What is a Life Settlement?

A life settlement occurs when a person sells his or her whole or universal life insurance policy to a third party, who maintains the premium payments and receives the death benefit when the insured dies.

How Does a Life Settlement Work?

Let's say John Doe has a life insurance policy that he no longer needs. He's decided that he has saved enough for retirement, his children are grown and out of the house, and he is comfortable with the assets he'll be leaving them when he dies. John doesn't need to leave his kids any more money, so he decides he wants to get rid of his life insurance policy so he can stop paying the premiums. Because he has a whole life policy, there is some cash value in the policy.

Company XYZ is a life-settlement provider. A life-settlement provider purchases whole and universal life insurance policies from people who no longer need or want the coverage but want to recoup their investments in the policies. The sellers receive cash to use as they wish; the buyer begins making the premium payments on the seller's behalf. In this way, Company XYZ essentially has a policy on the life of the seller.

John Doe sells his policy to Company XYZ. When he dies, Company XYZ receives the death benefits from the insurance policy.

Why Does a Life Settlement Matter?

Life settlements are very novel but very controversial. On one hand, John Doe can receive cash to fund retirement or pay medical expenses while he is still alive. On the other hand, the sooner he dies, the higher the returns are for Company XYZ (after all, Company XYZ does not have to keep paying the insurance premiums for the person). From a financial perspective, there is certainty that payments will come -- after all, everybody eventually dies. The risk, therefore, is that Company XYZ will not pass through the payments as promised or that the insurer will withhold the death benefit.

Life-settlement providers tend to purchase many insurance policies and have a large portfolio of them. Because the people covered by the policies will die at different times, the life-settlement provider will have a stream of cash flows (from the death benefits) coming to it over time. Additionally, the cash flows are not correlated to what is happening elsewhere in the markets.

A life-settlement provider can securitize this stream of cash flows by pooling the policies and issuing bonds to investors. These investments are called death bonds.