The states hope to stop people from dropping their life-insurance policies in order to qualify for Medicaid. To keep policy owners from spending settlements frivolously, the bills generally require that the money go straight to an irrevocable bank account used solely to pay for long-term care.

Medicaid is a jointly run state and federal health program for the poor that also provides long-term care to people who generally have used up all but a few thousand dollars in savings.

In most cases, there is nothing to prevent life-insurance owners from selling their policies now to pay for long-term care, but the new laws will help publicize and regulate the strategy. “This focuses on middle-class policyholders with term coverage worth $100,000 on average,” said Chris Orestis, chief executive of Life Care Funding LLC of Portland, Maine. “They’re not wealthy enough to pay for long-term care for a long time, and they’re not poor enough to qualify for Medicaid right away.”

Such settlements have one big drawback: The company buying the policy keeps a sizable chunk of its value. For example, customers of Life Care Funding get about 45% of their policy’s death benefit, depending on their age and health, Mr. Orestis said.

Investors piled into life settlements in the mid-2000s in search of high returns, but many encountered a thicket of litigation and, in some cases, scrutiny from state and federal regulators.

The seal of approval from some states demonstrates the desperation of lawmakers to stem rising Medicaid costs as 78 million baby boomers head into old age.

“It saves the state money, because otherwise you would just cash in the value of the life insurance and get $5,000 or something, and go on the Medicaid roll immediately,” said Texas Rep. Craig Eiland, a Galveston Democrat who introduced the bill in the Texas House. “The policyholder benefits because he has cash he can direct to his own care and expenditures.”

In Texas, about 27,000 people a year apply for Medicaid coverage of long-term-care bills. If 10% of the estimated 10,000 applicants with life insurance worth $75,000 used settlements to pay for long-term care, Medicaid could save $20 million a year, said Michael Freedman, a lobbyist for Coventry First LLC, a life-settlement company in Fort Washington, Pa.

Adult children facing immediate long-term-care bills for their parents in some cases are willing to take a smaller amount upfront than a larger inheritance later.

Rick Anderson, a 60-year-old AT&T Corp.retiree in Lubbock, Texas, is caring for his 84-year-old father, who has had Alzheimer’s disease for 15 years. For almost five years, his father has lived in a facility that costs more than $5,000 a month. He pays for half of it with a long-term-care insurance policy that will run out Dec. 31. Mr. Anderson has been covering the rest with his own savings. Now, he said, his increasingly frail mother needs to move to a facility, as well.

When Mr. Anderson discovered a $50,000 life-insurance policy on which his father was paying $71.97 a month in premiums, at about the same time he picked up a brochure at his father’s facility explaining the life-settlement option to pay for long-term care, “I didn’t even hesitate,” Mr. Anderson said. “You’ve got to use the resources you have at the time.”

He is getting a $35,000 settlement, which “I’ve told a lot of people about, because they didn’t know they had that option. They say, ‘You’re giving up $15,000.’ I guess it’s how you look at it. I need the help now,” Mr. Anderson said.

One big advantage over using Medicaid: “You can pay for the health-care providers you choose, not that the state chooses,” said Scott Page, chief executive of Lifeline Program, a life-settlement company in Tucker, Ga.

Few families attempting to care for frail, elderly relatives realize they have the option, so many simply abandon or surrender the policies instead, getting little or no cash after years of paying premiums, advocates say.

The American Council of Life Insurers, a trade group in Washington, D.C., is “closely reviewing these new proposals,” spokesman Jack Dolan said in a written statement and feels that “the life insurance product should remain intact.”