Does life insurance 'life settlement' make sense?

I am 80 years old and considering buying a $1-million life insurance policy, using a "non-recourse premium financing" loan. I intend to sell the policy after two years by making a "life settlement" and repay the loan from a portion of the sale proceeds. Everything I've read about this plan seems positive and legal; however, experience tells me there is no such thing as a free lunch.

E.B., via e-mail

Your caution is well-founded. This plan is riskier and less potentially rewarding than it seems.

Life settlements are aggressively marketed and likely to be pitched to other readers. They're too complex to address in one column, so this is the first of two.

Let's set the stage with a hypothetical 80-year-old, Joe X, who owns a $1-million life insurance policy. His heirs are already well provided for, and he doesn't want to pay premiums anymore. He could return his policy to the insurer for its cash "surrender" value. But he may be able to sell it to a life settlement company for a lot more money -- perhaps $200,000 or $300,000, depending on his health. That company would become the new policy owner, pay the premiums until Joe dies, and then collect the $1-million death benefit. "If you have an old policy that has outlived its usefulness, this is an alternative worth exploring," says Richard B. Freeman, a Greenwich, Conn., financial adviser. For now, let's stick to the deal you're contemplating: buying a policy in order to sell it. (Next week, I'll discuss the pros and cons of selling a policy you already own.)

One problem for the settlement business is that people like Joe are relatively rare. That's where you come in. You've been recruited to buy a $1-millon policy with a "non-recourse" premium loan. That means you don't put up a dime; it's like buying a house with no downpayment. You then sell the policy -- giving up permanent access to your medical records as part of the deal -- to a settlement company. It collects $1 million when you die.

Is this legal? Technically, at least for now. But it violates the spirit of the law. Legally, insurers can sell coverage on your life only to someone with an "insurable interest" in you -- i.e., a reason for wanting you to stay alive. That's why the settlement company needs you to buy the policy from the insurer. You'll probably have to lie when you do, because many insurers now require a signed statement that you're not borrowing to buy a policy you intend to sell. This requirement has made non-recourse financed policies less attractive to settlement firms: If an insurer can show you lied on its application, it can contest a claim beyond the usual two-year limit. Some settlement firms no longer buy non-recourse financed policies, says Glenn Daily, a New York City fee-only insurance consultant.

If you do this deal, the financing company gets hefty interest on its loan. The middlemen -- the agent who sells you the policy, the broker who shops it to settlement firms, the broker who represents the buyer -- all get big commissions. The buyer gets the $1 million pay-off when you die.

And you? You give your health records to strangers who'll profit from your death. In exchange, you get two years of "free" insurance and a share of the proceeds for selling the policy. That may be much less than you expect. The policy's sale price depends on whether your health has deteriorated since you bought it. "You get a really big offer only if you're going to die much sooner than anyone anticipated two years earlier," says Freeman. If not, the price is relatively modest. After everyone else has been paid, there may be little or nothing left for you.

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