It's easy to take your health for granted. If you've rarely had any medical problems and never had to deal with anything serious affecting your health, you may have a hard time understanding the challenges that less fortunate people face every day. However, years of never worrying about your health can disappear in an instant. All it takes is a single doctor's visit or test result to change your life forever.
From a financial perspective, facing a serious illness can be difficult to handle. When you look closely at your medical insurance, you may find some unwelcome surprises in provisions that limit or eliminate coverage for certain types of medical conditions. In addition, if you find yourself no longer able to work, you may suffer the complete loss of your regular stream of income. Even those who are fortunate enough to have disability coverage, either from their employer or through a private insurance policy, often do not receive enough benefits to replace their former income in full.
In the face of these financial challenges, many people must consider taking unusual measures to raise money to pay expenses. One relatively new way to do this is through the use of a viatical settlement. If you have a life insurance policy, a viatical settlement can help you unlock some of the proceeds of your policy before you die and allow you to use the money for living expenses.
How viaticals work
In essence, viatical settlements allow the owner of a life insurance policy to sell it to an independent third party. Before viatical settlements became an option, the only alternatives that policyholders had were either to borrow money against the policy or to surrender the policy outright. In the case of someone with a serious illness, however, the cash surrender value of a life insurance policy often grossly understates its real economic value. Cash surrender value is often just a small fraction of the death benefit a policy will pay to beneficiaries, and if a serious illness shortens a person's life expectancy, then settling for the cash surrender value is a major sacrifice of value.
In theory, the value of a life insurance policy should include a number of variables, including the insured person's age and medical condition, the type of policy, the policy's death benefit, and the premiums necessary to keep the policy in force. Cash surrender value, however, doesn't necessarily correlate with these variables.
For example, say that a person had a life insurance policy with a death benefit of $1 million. If that person had a terminal illness with only one year to live, then the insurance company could expect to pay out $1 million within a year. By discounting the value of the future payment, a present value calculation would put the value of the policy's future at around $950,000. However, depending on how long the person had owned the policy, its cash surrender value could quite possibly be just a small fraction of this amount. However, a viatical settlement could give the policyholder an amount much closer to its actuarial value.
Ethical concerns
Until recently, most people didn't buy or sell life insurance policies in the same way they trade stocks or buy and sell real estate. Intuitively, this makes sense; because a life insurance policy is specifically tailored to a particular individual, having unrelated third parties buy and sell policies on another person's life raises some uncomfortable issues. In the simplest terms, someone who buys a life insurance policy wants you to die as soon as possible to collect the policy proceeds.
On the other hand, other types of personal contracts have found their way into the marketplace. For instance, home buyers used to consider a mortgage loan as establishing a relationship with a local bank, and most banks treated such loans as assets that would remain within the bank until maturity. Now, however, it's extremely rare to find a bank that won't immediately resell that mortgage to a third party. Indeed, successful businesses such as Fannie Mae
Going beyond the chronically ill
The use of viatical settlements among the seriously ill to unlock value from life insurance policies has attracted the attention of those who wish to extend the concept to a broader range of situations. After all, there are a huge number of reasons why one might no longer need or wish to continue paying premiums on a life insurance policy, including a change in one's estate-planning needs, difficulty in affording premium payments, or simply a lack of any further purpose for holding the policy. Outside the context of serious illness, third-party sales of insurance policies are sometimes called life settlements.
Given the unfavorable terms of surrendering many policies, life settlements represent a vast potential market for insurance owners and investors. While reasonable people can debate whether such arrangements offer profitable investment opportunities, policyholders who would otherwise surrender policies or simply discontinue making premium payments have little to lose and much to gain by seeing what a life settlement arrangement might offer them in exchange for their policies. Policyholders should be especially cautious, however, because the industry is still in its infancy, and the lack of regulation makes life settlements more risky than more established forms of insurance.
Viatical settlements can provide those with serious illnesses with a source of funds to pay medical and other expenses. Although finances may be a difficult subject to handle during a personal health crisis, taking a viatical settlement may make a big difference in the quality of care that one gets and can take at least one worry away from family members.
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Robert Brokamp of our Rule Your Retirement service had an estate plan before graduating from junior high school. If you need help planning your golden years, take Rule Your Retirement for a 30-day free trial.
Fool contributor Dan Caplinger hopes that anyone buying a policy of his would be making a bad bet. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy will outlast us all.
