To some, stranger-originated life insurance is a cutting-edge idea. Others see it as a practice that cuts both ways--into your affluent client's savings and his ability to purchase additional insurance.
Says St. Louis attorney Larry Brody: "These policies were sold as a free lunch to many insureds, and for many of them that meant that they weren't going to pay an attorney to look at the documents. As a result, I think we're going to see a lot of fall-out from the sale of STOLI."
The practice that Brody is talking about is not your typical life insurance sale. Instead, it generally involves investors--a hedge fund, say--who approach a wealthy individual in his 70s, either directly or through a life settlement company, with an offer to finance the purchase of huge amounts of insurance on his life. The usually non-recourse loan pays the insurance premiums for the first two years of the policy. If the insured should die during that period, the insured's beneficiaries stand to receive the net death benefit. At the end of that two-year period of "free life insurance" (which, not coincidentally, marks the end of the policy's contractual contestable period as well as many states' "wet ink laws") the insured has three options: First, he can pay back the insurance premiums advanced plus interest and any fees and continue to pay the premiums himself. Second, he can turn the policy back to the lender in satisfaction of the premium loan. And third, he can sell the policy directly to the life settlement company.
Attorney Stephan R. Leimberg argues that the first two options are a "crock." For one, he says the premiums, interest and fees in the first two years are so high that no one would want to pay them. For another, what lender in his right mind would cancel a debt of several hundred thousand--even millions of dollars--in exchange for a policy with a cash value worth a fraction of that amount? "The answer is simple," says Leimberg, who is CEO and publisher of Leimberg Information Services. "Behind the scenes, the life settlement company that instigated the whole transaction has a deal with the lender to buy the policy. That was the intent from the beginning."
The third option--selling the policy directly to the life settlement company--leads down that road as well. "They say you can't lose," Leimberg says. "In essence, they've turned what was meant to provide security into a security."
But given the amount of money and often, other incentives involved, your client might be inclined to believe the hype. From the start, STOLI promoters have used everything from cruises to a brand new car to entice rich, elderly prospects to sit for an insurance physical. And if that's not enough, the promoters remind them of all the money they will make when they sell their policy two years down the road--often without anything out-of-pocket on their part. Leimberg is quick to point out that there is no guarantee that the insured will make anything. "Still, since the insured typically invested nothing in the deal, if the investors do buy the policy, his ROI is going to be huge."
In fact, Leimberg says, many insureds who sell their policies two years later do receive cash compensation of as much as 20 to 30 percent of the death benefit--enough to pay off the loan plus interest and still walk away with a sizeable nest egg. And that's not all. In many cases, the insured will receive a signing bonus befitting that of a college athlete turning pro. "Who could turn down a deal like that, especially if you don't have an attorney who goes through the fine points of the transaction?" Leimberg asks.
And to be sure, there's a lot buried in the fine print that warrants a close look. For example, that signing bonus is taxable as ordinary income--so much for the free lunch. There's also a good chance that the IRS could come after your client for taxes on the economic benefit of the two years of "free insurance." And any gain on the sale of the policy to a life settlement company will be taxable as ordinary income as well. "When somebody provides you with income that you didn't have before, and it's not a gift, it's income. And it's a basic tenet of tax law that you are taxed on all income from whatever source," Leimberg cautions.
Taxes are not the only thing your client should be concerned about. Many of the people approached by promoters don't realize that by signing up for one of these deals, they are selling their unused insurance capacity. That is, if they later need additional life insurance, they may not be able to get it--regardless of how great their need.
One of the basic problems with stranger-originated life insurance, and the problem that gets the caretakers of the life insurance industry all worked up, is the fact that the practice violates the time-honored--and court-tested--insurable interest rule. Essentially, that rule states that only people or institutions that have an interest in seeing your client/the insured living long and prospering can buy insurance on his or her life. In other words, your client's spouse or employer in some cases, has an insurable interest; Tony Soprano doesn't. However, if your client sells the policy, as Leimberg points out, Tony and his family could end up owning it. "That's a possibility," Leimberg says. "There's no legal limit to how many times the policy on your life can be sold or to whom. In fact, a recent story in The Life Settlements Report says a Columbian drug cartel is buying these policies. I'm not saying it happens all the time, but the whole idea of insurable interest is to eliminate that risk."
Unlike Leimberg, who advocates for the insurance industry, Brody has represented individuals who have entered into these transactions well aware of the potential risks and rewards. "I find it hard to tell my client, the potential insured, that this may be a good deal for you, if you understand the risks, but I don't think you should do it because it's bad for the life insurance industry," he says.
Nevertheless, he sees trouble on the horizon--particularly in cases where the insured dies after the initial two-year period, and the lender collects the death benefit. Brody cites a recent WalMart case where the company had insured all of its 300,000-plus employees. After a greeter died, WalMart collected on the policy. The greeter's wife sued, arguing that WalMart did not have an insurable interest in her husband under the laws of her state, and therefore the proceeds should be hers. "And she won. WalMart has since sued the insurance carrier to get its $2 billion in premiums back. That's going to be the next series of law suits in these STOLI cases," Brody claims. "And depending on what state they live in, the insured's family may win."
For that reason and others, the life insurance industry is actively trying to shut down STOLI sales. Industry representatives are waging the fight on two fronts, beginning with an active campaign to convince state insurance commissioners to adopt uniform legislation that effectively addresses STOLI while protecting legitimate life insurance and life settlement arrangements. "Our policy goals are clear. It is essential that we both address STOLI and protect legitimate (life settlement) arrangements," explains Tom Korb, vice president of policy and public affairs for the Association for Advanced Life Underwriting.
Like STOLI, life settlements allow third parties to own life insurance on an individual without having an insurable interest in that person. Unlike STOLI, they don't violate the spirit of insurable interest laws because there initially was an insurable interest. It's one thing for an unrelated third part to apply for life insurance on your client's life purely for investment purposes. It's quite a different thing to apply for life insurance for family protection or to cover a key employee and then to decide years later--after the kids have moved out or the employee has retired--that the need is no longer there. "We very much want to protect people's ability to sell their policies when their circumstances or needs change," Korb explains. "However, we don't think it's healthy for the life insurance industry for third-party investors to approach people in whom they have no insurable interest."
And neither do an increasing number of insurance companies who are fighting the STOLI battle on another front by adding as many as two pages of questions to their applications to ascertain the real purpose of the proposed insurance. Where once there may have been one question--something like, "What is the purpose of the insurance?"--there are now many, more probing questions aimed directly at discovering the structure of a STOLI transaction and the honesty of the applicant:
o "Who's paying the premiums?"
o "Is there an outside lender lending you money?"
o "Is the loan recourse or non-recourse?"
o "What collateral did you have to pledge to get that loan?"
o "Did anyone tell you about life settlements?"
The additional questions are necessary because the query about "purpose" left too much wiggle room. Respondents simply answered, "estate planning," and they were off the hook.
"If you answer these new questions honestly, the insurance company is not going to issue the policy," Brody says. "If you answer dishonestly, you run the risk that the insurance company won't pay the death benefit because of the fraudulent application." Leimberg agrees adamantly: "The entire transaction is a fraud," he says.
Given that STOLI policies always involve very large amounts of insurance and premiums--and isn't that why insurance companies are in business?--some may wonder what all the fuss is about. The answer revolves around even more money. Insurance companies price their products, in part, on the statistical fact that people often allow their life insurance to lapse long before any death benefit would be paid. "And the companies make a huge amount of money on that," Brody says. "Therefore, they reduce their premiums now, knowing that they are going to make money on the lapse in the future."
And there's the rub. In a STOLI transaction, the lender is never going to allow the policy to lapse. If an insurance company has a number of these large insurance policies on the books, it is going to lose money because of its lapse pricing. "So the major insurance companies have decided they want to know which applications represent STOLI arrangements, and these additional questions are one way to find out," Brody continues.
The new questions may be working. Brody used to receive a couple of calls a week from attorneys and accountants whose clients had been approached by a STOLI promoter. It's been months since the last call. "There may be people out there doing them," he reports, "but I just haven't seen them."
That's not to say he won't receive calls in the future. Unfortunately, some states limit the types of questions insurance companies may ask on their applications, including some of these STOLI-prevention questions, according to Gary Sanders, senior counsel for law and state relations at the National Association of Insurance and Financial Advisors (NAIFA). Worse, he says, "It seems like every day, STOLI morphs into something new. In order to stop it, we're going to have to stay ahead of the game." Given the dollars involved and the number of life insurance agents out there, he's probably right. Advisors beware.
Gregory Taggart (email@example.com), a former practicing attorney who has worked in insurance and financial planning, teaches writing at Brigham Young University. His story on Split Dollar Insurance appears on p.37. In the interest of full disclosure, he notes that his brother, Jeffrey J. Taggart, is NAIFA president-elect.