Viatical Settlement

A viatical settlement is a transaction in which the owner of a life insurance policy sells it, or an interest in it, to a buyer for a cash payment worth less than the death benefit, in circumstances where the insured is terminally or chronically ill. The buyer takes over the premiums and collects the death benefit when the insured dies. Two separate bodies of law describe the same transaction and they do not draw the same boundary, which is the source of most of the confusion about the term.

Under state insurance law the transaction is regulated without reference to health at all. The NAIC's Viatical Settlements Model Act defines a "viator" as the owner of a policy who enters into a viatical settlement contract, and adds that "for the purposes of this Act, a viator shall not be limited to an owner of a life insurance policy or a certificate holder under a group policy insuring the life of an individual with a terminal or chronic illness or condition except where specifically addressed." The model act also carries a drafting note telling states they "may elect to use terminology referring to life settlements rather than viatical settlements," so which of the two names a state uses is a drafting choice rather than a difference in the transaction. The line that does real work is the federal one: Internal Revenue Code section 101(g)(2) reaches sales only where the insured is terminally or chronically ill, and a sale by a healthy insured falls outside section 101 entirely. That sale is a life settlement, and it is taxed on completely different principles.

How the tax exclusion is built. Section 101(g)(1) treats an amount received under a life insurance contract on the life of a terminally ill or chronically ill insured as an amount paid by reason of death. Section 101(g)(2)(A) then extends the same treatment to a sale: if any portion of the death benefit on the life of such an insured "is sold or assigned to a viatical settlement provider, the amount paid for the sale or assignment of such portion shall be treated as an amount paid under the life insurance contract by reason of the death of such insured." That characterization is what carries the money into the exclusion at section 101(a), so nothing is included in the seller's income. Section 101(g)(4)(A) defines a terminally ill individual as one certified by a physician as having an illness or physical condition "which can reasonably be expected to result in death in 24 months or less after the date of the certification."

The chronically ill route is narrower, and the difference is easy to miss. Section 101(g)(3)(A) provides that paragraphs (1) and (2) do not apply to a payment received for any period unless the payment is for costs incurred for qualified long-term care services for the insured for that period and the contract meets specified requirements. So the terminally ill seller has no condition on what the money is used for and the chronically ill seller does. Section 101(g)(5) switches the whole subsection off for an amount paid to a taxpayer other than the insured where that taxpayer's insurable interest arises from the insured being a director, officer or employee, or from the insured being financially interested in a trade or business the taxpayer carries on.

A federal statute that adopts a private model act. Section 101(g)(2)(B)(i) defines a viatical settlement provider as a person regularly in the business of buying or taking assignments of policies on the lives of insureds described in paragraph (1), and requires that the person be licensed for that purpose in the state where the insured lives. Where the insured lives in a state that does not license such buyers, clause (ii)(I) supplies a substitute test for terminally ill insureds: the buyer must meet "the requirements of sections 8 and 9 of the Viatical Settlements Model Act of the National Association of Insurance Commissioners," and the NAIC's model regulations on evaluating the reasonableness of the amounts paid. A federal tax statute incorporating a private association's model act by reference is unusual, and it is why the NAIC document matters to a transaction that is otherwise a matter of state law.

The broker is legally the seller's, whoever writes the check. The model act defines a viatical settlement broker as a person working exclusively on behalf of a viator, and adds: "Notwithstanding the manner in which the viatical settlement broker is compensated, a viatical settlement broker is deemed to represent only the viator, and not the insurer or the viatical settlement provider, and owes a fiduciary duty to the viator to act according to the viator's instructions and in the best interest of the viator." The same definition excludes an attorney, a certified public accountant or an accredited financial planner retained to represent the viator whose compensation is not paid directly or indirectly by the provider or purchaser, so a professional paid by the seller alone is outside the licensing regime rather than inside it.

The disclosures are the most useful thing in the model act. Section 8A requires the provider or broker to give the viator eleven separate disclosures, in a signed document, no later than the time the application is signed. The four a seller is most likely to need are that "there are possible alternatives to viatical settlement contracts including any accelerated death benefits or policy loans offered under the viator's life insurance policy"; that "proceeds of the viatical settlement could be subject to the claims of creditors"; that receipt of the proceeds "may adversely affect the viator's eligibility for Medicaid or other government benefits or entitlements"; and that entering into the contract may cause other rights or benefits, "including conversion rights and waiver of premium benefits," to be forfeited. The act also gives a rescission right, exercisable before the earlier of 60 calendar days after the contract is executed by all parties or 30 calendar days after the proceeds are paid, and it is conditional: rescission "is effective only if both notice of the rescission is given, and the viator repays all proceeds and any premiums, loans and loan interest paid."

Where the boundary with the insurer's own products sits. The model act says a viatical settlement contract "does not include ... a policy loan or accelerated death benefit made by the insurer pursuant to the policy's terms." That is the cleanest available statement that borrowing from the insurer, or drawing an accelerated benefit from the insurer, is a different transaction from selling the policy to a third party, and each is covered separately.

1. The owner applies, through a broker or directly to a provider. The provider underwrites the case, which for this transaction means estimating life expectancy rather than assessing insurability.

2. The required disclosures are delivered and signed, in a separate document, no later than the time the application is signed.

3. An offer is made and the contract is executed. Among the disclosures the model act requires is that funds will be sent to the viator within three business days after the provider receives the insurer's written acknowledgment that ownership has been transferred and the beneficiary designated.

4. The rescission window runs, and closing it requires repaying everything received, including premiums and loan interest the buyer has paid.

5. The buyer pays the premiums for the rest of the insured's life and collects the death benefit. The original beneficiary receives nothing from the policy.

A hypothetical, showing why the tax characterization is the whole transaction. Hector owns a $500,000 policy and has paid $48,000 of premiums; the contract's cash surrender value is $60,000. He has been certified as terminally ill, and a licensed viatical settlement provider offers $340,000. Because section 101(g)(2) treats that payment as an amount paid by reason of his death, the whole $340,000 is excluded from his income under section 101(a), and he reports nothing.

Set the same policy against the alternative of surrendering it to the insurer. The check would be the $60,000 cash surrender value, and the gain over his premiums, $60,000 − $48,000 = $12,000, would be ordinary income. The sale produces $340,000 − $60,000 = $280,000 more cash and no tax at all. That gap is the reason the transaction exists, and it is also why the disclosures about creditors and means-tested benefits matter: a large untaxed sum is still a countable resource for a program that counts resources. Figures are illustrative.

Pros

• Where section 101(g)(2) applies, the proceeds are excluded from income entirely, which no other exit from a policy achieves.
• The payment is normally far larger than the cash surrender value, and a term policy with no cash value can be sold although it cannot be surrendered for anything.
• The buyer takes over the premiums, which ends an obligation a seriously ill owner may no longer be able to fund.
• The seller's broker owes a fiduciary duty under the model act regardless of who pays the commission, and the required disclosures are specific and written.

Cons

• The beneficiary receives nothing from the policy afterwards. The coverage is gone, not reduced.
• Proceeds can be reached by creditors and can cost eligibility for Medicaid and other means-tested benefits, which the model act requires the buyer to disclose precisely because it is easy to overlook.
• Riders and rights attached to the policy, including conversion rights and waiver of premium, can be forfeited on transfer.
• Rescission requires repaying every dollar received plus any premiums and loan interest the buyer has paid, so the window is narrower in practice than it looks on the calendar.
• Pricing depends on a life-expectancy estimate the seller cannot audit, so two offers on the same policy can differ for reasons the seller cannot see.
• The buyer acquires a financial interest in the insured's early death and, under the model act, may contact the insured periodically to confirm health status.