If you have ignored the latest schemes dreamed up by enterprising insurance agents to sell large life insurance policies, it is time to get educated about Stranger Owned Life Insurance. This scheme has become so pervasive in the last couple of years that you are bound to get a call from an affluent elderly client who has discovered that his “no skin in the game” easy-money opportunity is as flat as a deflated balloon. Or worse, he just got a 1099 reporting taxable income for more than he actually pocketed.
A few years ago, there was an explosion in the life settlement market. The primary buyers of after-market life insurance policies were hedge funds looking for the truly noncorrelated investment. Not just any life insurance policy would do; investors were interested in the elderly insured whose health had declined since the policy’s issue. The profits were so attractive that there was more demand than supply. Seeing an opportunity, middlemen undertook to create a supply to fill the void. What emerged was Investor Owned Life Insurance, otherwise called Stranger Owned Life Insurance (STOLI).
The first time I heard about STOLI, it had been proposed as a fund-raiser by a client’s alma mater. The college’s elderly supporters were solicited to apply for insurance policies on their lives, hold them for two years, sell them in the life settlement market, and make a sizable tax-deductible charitable donation to the college. To sweeten the deal, a third party loaned would-be donors the seed money to buy the policy. The terms were ridiculously favorable to the lender, but the client was assured that she could walk away from the nonrecourse loan, a loan in which only the life insurance policy is at risk.
The two-year delay was significant and set off alarms for me. The time period just happens to coincide with a life insurance policy’s contestable period, during which the insurance company can contest and rescind the policy.
The probable justification for contesting the policy is the investors’ lack of insurable interest in the life of the insured; insurable interest in the continued life of the insured is required at the time of the policy’s issue by almost every state. Otherwise, the purchase of life insurance by an investor is no more than a gamble. And a prearranged sale to investors flies in the face of public policy. But no amount of reasoning could dissuade the donor. The college’s young president had wholeheartedly endorsed the fund-raiser, excited by the prospect of donations equal to 2% to 5% of death benefits.
It wasn’t long before promoters of STOLI realized that greed is a much stronger impulse than philanthropic intent. High-net-worth seniors were induced to contribute with offers of up-front bonuses, cruises, luxury cars, or a cut of the action. In the meantime, the insured got the benefit of “free” insurance during the waiting period. Lest you mistake these seniors for victims, consider that they were wealthy enough to get the best independent advice, and often did, and sophisticated enough to know better. In fact, some seniors bought into the argument that it was the insurance company’s faulty underwriting standards that created the arbitrage in the marketplace.
Three years later the downsides of STOLI have begun to come to light. You may get a call from a client who entered into a STOLI arrangement and just received a call from the agent saying that the market is soft for life settlements–the client’s cut will not only be smaller than anticipated, but the policy’s sale price might not even cover the loan. Can you, her financial advisor, shop for a better deal, she asks? Another client may bring in a 1099 for a taxable amount that is larger than the money he received for his participation. A third client comes to you worried about who owns his policy now that the hedge fund investor has gone bankrupt.
A Soft Market
The biggest impact on the settlement market is the new life expectancy tables issued in the last year by several settlement underwriters. Life expectancies have been lengthened an average of 20% for men, depending on age and health, and 15% for women. Longer life expectancies have also narrowed the insured profile to ages 70 or older for men and 75 for women, preferably with impaired health since the policy’s issue. This has also translated into lower returns for investors and thus lower purchase offers for policyowners.
The market has also been affected by the withdrawal of several large players. With investment capital drying up, life settlement companies have been quick to take offers off the table, forcing sellers to make decisions before thoroughly shopping the market. Moreover, the recent economic slowdown has caused many retirees to search for alternative sources of liquidity, further flooding the life settlement market.
All of these changes have depressed resale prices for life insurance policies. Bloomberg reported on March 26 that whereas last year retirees could expect to sell a $5 million life insurance policy for $1 million, the same policy would only bring in $600,000 today.
The credit crunch has also had its impact on the life settlement market. Without premium financing, very few seniors would be willing to enter into a STOLI scheme, but the choices for leveraged policyowners are limited. The after-tax value of a life settlement may not cover the loan repayment, and the interest rates are generally too high to refinance while waiting for the settlement prices to recover.