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The deal offered to affluent seniors sounds awfully good: two years of free life insurance, plus a luxury car, a cruise, or a cash payment. All you have to do is take out a multimillion-dollar life insurance policy with a loan you're not obligated to repay and sell or transfer the policy in a couple of years.
The buyers? Small investment firms, which package and sell the policies to hedge funds, investment banks, and pension funds. The investors continue to pay the premiums and cash in on the death benefits when the insured seniors die. They see life insurance policies as desirable assets because the expected returns—about 13% a year, according to one study—don't correlate with returns from the stock or bond markets. While some firms have for years stood ready to buy policies that people no longer want or need, not enough come over the transom to feed institutional investors' growing appetite. So, some enterprising investment firms are trying to expand the pool available for sale by recruiting seniors to sign up for policies. Pitches for such deals have become "commonplace in affluent communities of seniors," says J. Alan Jensen, a partner at Holland & Knight in Portland, Ore., which has represented high-net-worth clients in these transactions. The marketing materials make these arrangements sound like a sure thing. "You have literally no risk," claims one brochure.
Not exactly. Seniors entering these insurance arrangements could get stuck with significant tax or legal bills if the deals don't work out as advertised. "Nowhere in the hype will you learn of the potential tax liabilities or the fact that anticipated profits may not materialize," says Jensen. There are other risks, too. For example, if you sell a policy and then decide later that you need additional insurance, you could find you've used up all of the coverage an insurance company will sell you.
Lawmakers and insurance regulators have started to examine these deals. In recent months insurance commissioners in New York, Utah, Idaho, and Louisiana have concluded that some of them violate state laws designed to protect consumers from strangers who want to bet on their lives. Lawmakers in at least five states are backing bills that would regulate or outlaw many insurance deals initiated and financed by investors. Insurance commissioners are also pushing states to enact laws requiring policyholders who participate to wait five years before selling policies to investors vs. today's two-year delay.
Insurance companies are cracking down, too—in part because they fear these arrangements will depress profits. When insurers set premiums, they often assume a certain number of policyholders will drop their coverage as financial or personal circumstances change. But as investors intent on collecting death benefits amass policies, insurers worry they'll have to pay benefits on a greater number of policies than their actuarial models anticipated. To make these deals less appealing, American International Group (AIG
) recently hiked the cost of a universal life policy—the variety typically used—by 15% for those over age 70, says spokesman Chris Winans. Other insurers have rescinded policies. MetLife Inc. (MET
) has gone after policyholders for allegedly violating signed statements in their applications. "It clearly asks them to attest that they are not purchasing with the intent to resell," says spokeswoman Holly Sheffer.
The transactions often work like this: Insurance brokers, attorneys, and other promoters arrange for high-net-worth seniors to apply for multimillion-dollar life insurance policies paid for with loans from the promoters and other lenders. A senior isn't typically required to put up any cash or collateral aside from the policy itself. If the insured dies in the policy's first two years, the heirs are entitled to keep the death benefit so long as they repay the loan and interest. Otherwise, when the loan comes due, the policyholder must pay it off from personal funds or sell the policy to investors. If a sale generates more than what's needed to retire the loan, the senior can pocket the excess. If a sale won't cover the loan, the senior simply signs the policy over to the lender and walks away.
Still, the gains may be significantly less than the promoters claim. Interest payments, lenders' fees, and brokers' commissions can take a big bite out of policyholders' profits. John Shannon, an 82-year-old Arizona resident, discovered that when his $4.4 million policy was sold last October for $1.1 million. Once the loan that financed the policy's premiums was repaid, Shannon was left with $361,256, according to court documents in the lawsuit Shannon filed over the sale. Worse, the terms of the deal required him to hand over 51% of the remaining funds, almost $200,000, to the lender and promoter, Cove Management of La Jolla, Calif. The two sides settled for an undisclosed sum. "The people who put these deals together see there's profit to be made, and they do their best to take it all," says Thomas David, a Miami attorney who represented Shannon. Dan Miller, manager of Cove Management, counters that Cove clearly discloses its 51% fee and only levies it when policyholders choose to sell their policies rather than repay their loans. "Ninety-nine percent of our customers are very happy."
Shannon's situation isn't unusual. Typically, those who sell policies receive about 20% to 30% of the death benefit. For a $1 million policy belonging to someone with a life expectancy of seven years, a purchaser might pay $250,000, says Adam Balinsky, a partner at Baker & McKenzie in Toronto. But after paying various fees to middlemen that buy policies, the seller would be likely to take home only about $150,000, he calculates. From those proceeds, the seller would have to repay the loan plus various lender fees and interest of 12% to 18%. In the end, the insured might only net about $42,000, Balinsky figures.
Moreover, because the market isn't transparent, it's hard for those who sell policies to know whether they're getting a good price. Brokers are supposed to act in the interests of clients. But New York Governor Eliot Spitzer (while still serving as the state's Attorney General) last year brought fraud charges against Coventry First, a Philadelphia leader in buying life insurance policies, for allegedly making secret payments to brokers to suppress competitive offers from Coventry's competitors. Coventry has filed a motion to dismiss the suit. "It is entirely without merit," a spokesman says.
There are also thorny tax issues. Because the tax code doesn't specifically address such deals, the rules that apply aren't always clear. Those who profit may forfeit a significant chunk of their gains to the Internal Revenue Service. For example, seniors who receive cash, cars, or other sign-up bonuses must pay income tax on the value of those goodies. Those who sell their policies are required to pay tax on the gains. It's not certain whether ordinary-income or capital-gains tax rates apply, says Stephan Leimberg of Leimberg Information Services, a publisher of newsletters for tax and estate planning professionals.
There may even be a tax liability if the sale price for a policy falls short of the loan that financed it. Although a senior can always satisfy the loan by turning the policy over to the lender, the IRS could levy income tax on at least some of the amount of debt forgiven. A senior might also have to pay tax on the two years of "free" insurance benefits he or she received. In such a situation, a policyholder could sustain a loss. So much for the free life insurance pitch. By Anne Tergesen