, reasons to keep your policy in force even in hard times. One is that your policy may have hidden value -- even a term life insurance policy with no cash value. Another is that, if your 401(k) plan dwindled like everyone else's in 2008 and 2009, you might want to keep your insurance in force just to make sure that your family gets something when you die. All things considered, the traditional whole life insurance policy, in good and hard times alike, isn't a bad use of money.

Let's start with the first reason -- the hidden value in many life insurance policies. A marketplace for the buying and selling of life insurance policies, even term policies with no cash value, has cropped up in recent years, and if you don't know about it, Google the term “life settlements” and you'll find this Wikipedia entry:

A life settlement is a financial transaction in which a life insurance policy owner possessing an unneeded or unwanted life insurance policy sells the policy (at fair market value) to a third party for more than the cash surrender value offered by the life insurance company. The purchaser becomes the new beneficiary of the policy at maturation and is responsible for all subsequent premium payments.

This is accurate except for one thing: Term policies don't have cash values, but they sell in the life-settlements marketplace, too. Who are the buyers in this marketplace? Often investor groups looking for opportunities better than those available in traditional equity markets. Who are the sellers? Usually older people, most in failing health, along with younger people whose health problems make it unlikely that they will live to normal life expectancy

In essence, it works this way: The investor groups assess the health of a potential seller; the worse the seller's health, the better. They also check the details of the seller's policy and calculate an offer to buy based on whether the buyers think they will find themselves ahead of the game when the seller checks out.

If you think there's something ghoulish about this, you're right; the very idea that someone will turn death -- yours -- into a profitable event is unsettling. But not everything is doom and gloom, as it were, for the seller of an insurance policy, since he or she can come away from the deal with a pile of unexpected cash to be used for medical expenses, for family needs, or just for having a good time before the grim reaper comes knocking on the door.

How much cash do sellers of life insurance policies get? A man 65 and in declining health might get $250,000 for a $1 million term life insurance policy with no cash value. The same man with a whole life insurance policy with, say, $100,000 in cash surrender value might get more.

What's the catch? Not every policy finds a buyer in the life settlements marketplace. If you're in declining health and own $100,000 in life insurance, you're probably out of luck; investor groups want bigger numbers. You're also out of luck if you're 30 and in good health. But no matter what your age, if you're fighting a bad cancer -- if, in other words, you're not likely to live five years – and you own a lot of life insurance, you'll probably find a buyer for your policy.

The life insurance industry doesn't much like life settlements; after all, some policies that end up in the hands of investor groups would otherwise lapse, relieving the insurer of the duty to pay those particular death benefits. In plain English, the life-settlements marketplace raises the costs of life insurers, and they don't like it.