The acquisition of an insurance policy by an insured for the purpose of selling that policy to a third party has bloomed into a new and very controversial cottage industry, according to J. Alan Jensen, J.D. and Stephan Leimberg, CLU.
This is stranger-owned life insurance, and the experts covered the pros and cons during a breakout session at the Million Dollar Round Table annual in Indianapolis this summer.
Jensen, an attorney with Holland & Knight LLP, Portland, Ore., argued in favor of STOLI, while Leimberg, chief executive of both Leimberg Information Services Inc. and Leimberg Associates, both of Bryn Mawr, Pa., spoke in opposition. The two presented their points and counterpoints and also engaged in lively rebuttal.
STOLI “conjures up an unsettling, if not un-American, image of profiteers bilking unwitting elderly insurance prospects,” allowed Jensen.
He said he prefers the term “disposable policies,” because it is “more apt and devoid of some of the negative connotation in STOLI.” The term reflects that this is an “anticipated sale (hence disposable) of the policy after the 2-year contestability period has lapsed,” he said.
Disposable policies are part of the life settlement market, Jensen maintained.
The sale of an insurance policy by an owner to a third party buyer is not illegal, Jensen continued. But he said such sales are subject to some significant qualifications.
When the market exploded and the inventory of qualifying policies could not keep pace with demand, Jensen recalled, some “resourceful agents” started marketing disposable policies to elderly insureds who had no particular need or desire for additional insurance. The elders were told that the transaction “would net them a considerable amount of cash with no out-of-pocket expense required.”
That incurred the wrath of the insurance industry, he said.
Jensen reviewed how disposable policy transactions work, and then presented his take on why the transactions raised a fuss. “The preservation of the insurer’s profit margins seems to be the core of the controversy,” he said.
“Had the insurers profited in typical fashion from the sale of billions of dollars of new coverage, we would not be discussing the issue.”
As for why insurers are fighting sales of the disposable policies, he suggested reason is that the disposable policy probably will not lapse. “This basic fact distinguishes them from other types of whole life insurance policies,” Jensen said.
Since insurers have priced policies on the assumption that a large percentage will not be retained until the insured dies, he explained, this has “raised havoc” concerning policy pricing and profitability.
He argued that “the creation of the secondary market, which allows the sale of the disposable policy, should be regarded as a favorable economic development for the consumer.” Insureds who now find a policy they purchased to meet a need in the past is now unneeded or cannot be afforded “should be allowed to sell in the secondary market,” he said.
Jensen conceded some abuses do exist. For instance, the dearth of best practices has “encouraged hyperbole” at times, he said. This “invites misrepresentation by some agents or brokers who are either unscrupulous or simply do not fully understand the market themselves,” he said.
Also, there is no certainty that the disposable policy can be sold in the secondary market, particularly if the insured’s health stays the same as at policy issue, Jensen said. “However, if this possibility is explained to the insured, he cannot complain of loss of profits in the event of no sale.”
The associated tax costs may be significant, he said, noting that an agent’s written disclosure to the client will often have a brief suggestion to consult a tax adviser about the tax effects of a disposable policy, “but those potential effects are left unstated.”
Insurable interest is an issue too, he indicated. Virtually all states have an insurable interest requirement, but many disposable designs do not appear to have an insurable interest, Jensen said, noting that this can void the transaction.
For a disposable plan to be enforceable, he continued, “the original owner must have an insurable interest, which is then assigned to investors.”
Amendments to the Viatical Settlements Model Act of National Association of Insurance Commissioners, Kansas City, Mo., do address disposable policy issue and sale in the secondary market, Jensen said.
In the future, some parts of the model will need refinement, and the secondary market will change, he said. However, he said the hope is that the secondary market “will be left intact and provide a valid option for the disposal of an asset that the insured has bought and paid for, owns, and should be allowed to transfer freely.”
In his counterpoint, Leimberg listed several things he said are “wrong with STOLI.” They include: insurance fraud, illegality, foolishness, tax issues, disappointing to the insured’s family, liability protections for the investors but no protections for the insured, uncertainty in the transaction itself, mortality risk, conflict of interest issues, and “ethically wrong.”
About fraud, Leimberg contended that “STOLI almost invariably starts with theft by deception, a fraud on the insurer. In fact, he said, “prospective insureds have been coached to lie, deliberately omit key information, or otherwise misdirect so as to trick the insurer into issuing a contract it would not otherwise issue.”
In most states, insurance fraud is a misdemeanor, but in some states, he warned, it is a felony crime.
As for illegality, he contended that “STOLI is a violation of the spirit, if not the letter, of the insurable interest law in every state in this country.” It starts with a purchase the investors cannot legally make on their own, he said, noting “it is unlawful in every state for investor strangers to buy insurance on the life of a person with no insurable interest.”
Regarding taxes, Leimberg pointed out that “any incentive, such as a car, cash, trip, or other ‘gift’ to entice a person to purchase the policy, will be taxable to that person immediately as ordinary income.” Also, he said “the ‘free’ insurance is not free, because the insured will probably be subjected to significant income tax each year on the economic value of the coverage that is provided.”
If the insured or the insured’s trust decides to turn over the policy to the lender and walk away from the nonrecourse loan, he added, “it is highly likely that the IRS will treat that discharge of indebtedness as ordinary income.”
Turning to liability concerns, Leimberg pointed out that insureds often do not obtain competent and diligent legal counsel and that this can make the insured’s estate “liable to investors for millions of dollars.”
Further, “the insured will be asked to sign literally dozens of lengthy and complex legal documents designed to protect the investors’ and the lender’s interests,” he said, but the provisions favor the investors and lenders rather than the insured.
Regarding uncertainty, Leimberg pointed out that investors are typically not bound to purchase the policy at the end of 2 years. And, even if they do offer to buy it, “they may offer much less than anticipated,” he said. That can happen if, say, the insured’s longevity has, for any reason, improved at the end of 2 years, rendering the policy not as valuable to investors as originally predicted, he said.
Regarding mortality risk, he noted that “the insured is the only party to the contract that hopes he or she lives a long time.”
In discussing ethical issues, Leimberg recalled that the taking out of life insurance is it is an altruistic act. This purpose is “violated” when reduced to a mere investment vehicle and a “market in death,” he said.