Overview: Not every policyholder needs or can afford to keep a life insurance policy, and a secondary market has developed that allows them to sell that policy to third-party investors for more than its cash surrender value.

Viatical Settlements

A viatical settlement is a transaction in which a terminally or chronically ill policyholder — called the viator — sells their life insurance policy to a third-party investor for a lump sum. The payout exceeds the policy's cash surrender value (what the insurer would pay upon surrender) but is less than the full death benefit (what would be paid at the insured's death). The buyer assumes ownership, pays ongoing premiums, and eventually collects the death benefit.

Viatical settlements emerged in the 1980s during the AIDS crisis, when terminally ill individuals needed immediate cash for medical care and quality of life. The market provided a financial lifeline for people facing imminent death with an illiquid asset — their life insurance policy — and no immediate need for it as a death benefit.

To be a viatical (as distinct from a general life) settlement, the insured must typically be terminally or chronically ill. Terminal illness is usually defined as a physician-certified life expectancy of 24 months or less. Chronically ill means being unable to perform at least two Activities of Daily Living (ADLs) without assistance.

Tax treatment: Under IRC Section 101(g), viatical settlement proceeds received by a terminally ill individual are fully excluded from federal income tax — they are treated as an advance on the tax-free death benefit. Proceeds received by a chronically ill individual are tax-free only to the extent they are used to pay for qualified long-term care services.

Life Settlements

A life settlement involves a policyholder who is not terminally or chronically ill — typically an older individual (often 65 or older) who no longer needs the coverage, cannot afford the premiums, or simply wants to monetize an asset they would otherwise lapse. Life settlements generally yield a lower percentage of the face amount than viatical settlements because the investor's expected wait for the death benefit is longer.

Tax treatment of life settlements is more complex: proceeds are taxed in three tiers. The first tier (amounts up to the policyholder's tax basis, i.e., total premiums paid) is tax-free. The second tier (amounts above basis up to the policy's cash surrender value) is taxed as ordinary income. The third tier (amounts above the cash surrender value) is taxed as capital gains. This three-tier structure was clarified by the Tax Cuts and Jobs Act of 2017, which also eliminated the prior requirement to reduce the tax basis by internal cost-of-insurance charges.

Regulatory Concerns and Protections

Regulators have identified several concerns about the secondary market for life insurance:

Stranger-Originated Life Insurance (STOLI): Investors induce individuals to take out new policies solely to sell them immediately, violating the insurable interest requirement.
Exploitation of vulnerable sellers: Terminally ill or elderly policyholders may accept inadequate offers under financial and emotional distress.
Privacy: Policy buyers have a financial interest in tracking the insured's health.

The NAIC's Viatical Settlements Model Act (#697) and state laws address these concerns through: mandatory licensing of providers and brokers; fiduciary duties requiring brokers to represent the seller, not the buyer; mandatory disclosure of alternatives (accelerated death benefits, policy loans) and tax consequences; rescission rights (typically a 30-day cooling-off period); and holding period requirements (generally two to five years from policy issuance) that ban STOLI by prohibiting sales during the early policy years.