An increasing number of retirement-age Americans are considering an unfamiliar financial scheme -- a way to tap into the value of their life insurance through what are known as "life settlements." But consumer advocates urge policyholders to be cautious, because a number of the companies operating in the industry have murky histories, possibly involving fraud.

Life settlement companies persuade financially secure seniors to sell their life insurance policies. The sellers get a payout that's greater than the cash value of the policy.

Meanwhile, the purchasing company keeps paying the premiums and eventually collects on the insurance payout when the former policyholders die.

Though terminally ill people have been the biggest users of this strategy, a growing number of affluent retired people are now using it, says Doug Head, executive director of the Viatical & Life Settlement Association of America. "They're finding the insurance policies they bought for protection of their children's welfare when their kids were little or for college or retirement plans, they no longer need. They have acquired other assets that meet those needs."

But life settlements have plenty of downsides, critics say. Chief among them: The relatively young industry is rife with scams. "There are no more than a handful of companies that can be trusted," says Gloria Wolk, a consumer advocate and author based in Laguna Hills, Calif.

Moreover, the benefits of life settlements tend to be exaggerated by sales agents. "I personally have not come up against a situation where it's been advisable to cash in," says Frank Gleberman, a certified financial planner and principal of Century Benefits Group, a benefits company. "Most of my clients are using

life insurance for estate tax settlements. Many are giving their insurance policies to institutions ... churches, a hospital or family foundation, to continue their largesse after their death."

Caveat Emptor

Life insurance buyouts began in the 1980s, when it became clear that people who contracted AIDS would die within a few years. A new breed of companies called viaticals (from the Latin word viaticum, which means provisions for a journey) started buying the life insurance policies of AIDS sufferers, assuming a quick collection on the insurance payout. In exchange, AIDS sufferers received cash they could use to pay for medical care.

The industry quickly developed a shady reputation. Unlicensed brokers started selling investments in fraudulent or nonexistent life insurance policies to small investors, many of whom lost their money. "In a couple of cases, people were caught, indicted and put in prison," says Meir Eliav, president of Legacy Benefits, a viatical and life settlement company.

Some states now regulate viaticals that target the terminally ill, though critics say that penalties for fraud are far too weak. But few states govern the newer life settlements, which focus on people with longer life expectancies. "As a result, there aren't sufficient protections for people to know what's a fair deal," says Bob Hunter, director of insurance for the Consumer Federation of America.

People should sell their life insurance policy only as a last resort, advises consumer advocate Wolk. "Sales agents make it sound as if people are gaining if they get, say $10,000 more than the cash value of the policy. It's made to sound so good, such a perfect solution ... why should people pay premiums? But that's not the whole story." For instance, she adds, sales agents sometimes lie about the tax implications of policy sales.

And, she says, elderly people may think they no longer need life insurance, but benefits can offer important transitional money in the event of a death. Consider, for example, a wife who plans to sell the house after a husband's death. In theory, she could move into a smaller apartment and live off the money from the house sale. But in reality she may not be emotionally prepared to sell the family home right away, Wolk points out. In the meantime, a death benefit could help cover expenses.

Indeed, older people can cut the size of their premiums in other ways, Wolk adds. "They could reduce the death benefit, so the premium is very small. Or they could use one of the nonforfeiture options available from all insurance companies. Maybe they could trade in their half-million-dollar policy with cash value in it for $100,000 of paid-up term life insurance. They don't have to pay another dime for the rest of their life."

Meanwhile, the terminally ill who want money upfront should investigate whether an issuing insurance company offers accelerated benefits. This is a relatively new development that allows policyholders to collect between 25% and 75% of the value of their policy before they die. The balance goes to the beneficiary upon their death.

Before agreeing to a life settlement, people should seek advice from an estate planner familiar with taxes, Wolk says. "You would think that high-net-worth people would go to a financial planner before they sell their policies, but even they don't," she says. "These con artists are very suave people. They're not petty thieves."