Stranger-Owned Life Insurance
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By Joseph Bayewitch Director Tax Services jbayewitch@rbz.com |
| Publication Date: Spring 2009 | |
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Stranger-owned life insurance is not an insurance product as much as it is an investment vehicle using life insurance as an article of trade in what can be considered a futures contract transaction. Rather than a futures contract involving a currency or commodity, in this case it is a bet on life expectancy. This type of transaction came into being roughly six years ago and can be marketed under a number of different titles and acronyms including SOLI or STOLI (Stranger-Owned Life Insurance), IOLI (Investor-Owned Life Insurance), ChOLI (Charity-Owned Life Insurance) and SPINLife (Speculator-Initiated Life Insurance).
The use of the word “stranger” in the name of these arrangements touches on the concept of insurable interest and the lack thereof in these types of transactions. The legal concept of insurable interest dates back to early 18th century England. It was a time when policies were usually owned by the beneficiaries and frequently purchased without the knowledge or consent of the insured. Purchasing policies on strangers became a popular form of gambling, so Parliament enacted laws requiring an “insurable interest” in the insured in order to limit gambling on human lives. Similar laws were adopted early in the U.S. An insurable interest is an interest based on the reasonable expectation of financial advantage through the continued life of another and consequent loss by reason of the person’s death. It can also be an interest engendered by love and affection in the case of individuals closely related by blood or law. Everyone is considered to have an insurable interest in their own lives as well as the lives of their spouses and dependents.
Although the insurable interest laws vary widely from state to state, they deal with three main concepts when a policy is purchased on the life of another:
- The buyer must have a reasonable expectation of benefit or advantage from the continued life of the insured, an insurable interest.
- The owner must have an insurable interest in the insured when the policy is purchased.
- The informed written consent of the insured is required in most states.
The typical transaction is one in which a wealthy elderly individual is approached with the offer of free life insurance via a loan regime by a “stranger” who offers to finance or pay the premiums. In addition, the offer could include future profits and cash up front which would be ordinary taxable income to the individual. The transaction can be structured directly with the individual or through an entity of the individual’s, such as a trust or an LLC. It is a transaction under whatever name that involves wealthy seniors above the age of 70 who have excess insurance capacity and who don’t have a need for additional life insurance on their lives for estate planning or other family needs (insurance capacity is the amount of insurance a person can purchase on their life based on their net worth and annual income).
The insured usually pays nothing out of pocket towards the policy premiums. Rather the strangers, an investor group, arrange for a loan, sometimes non-recourse, at high interest rates to provide cash to the insured to cover the premiums for two years using the policy cash surrender value as collateral. Interest on the loan accrues and increases the outstanding loan. Two years is the period of contestability and it is impractical for the investor group to be viewed as “owning” the policy or be seen as directly paying the premiums on the policy during this time. Also, the deal could include an initial payment of cash to the individual as a further inducement to get the insurance. The arrangement usually includes the right of the insured to repay the loan and interest during the two year period and keep the policy. In addition, the typical arrangement also includes the suggestion that the investor group would purchase the policy after the two years at a fair market value. However, the investor group is generally not required to purchase the policy and the fair value determination is in the hands of the investor group.
The insured generally has three choices regarding the policy after the first two years. The insured could: 1) keep the policy by repaying the loan including accrued interest, 2) sell the policy to the investor group or, 3) turn in the policy to the lender and walk away from the loan. The cash surrender value will likely cover only part of the loan, however. Because the loan is generally non-recourse, any remaining outstanding balance would be cancelled which will usually be a taxable event to the insured. The insured would pay tax at ordinary rates on the portion of the loan cancelled. If the loan is recourse either by a letter of credit or personal guarantees, then the insured would be liable for any remaining unpaid loan balances.
As to the first option of keeping the policy, usually the insured did not need additional insurance anyway. Even if there was a thought to keep the policy and increase the level of insurance carried, the insured should be able to find cheaper premiums and lower loan interest charges than those involved with SOLI arrangements, assuming continued insurability. If the second option of selling the policy to the investors is available after two years, there is no guarantee that the fair market value will be greater than the cash surrender value or be enough to cover the loan, accrued interest, potential taxes and earn any promised profit. For the investors to make money they are of course motivated to put the lowest price tag on the fair value and the insured has no recourse (except not to sell, of course). If the fair value doesn’t cover the loan balance then the insured will still have cancellation of debt income. In addition to these issues, there is no definitive authority or guidance for the proper taxation of the sale to the investor group. Of particular concern is the basis of the policy and whether it would need to be reduced by the economic benefit of the “free” insurance received. If the policy’s basis were so reduced, it would likely cause the basis to be near zero and make the entire sale price subject to tax. A further open question is how much of the gain is taxable at ordinary rates and what portion, if any, will be taxed at long-term rates.
Aside from the financial considerations in the transaction, there is also the issue of insurance companies being ever mindful of the possible existence of SOLI arrangements at the time a policy is purchased and well motivated to find reason to rescind the policy rather than having to pay on the death of the insured, based either on gaps in the application (in an attempt to cover up the SOLI arrangement) or by proving that the real owners of the policy at the outset were the investors who did not have the requisite insurable interest at the time the policy was purchased. There are a number of cases involving attempts by the insurance carriers to rescind policies involving SOLI arrangements currently pending. Therefore, even if the insured dies during the first two years the policy is in force, collection on the policy could still be in doubt.
SOLI transactions are not necessarily free to the insured, as discussed above. In addition, it is possible that widespread use of these arrangements could cause dislocations in the life insurance marketplace because of shifting actuarial assumptions which could raise the cost of life insurance for everyone. Also tax laws and insurance laws can/will be changed to address perceived abuses. Already 13 states have modified insurance rules to block SOLI type transactions and at least 16 more are discussing it. In California SB 1543 was passed by the legislature last year but has yet to be signed by the Governor. The law is intended to tighten insurable interest rules in California to block SOLI type transactions here.
Without doubt there are legitimate reasons to sell existing policies to investors on the open market also referred to as the Secondary Life Insurance Market where qualified funding institutions purchase policies in exchange for beneficiary assignment. Reasons to dispose of a policy can include wanting to get rid of a policy with too high premiums, because the need for the insurance no longer exists (e.g., upon the death of the beneficiary), or where funds are needed immediately. In fact, for terminally and chronically ill individuals the tax code sanctions selling of the policies to qualified viatical settlement providers by allowing the proceeds received to be non-taxable.
For more information about RBZ’s Tax services, contact:
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Contacts |
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Stephen Rickert Co-Partner In-Charge, Tax Partner International Tax Services Group (310) 478-4148 x347 | srickert@rbz.com |
