Clearance Sale.

After a merger or acquisition, life settlements may recover value for company-owned life insurance policies.

Over the past few years, a high-face-value, corporate-owned executive life insurance policy has gone from being a good risk-management investment to a possible source of cash in the aftermath of a merger, reorganization or acquisition.

Due diligence does not yet require the sale of company-owned life insurance policies that are no longer needed after a merger. But good business sense requires a close look at the possibility of selling such policies as an alternative to simply surrendering or lapsing a policy.

Life settlements, which also are known as lifetime settlements or senior settlements, involve selling an in-force life insurance policy at a discount of the face value to a buyer interested in taking over the policy as an investment. The typical policyholder is an older executive with a life expectancy of a decade or more whose health status has declined since the policy was originated. Typically, the policy is term, whole or universal life insurance with a face value in excess of $250,000.

As the number of mergers and acquisitions continues to increase, the decision of how to realize value from these corporate assets will be faced more often. For example, when two midwestern bank chains merged, 20 bank presidents and senior vice presidents took early retirement or found jobs elsewhere. The company held more than $10 million in face value of bank-owned life insurance policies on these executives and would have to pay substantial premiums to keep the policies in force.

However, there was no longer a business reason to keep the key-man policies, and it would be difficult to justify the annual expense for the next 10 or more years, so the company planned to let the policies lapse. Most of the executives were older, and many had experienced some decline in health since the policies were issued. A consultant recommended taking a closer look at the life-settlement value, and they were subsequently sold for more than $1.1 million.

Declining Health

Buyers in the market for "used" life insurance are looking for two things: some decline in health status since the policy was written that allows them to more accurately predict the current life expectancy of an older policyholder; and the cost of maintaining the policy vs. the eventual value at maturity.

Among the indicators are:

* a change in ownership that makes key-man policies obsolete, such as a merger, acquisition, sale of a business bankruptcy, dissolution of a partnership or execution of a buy-sell agreement;

* the cost of renewing a large policy is growing more rapidly than its expected benefit; and/or

* the insured is over age 65 or has a health condition that was not present when the policy was written.

The amount of money the policyholder receives for the policy is calculated based on age and relative health of the insured, as well as the policy's costs, duration and cash surrender value. Factors such as smoking, medical history and other risks are weighed. Each transaction is evaluated individually.

The following examples illustrate how the sale of key-man policies can reap unexpected cash:

* A small manufacturer bought a competitor. The 64-year-old chief executive officer of the purchased company signed a noncompetition agreement and went to work in a new sector of the economy after a six-month transition period. His former company held a key-man insurance policy that was included in the assets of the purchased company. That whole life policy had been fully borrowed against and the new management was ready to jettison it quickly because the large annual premium was coming due. An accountant on the acquisition team did some fast research. The $750,000 policy with no remaining cash value was sold for $60,000.

* With another reorganization in progress, a company vice president opted to start a dot-coin rather than stay put. His former corporation held a $3 million key-man life policy. It was a term policy with no cash value and annual premiums of $12,000, which were increasing next year. Even if he had stayed on board, he would have faced mandatory retirement in two years. The company wanted to let the policy lapse because of the nearly threefold increase in next year's premiums. However, a consulting firm suggested a life settlement. Viaticus, an affiliate of CNA Insurance specializing in life settlements, agreed to purchase the policy for more than $500,000.

High-net-worth life settlements, while still fairly rare, are becoming more common. Insurance industry analysts estimate that well over $1 billion worth of policies changed hands in settlement purchases in 1999. But a Conning & Co. report estimates that there is a potential market of more than $100 billion of policies that are good candidates for a life settlement in the present decade.

Taxable Gains 

There are tax consequences to life settlement transactions, most of them favorable (see "Tax Implications" graphic, above). While there is limited case law, a leading national accounting firm has expressed the following opinion:

"In general, the difference between the settlement price and the cash surrender value is treated as a capital gain. The difference between the tax basis (cumulative premiums paid) and cash surrender value is taxed as ordinary income. All clients should discuss their individual tax consequences with a professional tax adviser. With the lowered capital-gains rates provided in the Taxpayer Relief Act of 1997, selling a life insurance policy becomes an even more tax-efficient transaction."

The seller-be it an individual, a business owner, partner, trustee, assignee or company--works with a third-party buyer to determine an offer amount for the policy. The buyer calculates this value after consideration of the age, gender and health of the insured, the face amount of the policy, premium obligations, the remaining cash value and the type of policy. The buyer typically underwrites the current health of the insured as part of this process, which requires the insured to make certain medical records available.

The buyer is simply calculating the present value of the death benefit, after considering the outflow for the purchase price and continuing to pay policy premiums.

It is expected that the market will continue to grow as corporations and individuals learn more about the asset value available in life insurance policies they once thought of as a drain on cash flow.

Gary Chodes is president of Viaticus Inc., a Chicago-based affiliate of CNA Insurance that specializes in life settlements.