Life Settlements for Businesses


Businesses often use life insurance to help meet business needs. However, since business situations can change dramatically (for example, a family business is sold or a key executive leaves a firm) the need for which the life insurance was purchased may also have changed or evaporated. For these reasons and others, businesses are finding it worthwhile to consider senior settlements. We will begin our discussion of the business applications of senior settlements with some of the reasons why a business may no longer need existing life insurance.

Buy-Sell Agreements

One of the fundamental uses of business life insurance is to fund business succession plans. Under buy-sell agreements between the firm’s owners, the surviving business owner(s) or the business itself agrees to purchase a deceased owner’s business interest from the estate at the time of his or her death. The principal business motivation is to enable the business to continue in existence with the remaining owners in charge.

Despite the existence of a buy-sell agreement and the owners’ intention to continue the business with the existing ownership, things can change. The business owners may sell the business to a competitor, or one or more of the owners may sell their interest to the other owners. Regardless of why a business is sold, the life insurance policies purchased to fund a buy-sell agreement are often no longer needed for that purpose.  The business or partners are left to pay premiums on a policy that has outlived its usefulness.  


Key-Person Insurance

Businesses frequently purchase life insurance to guard against the loss of an important executive or employee; this type of life insurance application is called key-person insurance. The death benefit is often used to hire and train a replacement and to help replace some of the lost business profits while the new executive gets up to speed in his or her new job.

A fact of business life, however, is that executives often move from company to company or retire. When they do so, their firm no longer needs the key executive coverage that applied to them. If an executive leaves the firm to retire, the company may offer the opportunity to purchase the life insurance policy for its cash value. Often, however, the retiring executive declines the offer because of a reluctance to take on the premium commitment.

Similarly, a key executive may no longer be as critical to the firm's operations when the business grows and the management team expands.   Or if the business is sold or merged, the firm’s new owners may consider the key executive policies covering certain employees unnecessary.


Non-Qualified Benefit Plans

Life insurance may also be used by a firm to fund an informal deferred compensation plan for an important executive. These plans are often referred to as golden handcuffs because they tend to tie the executive to the company until retirement.   Split dollar plans, executive bonus plans or group carve-out plans represent other "perks" offered to key employees that are funded with life insurance.  Sometimes, however, the executive leaves the firm before retirement and forgoes these selective benefits. When the executive does so, the reasons for maintaining the policy no longer apply.


Suitability

Even if the business need for insurance continues to exist, the business must be concerned with the suitability of the policies it holds.  As with individuals contemplating a senior settlement, businesses should also periodically review the suitability and performance of their insurance assets.  Does the type of policy owned by the business meet the firm's needs?  For example, a joint life policy owned by the business covering all of the owners might be more suitable  (and less expensive) than numerous individually-owned policies under a cross-purchase buy-sell plan.  Or perhaps the investment performance of the existing policy lags its anticipated returns.  By selling such policies and redeploying the proceeds, a business may be able to still meet its needs and free up capital to fund new ventures or expansion of its operations.   


Debt Repayment

While life insurance owned by an individual is generally protected from creditors, a policy owned by a corporation is not, and a sale of the policy may be useful for satisfying the claims of creditors.  In a corporate liquidation, creditors want to make sure the trustee realizes the "true" value of the policy.  In a corporate reorganization, the corporation also may want to sell a key-person policy, especially if that person's health has deteriorated.  For businesses facing bankrupcy, using such policies to  raise cash and retire debt may spell the difference between the business' continued operation or dissolution. (After all what good is insurance on the key-person if the business is no longer in existance?) Creditors can argue that the potential sale of a policy should be taken into account in determining a corporation's liquidation value for purposes of confirming a reorganization plan.

Lenders who receive a life insurance policy as collateral after a default may want to liquidate the policy. A lender may want to anticipate this possibility when they draft security agreements covering life insurance policies, by making sure the agreement covers proceeds from a policy sale and gives the lender consent to sell the policy.
Such consent may be important because the policy probably can't be sold without the insured person's cooperation, since any potential buyer of the policy will want to review the person's medical records.


Uses for Settlement Proceeds

Regardless of the reasons why life insurance is no longer necessary, the policyowner (whether a business, stockholder or partner) has traditionally had three options:

keep the policy in force and collect the death benefit when the insured dies;
surrender the policy for its cash value; or
allow the policy to lapse.

With the emergence of  a market  for “senior settlements“, businesses gained a fourth option: sell the policy to a third party who purchases it as an investment. If the insured has suffered some deterioration of his or her health, the policy may be worth far more as a senior settlement than its cash value.

There are as many reasons why a policyowner of business-related life insurance might want to sell the policy as there are policyowners. However, some frequent uses of the funds provided by the sale of business-related policies include:

buying back a business interest from a partner or stockholder;
buying out an employer’s interest in a split-dollar policy; and
starting a new business or use the capital to expand an existing business.

There are, of course, many other possible uses for the funds freed up by the policy sale.



EXAMPLES:

Buy-Sell Policies No Longer Needed

A business owner, age 75, has a history of heart troubles, and had major bypass surgery four years ago. He recently completed the sale of stock of his closely held company to a public company for a substantial amount. Ten years prior to this sale, business owner established an irrevocable life insurance trust to fund a projected postmortem buy-out of his stock by his children who actively were working in the business. The trust is funded with a $3 million universal life policy that has not been performing as projected since interest rates have fallen.  (The cost basis in the policy is $900,000 and has accumulated cash value of $1 million). There is no longer a need for this coverage now that the company has been sold. The children who are beneficiaries of the trust and are interested in maximizing trust income.  So they investigated a senior settlement and were offered $2 million or $1,760,000 after tax -- payable to the trust.   (Even though the policy is owned in a trust, because trust income is used to pay premiums on a policy covering the grantor's life, the income in the trust is taxable to the business owner under the IRS "grantor trust rules".)   By eliminating the policy from the trust, the proceeds in the irrevocable trust will now be free of estate taxation.  In effect the business owner transferred $1.76 million to his children estate and income tax free.   


Faciliating a Corporate Takeover

Simmons Corporation owns life insurance on its President and CEO totaling $10 Million. The policies are mostly term insurance and the remainder have a cash surrender value of $800,000. Simmons is negotiating the company's sale to a strategic buyer whose last and final offer falls over $1 million short of the desired selling price. Simmons Corporation's lender wants the sale to go through and in discussions with its portfolio management committee has given more than passing consideration to the prospect of discounting its note to help make the sale a reality. Simmons is considering letting the policies lapse because the premiums are very costly and the management is absolutely certain that the company will be sold. The lender, aware of the Senior Settlement market, contacts a prospective buyer of the policies and is offered $1.5 million - a substantial premium over the cash surrender value. After payment of taxes on this transaction, the Simmons Corporation nets $1.25 million, is able to adjust its sale price, the buyer closes the deal and the bank is repaid in full.


Key Person Insurance No Longer Needed

A company terminates its CEO. The CEO was ousted by the Board following repeated failures to stem losses. During the first week review of cash needs and company assets, the company CFO indicated it carried "key man" insurance - a term policy with a $3.75 million face value and no cash surrender value. The insured was in his mid 60's and suffered adult onset diabetes and related complicating conditions. This policy had premiums due of $40,000 and the CFO had decided to let the policy lapse. The turnaround advisor called a buyer of these policies and was offered $760,000 pre-tax. Taxes reduced the net proceeds to $614,000.


Hidden Assets in Bankrupcy

A Midwestern manufacturer was operating in Chapter 11. As part of the process of submitting operating reports, the management consultant running the business thought she would confirm the cash surrender value of the "key man" insurance policy. She learned the policy had been fully borrowed against and was ready to jettison the policy because its annual premium was coming due. However, the bank's portfolio manager had read something about the possibility of converting the policy to cash. At the time of review, the insured was a 64-year-old in relatively good health and with no significant medical problems. The policy had no cash surrender value. The $750,000 policy was sold for $80,000 net of taxes.


Found Money

A $4.25 million term policy is held by a company which is experiencing cash flow difficulties. Those cash flow problems have just been compounded because policy premiums ($15,000 per annum) are significant and increasing. The policy is no longer needed because the insured is retiring in a few months and his young successor will need to be insured separately. The company decided to let the policy lapse because of the nearly three fold increase in next year's premium. A Senior Settlement was pursued on the suggestion of the company's banker. To the company's surprise, the policy was purchased for over $800,000 -- a policy with no cash value.