VIATICAL SETTLEMENTS

A Potential Financial Option

For the Elderly

By Thomas E. Martinec

Background Information 

Traditionally, the owner of a life insurance policy was limited to only two options in the event that the policyholder wanted to get out from underneath the insurance contract.  They could either allow the policy to lapse and subsequently receive nothing, or they could surrender the policy and only receive its net cash value.[1]  However, within the past decade or so, developments in a secondary market for life insurance policies have created another option for terminally ill life insurance policyholders.  Viatical settlements (sometimes also referred to as “life settlements” or “senior settlements”) allow for a life insurance policyholder to obtain substantially more than they would ordinarily receive by simply surrendering their policy to the insurance carrier.[2]

          In all actuality, a somewhat informal secondary market in life insurance policies has existed for some time in the sense that it is not uncommon for terminally ill policyholders to borrow money from relatives or friends, using their life insurance policies as collateral on the loan.  And, in some cases, the policies were even sold outright.[3]  However, this secondary market became significantly more formalized with the development of the viatical settlement industry in the late 1980s, at a time when the Acquired Immune Deficiency Syndrome (AIDS) outbreak seemed to be quickly approaching epidemic proportions.[4]  At this time, some of those infected with the AIDS virus found themselves in a situation where they had very high medical costs, very few assets other than a life insurance policy, and a very short life expectancy.  In response to the financial needs of this particular population, viatical settlement companies quickly came on to the scene.[5]  Desperate for quick cash, AIDS patients turned to the viatical settlement option to pay for their skyrocketing health care costs.[6] 

An interesting twist in the evolution of the viatical settlement industry occurred in late 1996 when researchers at the World AIDS Conference presented information showing that the use of protease inhibitors and other modern pharmaceutical medications were having a significant impact on the ability to prolong the lives of some AIDS patients.[7]  As a result, viatical settlement investors soon began focusing on life insurance policyholders who are terminally or chronically ill with other deadly diseases such as heart disease, cancer, Alzheimer’s disease, stroke, and sometimes just plain old age.[8] 

Today, the viatical settlement industry is alive and well.  It is estimated that viatical settlements have increased from a $90 million industry in 1991 to approximately $1 billion in 2000.[9]  In fact, the National Viatical Association claims that the increase in the amount of viatical settlement business is roughly 20 times as much as since their inception.[10]

What is a Viatical Settlement?

            The phrase “viatical settlement” developed from the ecclesiastical term “viaticum,” which is the “communion given to a dying person.”[11]  Viaticum takes place at the Roman Catholic sacrament of “extreme unction.” The Latin term “viaticum” roughly translates into the phrase “money provided for a long journey.”[12]  Prior to embarking on a long and perilous journey, Roman soldiers and other travelers were typically provided with a “viaticum.”[13]

The National Association of Insurance Commissioners (NAIC), through its Viatical Settlements Model Act, defines a viatical settlement contract as:

a written agreement establishing the terms under which compensation or anything of value will be paid, which compensation or value is less than the expected death benefit of the insurance policy or certificate, in return for the viator’s assignment, transfer, sale, devise, or bequest of the death benefit or ownership of any portion of the insurance policy or certificate of insurance.[14]

More simply put by the court in the seminal case of Securities and Exchange Commission v. Life Partners, Inc., “[a] viatical settlement is an investment contract pursuant to which an investor acquires an interest in the life insurance policy of a terminally ill person....When the insured dies, the investor receives the benefit of the insurance.”[15]

How Does it Work?

          In a typical viatical settlement situation, the terminally ill policyholder (known as the “viator”) contracts to sell the right to claim his or her life insurance proceeds to an investor.[16]  In this transaction, the viator will typically receive a lump-sum payment, which he or she can spend without restriction.  The investor then assumes the premium payments until the maturation of the life insurance policy (i.e., when the viator dies).  Therefore, from the investor’s perspective, the sooner the viator dies, the more lucrative the business transaction will be.[17] 

          The amount of money that a viator can expect to receive for his or her life insurance policy depends mainly on two factors:  the face value of the policy, and how long the person is expected to live.  Other factors may include any loans currently pledged against the policy, the amount of anticipated future premiums, the prevailing interest rates, and the solvency and credit ratings of the life insurance company.[18]  The NAIC Viatical Settlements Model Regulation dictates the minimum lump-sum payments as follows:

For example, assume that Sarah has a $100,000 life insurance policy and pays $200 in annual premiums.  Sarah is then diagnosed with a terminal illness, and subsequently is informed that her life expectancy is 6-12 months.  If Sarah chose to do so, she could sell her life insurance policy to a third-party investor.  Based on the rates in the NAIC Model Regulation, Sarah would get a lump-sum payment of at least $70,000 (70% of the policy’s face value) and the third-party investor would take over the annual premium payments.  Once Sarah dies, the third-party investor would be entitled to the entire $100,000 policy payout from the insurer.  Assuming that Sarah dies within one year from executing the contract with the third-party investor, the investor’s total return would be $29,800 ($100,000 policy payout less the $70,000 payment to Sarah and the $200 annual premium).

          Of course, given that proceeds from viatical settlements are obviously personal income, another issue that certainly needs to be addressed is the related tax implications.  In the early years of the viatical settlement industry, proceeds from viatical settlements were treated as ordinary income and taxed accordingly.  However, in the mid-1990’s, Congress changed that.  Through the federal Health Insurance Portability and Accountability Act (HIPAA), passed in 1996, individuals are now allowed to exclude most viatical settlement proceeds from gross income.[20]  This is to say that the proceeds from the viatical settlement are treated as income received by reason of death of the insured.[21]  However, the exclusion is only available to individuals who are terminally ill due to a medical condition, which could reasonably lead to death in 24 months or less.  Furthermore, the terminal nature of the condition must be certified by a physician.[22]  Likewise, chronically ill individuals also may be able to receive a tax break under HIPAA.[23]  A “chronically ill individual” is defined in the Internal Revenue Code as:  (1) being unable to perform at least two activities of daily living (eating, toileting, transferring, bathing, dressing, and continence) for a period of at least 90 days; (2) having a certain level of disability as prescribed in the federal rules by the Secretary of Treasury, in consultation with the Secretary of Health and Human Services; or (3) requiring substantial supervision due to severe cognitive impairment.[24]  Unlike those who are terminally ill, the health status of the chronically ill individual need only be certified by a licensed health care practitioner (as opposed to a physician).[25]

Who are the Various Players Involved

in a Viatical Settlement?

          There are several key players involved in a typical viatical settlement transaction.  They include the viatical settlement provider, investor, seller, reviewing physician, and the insurer.[26]  The “viatical settlement provider” is simply the party, other than the seller (or viator), who enters into a viatical settlement contract.[27]  The viatical settlement contractually binds the viatical settlement provider and the seller (the terminally or chronically ill policyholder) to its terms.  As previously explained, the viatical settlement provider pays the seller a lump-sum payment and takes over the premium payments on the life insurance policy, in exchange for the death benefit being made payable to the viatical settlement provider.

          When a viatical settlement provider enters into this type of contract, they can then either keep the life insurance policy or sell the policy rights they’ve obtained to an “investor.”[28]  In the event of the latter, the investor would pay the required premium payments and would subsequently collect the death benefit when the insured/seller passes away.

          The “seller” is the individual who was originally insured under the life insurance policy, at some point became either terminally or chronically ill, and subsequently entered into a viatical settlement.  The seller, also commonly referred to as the “viator” or the “insured,” transfers the rights of their life insurance policy to a viatical settlement provider in exchange for a lump-sum payment with which they are free to spend as they wish.[29]

          As most viatical settlement providers will require a medical consultation in order to determine the life expectancy of the potential viator, the “reviewing physician” also plays a key role in the transaction.[30]  Normally, these physicians are already on the payroll of the viatical settlement providers, and routinely perform these services.  It is interesting to note that confidentiality issues regarding the doctor-patient relationship may arise in these types of situations.  While there is no clearly established precedent on the matter, at least one state (Florida) has ruled “that a patient may lose his or her constitutional protection if he or she agreed to a limited waiver to the right of privacy as part of the business deal with a VSP [viatical settlement provider].”[31]

          Lastly, there is also the “insurer” which, of course, is the insurance company that issued the life insurance policy.  Granted, the viatical settlement has very little impact on the insurer.  After all, regardless of who owns the policy, the insurer still collects the premiums and eventually pays out the death benefit to the lawful beneficiary.  Although their role is very limited, the insurer is nonetheless involved in the viatical settlement transaction to the extent that the are typically notified of the change in ownership of the policy and the change of beneficiary, all of which they have to duly record.[32]

Regulation of Viatical Settlements

          Viatical settlements are somewhat difficult to regulate, particularly at the federal level.  In 1996, the District of Columbia Circuit Court in Securities Exchange Commission (SEC) v. Life Partners, Inc. ruled that viatical investments are not securities within the meaning of the Securities Act of 1933.[33]  In that case, the SEC claimed that the purchase of an interest in a viatical settlement is a security, and therefore it should fall within the SEC’s regulatory authority.[34]  However, the court did not agree with the SEC’s argument.  Therefore, viatical settlement providers do not have to register with the SEC, nor do they have to comply with any federal regulations regarding securities.

          Due to the federal government’s lack of regulatory authority over viatical settlements, state insurance laws make up the bulk of the regulation pertaining to viatical settlements.[35]  However, somewhat surprisingly, nearly one-half of the states have not adopted viatical settlement regulations, potentially leaving viators exposed to unscrupulous viatical settlement providers.[36]  As of May 1, 2001, twenty-nine states required viatical settlement providers to be licensed.  Those states include: 

Alaska                   Maine                    Ohio

California               Massachusetts       Oklahoma

Connecticut           Minnesota              Oregon

Delaware               Missouri                 Tennessee

Florida                   Montana                Texas

Illinois                    Nebraska               Virginia

Indiana                  North Carolina        Vermont

Kentucky               North Dakota         Washington

Kansas                  New Mexico           Wisconsin[37]

Louisiana               New York

In South Dakota, viatical settlement providers are not regulated under state law.  In fact, the only reference to viatical settlements in the South Dakota Codified Law is a provision, which essentially states that viatical settlements are exempt from the Uniform Securities Act.[38]

Ethical Issues Surrounding Viatical Settlements

          Although viatical settlements are a legal and sometimes very prudent financial option for the elderly, the buying and selling of life insurance policies certainly isn’t without controversy.  From an ethical perspective, there are three categories of key issues that need to be addressed:  fraud, conflicts of interest, and confidentiality.[39]  Fraud is believed by some to be the most pervasive ethical concern in regards to the viatical settlement industry.[40]  There are essentially four basic scenarios of fraudulent practices in the viatical settlement industry:  (1) dishonest insurance agents assisting viators in defrauding insurance companies by not disclosing the viator’s terminal illness; (2) viators relying on traditional insurance law incontestability clauses to defraud insurance companies on their own; (3) viatical settlement companies being defrauded by viators; and (4) viators and investors being defrauded by unscrupulous viatical settlement companies.[41]

          Conflicts of interest most commonly arise in the viatical settlement industry when health care professionals partner with the viatical settlement companies.[42]  Whenever a caregiver becomes financially liked to the viatical settlement industry, there is a concern that a conflict of interest will occur, putting the investor at a disadvantage.  Full disclosure of the potential for these types of conflicts of interest is essential in enabling the potential investor to make informed investment decisions.[43]

          Lastly, confidentiality can also be a concern when dealing with viatical settlements.  This is largely due to the inherently competing interests of protecting a viator’s privacy, and providing the viatical settlement companies with enough information in order to effectively make wise business decisions.[44]  Although in some instances this issue has been partially addressed through confidentiality provisions within the viatical settlement contract, there remains a need by the viatical settlement industry to share some of this personal medical information with investors.     

Conclusion

          Initially, the viatical settlement industry was created to provide AIDS patients an opportunity to sell their life insurance policies prior to their demise.  Over the years, this industry has evolved to encompass various types of both terminally and chronically ill patients.  While this growing industry may appear to founded upon a very macabre concept and the overall lack of regulation may be a bit unsettling from the consumers’ perspective, viatical settlements nonetheless are an entirely legal and valid financial option for those who are terminally ill, and have very few assets other than a life insurance policy.