How Viaticals Work

How viaticals work
In essence, viatical settlements allow the owner of a life insurance policy to sell it to an independent third party. Before viatical settlements became an option, the only alternatives that policyholders had were either to borrow money against the policy or to surrender the policy outright. In the case of someone with a serious illness, however, the cash surrender value of a life insurance policy often grossly understates its real economic value. Cash surrender value is often just a small fraction of the death benefit a policy will pay to beneficiaries, and if a serious illness shortens a person's life expectancy, then settling for the cash surrender value is a major sacrifice of value.

In theory, the value of a life insurance policy should include a number of variables, including the insured person's age and medical condition, the type of policy, the policy's death benefit, and the premiums necessary to keep the policy in force. Cash surrender value, however, doesn't necessarily correlate with these variables.

For example, say that a person had a life insurance policy with a death benefit of $1 million. If that person had a terminal illness with only one year to live, then the insurance company could expect to pay out $1 million within a year. By discounting the value of the future payment, a present value calculation would put the value of the policy's future at around $950,000. However, depending on how long the person had owned the policy, its cash surrender value could quite possibly be just a small fraction of this amount. However, a viatical settlement could give the policyholder an amount much closer to its actuarial value.

As you probably know already, viaticals are not as common or as popular as a Life Settlement. A Life Settlement is a similar transaction but does to require the individual to be terminally ill.

Source: Fool.com