Gambling On Guarantees - By James R. Robinson , Stephen "Bo" Wilkins - 10/1/2007
James R. Robinson is an associate in the Private Wealth Practice Group of Arnall Golden Gregory LLP in Atlanta. His practice focuses on wealth transfer taxation, business succession planning, estate planning and administration, and charitable planning and exempt organizations.View all articles by James R. Robinson
Stephen B. "Bo" Wilkins is a chartered life underwriter (CLU),chartered financial consultant (ChFC) and a chartered advisor in philanthropy (CAP). He is a registered representative of M Holdings Securities Inc., a member firm of Nease, Lagana, Eden & Culley Inc.in Atlanta.View all articles by Stephen "Bo" Wilkins
While we view the development of a secondary market for life insurance policies in general as a positive one, advisors should approach proposed Stranger Owned Life Insurance (SOLI) transactions with caution, if at all.
The Emerging Life Settlements Market
The past several years have seen the rapid development of a secondary market for existing life policies: the so-called "life settlement" market. Unlike a "viatical settlement," which is the tax-free purchase of a policy on a terminally ill individual (as defined by the Internal Revenue Code), a typical life settlement is a taxable purchase of a policy on the life of a relatively healthy person. The full tax consequences of a life settlement are as yet unclear and await IRS guidance, although it seems relatively certain that there is potential taxable gain to the policy owner (to the extent that the amount received in settlement exceeds the owner's basis in the policy) and to the purchaser (to the extent that the proceeds received at the death of the insured exceed the amount paid for the policy). Despite the tax cost, though, as shown in the table, a life settlement, properly structured, can produce a very favorable result.
Without a doubt, the rise of the life settlement market has brought new opportunities, as well as new challenges, for advisors who either act as fiduciaries or assist fiduciaries in managing investment portfolios. Institutional trustees in particular may face unanticipated liability for following the time-honored practice of "forgetting" old policies held in life insurance trusts. On the whole, though, the availability of an alternative market for life insurance seems a positive development. However, as with many alternative markets in their infancy, some aspects of the secondary market (particularly those involving premium financing) may be best avoided altogether. One of these aspects or activities concerns the current availability of SOLI policies.
Insurable Interest And SOLI
The basic idea of SOLI combines a pool of private investors, life insurance, annuities and, oftentimes, a charity and its donors forming a strategy for the ostensible benefit of all parties involved. Here is how it is typically pitched when a charity is involved:
1. A number of investors form a fund that is typically leveraged with debt.
2. The investors find a charity willing to ask its largest donors, typically older ones, to be insured. The "benefit" to the charity is that it will receive a portion of the death benefit when the donor dies. A sweetener is often added up front in the form of a payment of some amount to the charity.
3. The donors typically are insured with a large life insurance contract. Oftentimes, a "life only" annuity also is purchased as a way to pay the premiums and to service any debt the investors have taken on. The goal for the investors is to negotiate the most favorable risk class with the lowest premiums for the life insurance while placing an annuity with the least favorable underwriting, resulting in an actuarial shorter life expectancy and higher annuity payout.
4. Upon the death of the donor, the investors recoup their investment via the death benefit, while the charity might receive approximately 5% of the proceeds.
Most of the scheme's advantages belong to the investors and promoters. The investors' aim is to create a profitable pool of insureds, while the promoters make substantial fees and commissions up front. The promoters sell the concept to charities as being beneficial for them and the donors.
Nothing could be further from the truth. The bottom line is that the charities' involvement represents a way for the investors to legitimize the process in the eyes of regulators and to establish an insurable interest where there otherwise Gambling Pic 2would be none. Additionally, it provides a ready-made pool of people to insure rather than having to do "one off" transactions one person at a time. Charities also are willing to listen and cooperate in a difficult fund-raising climate.
The unfortunate part of this concept is that all the downside falls on the charity and the insured, not to mention the collateral damage that could affect the insurance industry. The charity risks losing its tax-exempt status under Section 501(c)(3) by accepting an inducement. Furthermore, the paltry amount of death benefit received by the charity could be deemed unrelated business taxable income (UBTI) if it is viewed as debt-financed income. Finally, a donor who is willing to be insured to "help the charity" could later find out that his or her insurability was used to put money in the investors' pockets. It doesn't seem sensible for a charity to risk losing its exempt status, create UBTI and drive away major donors for a possible 5% of a death benefit that may or may not be paid. Moreover, the Pension Protection Act of 2006 added to charities' compliance burden by imposing new reporting requirements: Charities that invest in pools of life policies such as those seen in a typical SOLI transaction must now report such investments, which presumably will be the subject of heightened IRS scrutiny.
The SOLI scheme underscores the policy justifications behind the insurable interest rule. One of the most important principles of insurable interest that is generally accepted, despite the lack of uniformity among the states, is that the purchaser must have a reasonable expectation of benefiting from the continued life of the insured. In SOLI, the investors have no interest in the continued life of the donors being insured. It recalls the days of buying insurance as merely a form of wagering, which the Anglo-American legal tradition has sought to curtail as far back as 1774.
Many states continue to be lobbied by promoters attempting to soften the insurable interest laws to allow SOLI transactions. This is causing the insurance authorities in some states to more closely scrutinize transactions involving insurance trusts. This could result in legitimate transactions being disallowed in the future. Another damaging side effect is the negative spotlight cast on the insurance industry as a whole. It would be very unfortunate to lose the tax-favored benefit of life insurance because of the mass commoditization of unsavory schemes in the marketplace.