By David A. Wexler, CLU, ChFC
At a recent life insurance industry convention, two pundits were debating the pros and cons of the Investor Owned Life Insurance - known as IOLI - transaction (also known as Speculator initiated Life Insurance and Stranger Owned Life Insurance). One put forth the notion that that there is nothing wrong with a person over age 70 purchasing a substantial amount of life insurance. They also stated that inherently there is nothing wrong with financing the premiums through a third party, such as a bank. And finally, they stated that there is nothing wrong with the institutionally funded secondary market for life insurance policies known as life settlements. Each transaction, in and of itself, is relatively harmless and is executed routinely everyday. However, if you package all three of these dealings together, it could potentially be a recipe for disaster.
Life Insurance is intended to be a risk management tool. It is used to transfer the financial risk of a premature death that will protect families, finance business succession for closely held businesses, finance non-qualified retirement benefit plans and provide liquidity for transferring wealth and a myriad of other financial planning strategies. It is not intended to create inventory for the life settlement market.
There are many organizations that promote IOLI transactions, hoping to reap the large revenues associated with both the life insurance sale and the life settlement commission. The prospects for an IOLI transaction are generally people over age 70 with a high net worth and who have the financial capacity to acquire a substantial amount of life insurance (for example $5,000,000 or more). These individuals are also healthy enough to pass the medical underwriting requirements of an insurance company, qualifying for one of the better underwriting categories such as standard or better. The IOLI transaction is often promoted to prospects the sale of unused "insurance capacity", and is referred to as a "valuable wasting asset" that can be captured by selling it on the institutionally funded secondary market. Sometimes the transaction is promoted as two years of free life insurance. Some promoters even offer an advance payment to the prospect of 1%, 2% or 3% of the death benefit to entice them to sign up. Others have offered a free cruise just to listen and learn about the program.
Here's how it works: The IOLI transaction is financed with a non-recourse loan, usually for two to three years. The note may have a substantially higher than market interest rate (10% or 15% are not uncommon) for assuming the risk of a non-recourse note. At the end of the note, the policy owner can either sell the policy to the institutionally funded life settlement market, pay off the loan and pocket the difference, if any, or pay off the loan and keep the policy - generally a good idea if there has been a significant change in health - or give the policy back to the investment group or lender. Some promoters will offer a lower interest rate in exchange for participating in any profits of a life settlement transaction. The IOLI transaction promoter will hedge its bets by also having the insured and the policy appraised during the underwriting process for a potential life settlement transaction in the future.
Having described the IOLI transaction, the question remains "What is the IOLI transaction in reality? According to Barry D. Flagg, Principal of the Insurance Advisor.Com, Inc. "It is a futures contract with at least six parties to the transaction." It is a futures contract because a policy is acquired with debt financing with the prospect that within two years, the value of the policy will increase in the institutionally funded secondary market sufficient to repay the loan with some profit that will go into the pocket of the purchaser. However, with many players in the transactions, each taking a piece of the pie, the probability of the purchaser realizing any profit diminishes with each party to the transactions. The players in the transaction usually include:
1. The insured that takes all of the investment and income tax risk
2. The life insurance agent or broker who places the financed life insurance policy - and, as noted above - will earn a substantial commission
3. The life insurance company that underwrites the insurance risk and issues a policy in consideration of the premium paid by the policy owner (aside: the life insurance company has the right to change the deal by lowering crediting rates or increasing the cost of insurance)
4. The life settlement broker - who also noted above will earn a substantial commission for representing the seller to the market
5. The Life Settlement Funder that underwrites and services the life settlement transaction (and is paid transaction and ongoing service fees from the life settlement investment group)
6. The life settlement investment group that buys only the insurance assets they want
7. The Non-Recourse Premium Financing promoter who integrates the life insurance sale, the premium financing and the life settlement shares in the substantial commissions and fees for putting the deal together or participates in the profits of a sale in exchange for lower interest rates and finally the special purpose lender (a bank or hedge fund) who earns usurious interest in exchange for accepting the higher risk of a non-recourse loan.
8. By the way, it could be argued that the IRS is considered party to the transaction since it receives income tax revenue based on the value of the incentive given to the insured, capital gains tax on the gain over basis if the policy is sold, capital gains tax on the non-recourse loan if it is forgiven and potentially ordinary income tax on the proceeds due to transfer for value.
Is the IOLI transaction a good deal? An article appearing in April 23rd, 2007 issue of Business Week Magazine in an article titled "The High Price of Free Insurance" the author stated "...the gains may be significantly less that the promoters claim. Interest payments, lenders fees and brokers commissions can take a big bite out of a policyholders' profit." It is therefore not surprising, that with so many parties to the transaction, that there is any profit left for the insured. It is important to keep in mind that the institutionally funded secondary market was initially created for policies that were issued to people that qualified for preferred or standard underwriting who have experienced a change in health. Using a Society of Actuaries Mortality Table, a healthy 75 year old has a life expectancy of 14 years. Two years later, a healthy 77 year-old has a life expectancy of 13 years. While there are life settlement investors that might purchase a life insurance policy on a healthy 77 year old with a 13-year life expectancy, it does not have the same appeal or pricing that a 77 year old with impaired health will have.
Then there is the question of how the transaction is taxed. If the policy is sold, the popular opinion is that the cash value in excess of the basis is taxed as ordinary income and the settlement proceeds in excess of the cash value is treated as a capital gain. Another question is what is the definition of "basis" in a life insurance policy? According to the 2007 Tax Facts published by the National Underwriter Company, "Recent guidance indicates that on a sale of a life insurance policy, the IRS will consider the basis of the contract to be the premiums paid minus the cost of insurance protection." If the policy is given back to the promoter and the non-recourse loan is discharged, then the amount of the unpaid principal of the debt and the taxpayer's adjusted basis would be treated as a taxable capital gain on the "sale or other disposition" of the property. Finally, there is the question of how those that receive cash in advance, trips or "two years of free insurance" will be taxed? Is the person who receives these incentives obligated to pay tax on the value of that which was received?
One possible use for the IOLI transaction is "bridge financing" for seniors. The current Federal Estate Tax is due to be repealed in 2010 and then return in 2011 when the legislation sunsets. For the older person that is not eligible for term life insurance who wants tempory coverage and wants to wait and see what happens with the Federal Estate Tax, an IOLI transaction might be an attractive, economical way of acquiring temporary coverage with the option of extending the coverage when the Federal Estate Tax is reformed.
Life insurance is deceptively complicated. It has a nomenclature of its own and terms are often used loosely. Loans and non-recourse bank financing documents are also complicated and must be thoroughly reviewed by uninterested third party advisors. The institutionally funded life settlement market is a relatively new industry, and can be akin to the wild west in that it's a new frontier where regulations have not yet caught up to the complexity of the marketplace. The IOLI transaction integrates life insurance, bank financing and life settlements. Up to now, many IOLI transactions have been "under the radar." However, currently there are several states, including New York, Utah, Louisiana and Iowa that are looking at IOLI transactions for potential violations of insurable interest statues.
In our firm, we offer many creative financing strategies for life insurance products. We have also made a public statement that we believe IOLI, SOLI and SPINLIFE transactions are not in our clients' best interest, in our best interest or the industry's best interest. Anyone looking to profit from the sale of their unused insurance capacity should heed the opinion expressed in Business Week, "the gains may be significantly less that the promoters claim. Interest payments, lenders fees and brokers commissions can take a big bite out of a policyholders' profit" and remember if is sounds too good to be true than it probably is.
At a recent life insurance industry convention, two pundits were debating the pros and cons of the Investor Owned Life Insurance - known as IOLI - transaction (also known as Speculator initiated Life Insurance and Stranger Owned Life Insurance). One put forth the notion that that there is nothing wrong with a person over age 70 purchasing a substantial amount of life insurance. They also stated that inherently there is nothing wrong with financing the premiums through a third party, such as a bank. And finally, they stated that there is nothing wrong with the institutionally funded secondary market for life insurance policies known as life settlements. Each transaction, in and of itself, is relatively harmless and is executed routinely everyday. However, if you package all three of these dealings together, it could potentially be a recipe for disaster.
Life Insurance is intended to be a risk management tool. It is used to transfer the financial risk of a premature death that will protect families, finance business succession for closely held businesses, finance non-qualified retirement benefit plans and provide liquidity for transferring wealth and a myriad of other financial planning strategies. It is not intended to create inventory for the life settlement market.
There are many organizations that promote IOLI transactions, hoping to reap the large revenues associated with both the life insurance sale and the life settlement commission. The prospects for an IOLI transaction are generally people over age 70 with a high net worth and who have the financial capacity to acquire a substantial amount of life insurance (for example $5,000,000 or more). These individuals are also healthy enough to pass the medical underwriting requirements of an insurance company, qualifying for one of the better underwriting categories such as standard or better. The IOLI transaction is often promoted to prospects the sale of unused "insurance capacity", and is referred to as a "valuable wasting asset" that can be captured by selling it on the institutionally funded secondary market. Sometimes the transaction is promoted as two years of free life insurance. Some promoters even offer an advance payment to the prospect of 1%, 2% or 3% of the death benefit to entice them to sign up. Others have offered a free cruise just to listen and learn about the program.
Here's how it works: The IOLI transaction is financed with a non-recourse loan, usually for two to three years. The note may have a substantially higher than market interest rate (10% or 15% are not uncommon) for assuming the risk of a non-recourse note. At the end of the note, the policy owner can either sell the policy to the institutionally funded life settlement market, pay off the loan and pocket the difference, if any, or pay off the loan and keep the policy - generally a good idea if there has been a significant change in health - or give the policy back to the investment group or lender. Some promoters will offer a lower interest rate in exchange for participating in any profits of a life settlement transaction. The IOLI transaction promoter will hedge its bets by also having the insured and the policy appraised during the underwriting process for a potential life settlement transaction in the future.
Having described the IOLI transaction, the question remains "What is the IOLI transaction in reality? According to Barry D. Flagg, Principal of the Insurance Advisor.Com, Inc. "It is a futures contract with at least six parties to the transaction." It is a futures contract because a policy is acquired with debt financing with the prospect that within two years, the value of the policy will increase in the institutionally funded secondary market sufficient to repay the loan with some profit that will go into the pocket of the purchaser. However, with many players in the transactions, each taking a piece of the pie, the probability of the purchaser realizing any profit diminishes with each party to the transactions. The players in the transaction usually include:
1. The insured that takes all of the investment and income tax risk
2. The life insurance agent or broker who places the financed life insurance policy - and, as noted above - will earn a substantial commission
3. The life insurance company that underwrites the insurance risk and issues a policy in consideration of the premium paid by the policy owner (aside: the life insurance company has the right to change the deal by lowering crediting rates or increasing the cost of insurance)
4. The life settlement broker - who also noted above will earn a substantial commission for representing the seller to the market
5. The Life Settlement Funder that underwrites and services the life settlement transaction (and is paid transaction and ongoing service fees from the life settlement investment group)
6. The life settlement investment group that buys only the insurance assets they want
7. The Non-Recourse Premium Financing promoter who integrates the life insurance sale, the premium financing and the life settlement shares in the substantial commissions and fees for putting the deal together or participates in the profits of a sale in exchange for lower interest rates and finally the special purpose lender (a bank or hedge fund) who earns usurious interest in exchange for accepting the higher risk of a non-recourse loan.
8. By the way, it could be argued that the IRS is considered party to the transaction since it receives income tax revenue based on the value of the incentive given to the insured, capital gains tax on the gain over basis if the policy is sold, capital gains tax on the non-recourse loan if it is forgiven and potentially ordinary income tax on the proceeds due to transfer for value.
Is the IOLI transaction a good deal? An article appearing in April 23rd, 2007 issue of Business Week Magazine in an article titled "The High Price of Free Insurance" the author stated "...the gains may be significantly less that the promoters claim. Interest payments, lenders fees and brokers commissions can take a big bite out of a policyholders' profit." It is therefore not surprising, that with so many parties to the transaction, that there is any profit left for the insured. It is important to keep in mind that the institutionally funded secondary market was initially created for policies that were issued to people that qualified for preferred or standard underwriting who have experienced a change in health. Using a Society of Actuaries Mortality Table, a healthy 75 year old has a life expectancy of 14 years. Two years later, a healthy 77 year-old has a life expectancy of 13 years. While there are life settlement investors that might purchase a life insurance policy on a healthy 77 year old with a 13-year life expectancy, it does not have the same appeal or pricing that a 77 year old with impaired health will have.
Then there is the question of how the transaction is taxed. If the policy is sold, the popular opinion is that the cash value in excess of the basis is taxed as ordinary income and the settlement proceeds in excess of the cash value is treated as a capital gain. Another question is what is the definition of "basis" in a life insurance policy? According to the 2007 Tax Facts published by the National Underwriter Company, "Recent guidance indicates that on a sale of a life insurance policy, the IRS will consider the basis of the contract to be the premiums paid minus the cost of insurance protection." If the policy is given back to the promoter and the non-recourse loan is discharged, then the amount of the unpaid principal of the debt and the taxpayer's adjusted basis would be treated as a taxable capital gain on the "sale or other disposition" of the property. Finally, there is the question of how those that receive cash in advance, trips or "two years of free insurance" will be taxed? Is the person who receives these incentives obligated to pay tax on the value of that which was received?
One possible use for the IOLI transaction is "bridge financing" for seniors. The current Federal Estate Tax is due to be repealed in 2010 and then return in 2011 when the legislation sunsets. For the older person that is not eligible for term life insurance who wants tempory coverage and wants to wait and see what happens with the Federal Estate Tax, an IOLI transaction might be an attractive, economical way of acquiring temporary coverage with the option of extending the coverage when the Federal Estate Tax is reformed.
Life insurance is deceptively complicated. It has a nomenclature of its own and terms are often used loosely. Loans and non-recourse bank financing documents are also complicated and must be thoroughly reviewed by uninterested third party advisors. The institutionally funded life settlement market is a relatively new industry, and can be akin to the wild west in that it's a new frontier where regulations have not yet caught up to the complexity of the marketplace. The IOLI transaction integrates life insurance, bank financing and life settlements. Up to now, many IOLI transactions have been "under the radar." However, currently there are several states, including New York, Utah, Louisiana and Iowa that are looking at IOLI transactions for potential violations of insurable interest statues.
In our firm, we offer many creative financing strategies for life insurance products. We have also made a public statement that we believe IOLI, SOLI and SPINLIFE transactions are not in our clients' best interest, in our best interest or the industry's best interest. Anyone looking to profit from the sale of their unused insurance capacity should heed the opinion expressed in Business Week, "the gains may be significantly less that the promoters claim. Interest payments, lenders fees and brokers commissions can take a big bite out of a policyholders' profit" and remember if is sounds too good to be true than it probably is.
1 "Stranger Owned Life Insurance Free Insurance? Found Money? A good investment? A Scam? What is it anyway?" Barry D. Flagg, The Insurance Advisor.com
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