For seniors with declining health and shrinking finances, a lump sum of cash can be a godsend. And for an increasing number, transactions called life settlements fit that bill.

A life settlement or "senior settlement" is where you sell your unwanted or unneeded life insurance policy to a third party, which in most cases is an investment company.

A life settlement allows you to receive a large sum of cash in exchange for your insurance policy when you are still alive; it eliminates premium payments; and it accommodates the changing financial needs of your dependents, who may no longer rely on you for financial support. The settlement buyer ultimately receives the death benefit when you die.

Life settlements have raised many questions in the insurance industry, including concerns about possible insurance and investment fraud. Several insurance companies and trade groups warn policyholders about the consequences of selling their policies to third parties. In addition, unlike viatical settlements, which are sales of policies by those who are terminally ill, life settlements sales of policies by folks who are not terminally ill but who likely have a health impairment.

Before you enter into a life settlement, it's important to determine whether selling your life insurance policy is your best option. (See Alternatives to life settlements.)

How it works

A life settlement sales pitch might go somthing like this: "Fund a lifelong dream! Take a long-awaited vacation! Make a charitable gift contribution! Purchase a luxury item that was never affordable before!" (This was an advertisement submitted to New York state for approval and ultimately denied because it lacked certain disclosures about the possible consequences of selling a policy.)

A life settlement investment company buys a life insurance policy by paying a percentage of the policy's face value to the seller.

From the investment company's perspective, the shorter your life expectancy, the greater the potential profit — and the higher the percentage of your death benefit you should receive as a life settlement. You generally must be 65 or older to receive a life settlement and your life expectancy must be two to 18 years; some life settlement buyers will purchase policies only from sellers age 70 and over.

Here are some main reasons policyholders consider selling:

• The policy is simply no longer needed.
• Beneficiaries don't need the death benefit.
• The insurance premiums have become unaffordable.

Make sure to check out a potential buyer as much as possible. Do they have a good track record in the business? Does your state department of insurance have any information on them?

A potential buyer must calculate the possible life expectancy of the seller in order to make an appropriate offer. You'll be asked to sign an authorization to release your medical and other personal information; make sure you know the life settlement company's privacy practices and how it shares this information with others.

Among the factors that are used to calculate the buying price are: the death benefit amount of the policy (generally no less than $100,000 and usually higher than $250,000); the age and health of the policyholder; the type of policy (whole, universal or term); the rating of the insurer that issued the policy; and the premiums needed to keep the policy in force.

The existence of a cash value component in the policy (as with whole life insurance) is generally irrevelant to the sale price.

When the company buys the policy, it becomes the new policy owner, pays all future premiums and collects the entire death benefit when the seller dies. The settlement company will likely set aside the estimated future premium payments in an escrow account.

The buyer takes on a certain financial risk: They don't know exactly when you are going to die and they are paying the premiums until you do. Life settlement transactions are typically handled by investment firms and sometimes bundled into securities. This is far better than having an individual buy your policy, as that individual would then have a financial interest in your more immediate death.

Reputable life settlement brokers will keep your personal information as a confidential portfolio asset.

Life settlement companies use various methods to determine when an insured dies so that they can submit the claim. Some firms periodically send a postcard asking you to send it back. If the postcard is not returned, the company investigates further. Others designate a third party (a lawyer, for example) to stay in touch with you.

Business is booming

The life settlement industry has seen significant growth in the last few years. However, because life settlements are not regulated in many states and there are no reporting requirements, exact figures are not available.

Doug Head, Executive Director of the Life Insurance Settlement Association (LISA), estimates that life settlement industry transferred between $10 billion and $15 billion in face amounts in 2006. Its members reported a business increase of about 60 percent from 2005 to 2006.

Life insurers quietly open the door

Up until recently, life insurers themselves sat on the sidelines watching settlement providers take over their customers' policies and reap the profits. But insurers have never been able to sit quietly for long letting competition get the best of them.

You won't find life insurers openly discussing their increasing involvement in the life settlement marketplace. Head of LISA says, "I think many are in it," and has heard of eight to 10 specifically. Insurers like AIG are making investments in portfolios of policies.

Transamerica has become a life settlement provider with its launch of Transamerica Life Solutions Group. The insurer says only that it is in the early development process and still exploring business opportunities.

Some insurers discourage agents from assisting with life settlements. Deanna Tillisch, a Northwestern Mutual spokeswoman, says the company's financial representatives are prohibited from receiving any financial benefits for helping to broker a life settlement deal for any of the company's clients. "We feel that policyholders need to be provided with the full disclosure of risks and rewards," Tillisch says. "It's important for them not to make a poor decision when they are presented with an opportunity like this."

The Phoenix Life Insurance Co. has devised a creative way to monitor how many of its customers' policies end up in the life settlement market: In mid 2006, Phoenix began adding a provision to its Phoenix Accumulator Universal Life III policy that gives Phoenix the right to make a bid if the insured decides to sell. Phoenix doesn't currently intend to make any offers, but the provision allows the company to receive notice of a potential life settlement and perhaps inform the policyholder about other alternatives, such as surrendering the policy for cash value.

"This is not our way to enter the life settlement market," says Phoenix spokesman Joe Fazzino. "This is our way to keep track of policies."

Look before you sign

While life settlements are a good option for some, the insurance industry warns policyholders to be careful. The American Council of Life Insurers (ACLI), a Washington D.C.-based trade group, points out beneficiaries will lose valuable insurance benefits if the policies are sold to an investor. Also, if someone sells his life insurance policy and his health is less than optimal, future insurance coverage might not be attainable.

Insurance companies generally urge customers to examine all options available with their current policies before they decide to sell. (See Alternatives to life settlements.) In addition, anyone considering selling a policy should consult a financial planner or attorney before signing a contract, plus their state insurance department to find out applicable laws.

Beware of schemes

Since it is a relatively new industry, the life settlement business is not heavily regulated. Ask the company if it's licensed. If you're not using a broker to shop around your policy, negotiate with several provider firms to determine the market for your policy.

Here are well-known schemes to avoid if you are considering selling your life policy:

"Cleansheeting." This is when someone partners with an investment firm to "doctor" their medical report to improve their health on paper and then buys a life insurance policy they otherwise would not have been able to get, for the purpose of selling it to an investor.

The "stranger-owned life insurance" (STOLI) scheme. In this arrangement, a speculator convinces a senior citizen to buy a life insurance policy for the sole purpose of transferring the policy to the speculator shortly after the sale. Seniors may get a sales pitch about "free life insurance" or other financial incentives. The National Association of Insurance Commissioners (NAIC) is attempting to take the wind out of these sails with its model legislation that calls for a five-year moratorium on the sale of a life policy after it has been purchased.

Jack Dolan, spokesman for the ACLI, says there is an important distinction between legitimate life settlements and STOLI. "We understand that people who purchased life insurance to protect their families may want to investigate the possibility of a life settlement after their coverage needs cease. The real problem is with manufactured sales, where elders in particular are induced to secure coverage so that third parties can greatly profit from their demise."

"Flipping." Although not a scam per se, the flipping of life insurance policies has been receiving attention. "Flipping" is when a person — often someone with substantial financial resources — buys a large face value policy for the purpose of quickly selling it for profit. TV host Larry King is suing an insurance brokerage over his life settlements after experiencing major flipper's remorse. (See The Larry King case: How not to do a life settlement.)

What to do before you sell

The NAIC offers these tips if you're considering selling your life insurance policy:

• Comparison shop by getting quotes from several companies.
• Find out how much tax you'll pay on the proceeds from selling your policy.
• Find out if any of your creditors could claim your policy benefit.
• Read the privacy notice outlining who will receive your personal information when the buyer wants to periodically check on your health.
• Make sure all life settlement application forms are completed accurately, especially your medical history.