Non-recourse premium financing arrangements purport to offer insureds `free' life insurance coverage for two years—but
there are risks, including violations of state insurance laws, violations of
securities laws, and uncertain tax costs.
Author:
R. MARSHALL JONES, STEPHAN R. LEIMBERG, AND
R.
MARSHALL JONES is an attorney and President of R. Marshall Jones, Inc., a life
insurance consulting firm, and Legacy Solutions Group, LLC, a family wealth
planning firm, in West Palm Beach, Florida.
He is a
non-practicing member of the Florida Bar and holds the designations of
Accredited Estate Planner, Chartered Financial Consultant, Chartered Life
Underwriter, and Fellow of the Life Management Institute. STEPHAN R. LEIMBERG
is an attorney and is CEO of Leimberg and LeClair, Inc., an estate and financial planning software
company; President of Leimberg Associates, Inc., a
publishing, software, and marketing consulting company in Bryn Mawr, Pennsylvania; and Publisher of Leimberg
Information Services, Inc. which provides e-mail-based news, opinion, and
information for tax professionals. He is also a former adjunct professor in the
Masters of Taxation Program of both
Recently, a
number of promoters have been offering a new life insurance scheme that
promises “free” insurance for two years through various non-recourse premium
financing programs. The program is more accurately described as “investor
initiated life insurance” 1
because both the initiative for purchasing the policy and the source of funding
are from outside investors or lenders who are totally unrelated to the insured.
Potential insureds are asking, “Why shouldn't I do
it?” and “What have I got to lose?”, while advisors, insurance companies,
regulatory organizations, and others should be studying the legal, financial,
regulatory, and ethical issues involved.
Currently,
there are dozens of non-recourse premium financing programs, and promoters are
developing new programs and permutations almost daily. 2
Advisors must be able to assess the potentially significant risks of each
non-recourse or recourse premium financing program in order to determine if the
proposal is better than a free ice cream cone or is an attractive, but
dangerous, iceberg that may sink their ship.
This article
will (1) explore the iceberg-like features and risks of "free" life
insurance arrangements, (2) suggest funding alternatives for clients whose
primary objective is to purchase needed life insurance on a cost-effective
basis, and (3) provide a checklist to assist advisors as they examine the
details of particular "free" life insurance transactions.
The purported
major benefit of non-recourse premium financing is to provide the insured with
life insurance coverage for two years with no out-of-pocket cost—in other
words, “free” insurance. Typically, the insured or the insured's trust 3
uses a loan to purchase life insurance that, in most cases, will be either (1)
transferred to the lenders who often have informal arrangements to re-transfer
the policy to a group of investors or (2) sold to a life settlement company
4
after the second policy year. Although the insured normally has an option to
repay the loan and keep the policy, most programs are deliberately structured
to discourage loan repayment and encourage divestiture so that at the end of
two years, the policy ownership will be transferred to the lenders in
satisfaction of the loan or sold to investors or a settlement company and
they—not the insured's selected beneficiaries—will be the recipients of the
policy's death benefit. 5
If, as expected, the insured chooses not to retain the coverage after two
years, he or she can purportedly “walk away from the loan at no cost” and
perhaps enjoy a profit. However, in many cases, the risks may outweigh the
rewards.
The mechanics
of the typical non-recourse premium financing transaction appear—at least on
the surface—to be both relatively simple and benign. But, like an iceberg, a
significant, and perhaps the most dangerous, portion of the transaction lies
below the surface. It is therefore essential for advisors to carefully review
all documents, authorizations, marketing materials, and representations to
become aware of the legal, practical, and ethical implications.
Most
"free insurance" financing programs are marketed primarily to
individuals between age 72 and 85 who have a net worth of at least $5 million
and the financial means to acquire large amounts of life insurance. 6
Marketers search for individuals with so-called excess insurability. 7
Ideally, these insureds will have mild health
problems that will not be serious enough to discourage the insurance company
from issuing a policy at standard or preferred rates, thereby increasing the
investors' expected profit. (The sooner the insured dies, the greater the
investors' profit!)
An example of
a typical non-recourse premium financing arrangement is shown in Exhibit 1,
which depicts the planned sale of a policy to a life settlement company.
Although there are many variations of these plans, the following steps provide
a typical “above-the-surface” view of what a client and his advisor might see
before carefully reviewing the documents.
Step 1. The prospective insured is promised one (or a
combination) of the following if he or she qualifies for the program: two years
of free life insurance; an up-front cash distribution of 1-1/2% to 3% of the
death benefit (or a free luxury car); 8
a portion of the net profits from the expected sale of the policy to a life
settlement company after two years or, in some instances, another 1-1/2% to 3%
of the insurance benefit when the insured dies.
Step 2. The client secures a non-recourse premium financing loan
from the lender to finance a life insurance policy.
Step 3. The proposed insured qualifies for the issuance of a $2
million or larger permanent life insurance policy.
Step 4. The third-party investor group makes or guarantees a
non-recourse loan to the non-grantor irrevocable trust created to purchase the
policy.
Step 5. As part of the policy purchase, the trust collaterally
assigns the policy to the lender.
Step 6. After 24 months or longer, in order to satisfy both the
policy's incontestability provision 9
and state insurance laws regulating the sale of newly issued policies, the
insured's trustee chooses from the following options, if available:
1. Repay the
loaned premiums with interest along with any cash advances, origination fees,
termination fees or other charges; pay all future premiums and keep the policy;
or
2. Sell the
policy to a life settlement company; or
3. Transfer
ownership of the policy to the lenders in full satisfaction of the loan.
When looking
below the surface of a non-recourse premium financing transaction, a thorough
review of the mechanics of the transaction may uncover undocumented or ignored
elements that may (1) constitute a violation of state insurance law or
regulations; (2) raise significant securities regulation and litigation issues;
and (3) trigger unexpected tax risk, financial exposure, litigation risk, and,
in some cases, potential criminal penalties. When navigating a client through a
non-recourse premium financing transaction, advisors should be wary of the
icebergs that could sink their ship:
Free
insurance and the `insurable interest' rule. Third-party investors
offer the insureds two years of "free"
insurance because it is illegal for them to purchase insurance on the life of
an individual unless the original applicant-owner has an insurable interest at
the time the policy is purchased. Without an insurable interest, the policy
would be void from inception and the death benefit will not be paid to the
investors. 10
To protect the public, all states have insurable interest statutes designed to
discourage speculation on an insured's life. 11
Generally, the initial owner and beneficiary must have a strong economic
interest in, and benefit from, the continued life of the insured. For example,
family members are generally presumed to have an insurable interest in their
spouses and parents.
The promoters
apparently believe that an initial purchase by the insured, followed by a 24-
to 30-month time lapse between the policy's issue date and its subsequent
transfer of ownership to the investors (or a life settlement company), will
avoid an insurable interest challenge. 12
Nevertheless, legal theories such as “form over substance” or the
“step-transaction” or "agency" doctrines may be used to assert that
the insurable interest provision was not satisfied and the insurance contract
is void.
On 1/9/06,
the New York State Insurance Department announced that a proposed premium
financing transaction violated the state's insurable interest law and was not
permissible under New York Insurance Law. 13
If the insurable interest law is violated, the insured, the insured's trust and
estate, and their agents and advisors may become embroiled in unexpected
litigation. This could occur either during the insured's lifetime or after
death.
Although this
is only an Opinion and if binding, only binding in
Fraud and misrepresentation by the insured. The standard life
insurance application requires insureds to sign
written statements regarding their health, financial circumstances, policy
ownership, and the purpose of the insurance. Companies rely on this information
as part of their consideration for issuing coverage. The answers to most of
these questions become part of the contract.
Most life
insurance contracts provide that the policy may not be contested by the
insurance company after two policy years. 14
For more than 100 years, the incontestability provision has helped maintain
public confidence that the death benefit will be paid as promised to the
beneficiaries without delay or challenge. Meanwhile, the provision gives the
insurance company a reasonable two-year period to rescind the life insurance
contract if it discovers any undisclosed or misrepresented facts that rise to
the level of a "material misrepresentation" that would have kept the
policy from being issued as applied for. 15
After two years, the validity of the insurance contract may be challenged only
in a narrow set of circumstances based on law that varies from state to state.
At this
point, the insured may ask, “Why should I care about these issues?” The answer
is submerged in the murky fine print in the mound of documents the insured
signed—the indemnification provisions for this "free" insurance!
A standard
part of "free insurance" premium financing transactions is an
indemnification provision whereby the insured agrees to indemnify the lenders
and investors for any loss resulting from a material misrepresentation or
omission. The insured, or the insured's family, may be liable for the
investors' loss—potentially the multi-million dollar death benefit that was not
paid to the investors—if any misrepresentation of these items is discovered
during the contestable period. If the misrepresentation is intentional and material,
it may give rise to fraud that extends beyond the contestable period.
In
particular, fraud constitutes one of those narrow circumstances that have
allowed companies to contest a policy beyond the two-year period. If the
insurance company chooses to contest the policy, these contract provisions
could trigger indemnification liability, plus the time and expense of
litigation, and the possible charge of felony insurance fraud.
With an
allegation of fraud and a subsequent policy contest, the outcome could be even
more uncertain if the beneficiary was an investor and the documentation showed
a purposeful misrepresentation of true ownership by the insured or an
undisclosed intent to transfer the policy from its inception. When
misrepresentations and omissions rise to the level of fraud, the insurance
company may have a right of rescission that continues beyond the insured's
death. 16
If the
insured, the insurance broker, or the insured's advisors fail to answer fully
the questions on the applications, medical forms, oral interviews, inspection
reports and other documents, the insurance company may be misled into issuing a
policy that the insurer can later argue is void and unenforceable. 17
The insured is responsible for verifying these statements before signing the
application. If the insurer successfully contests the death claim, the
investors may seek to recover from the insured, the trust, or the estate under
the investor indemnification provisions regarding material misrepresentations
or omissions.
How
could this happen? First, there may be a significant risk of material
or fraudulent misrepresentations and omissions when both the insured and the
investors are seeking nothing more than minimum technical compliance with the
insurable interest law. In reality, there is only a temporary or nominal
“insurable interest” disguising the true intent of the transaction to pass
ownership to the investors. 18
An incomplete or misleading answer by the insured or by others on behalf of the
insured—though not intentionally fraudulent—may be sufficient to create
liability.
Second, the insured may not
be aware of his or her representatives' material misrepresentations or
omissions even after a careful review of every aspect of the transaction,
including every statement in the application. For example, it is standard
practice for the insured to provide verbal answers that are recorded by others.
On the application and medical forms, the insured's signature is a
representation that the information provided is true and correct to the best of
the insured's knowledge and belief.
Once it
became apparent that many non-recourse premium loans were, in reality, a
disguised means of settling new policies with investors, an increasing number
of
Even for
those who accept the other risks associated with these transactions, it is
certainly unethical and probably criminal for any promoter to “coach” the
insured to answer questions in anything other than a complete and accurate
manner. 19
Rebating. Another area of risk to insureds
is the use of cash incentives to purchase the policy. The New York State
Insurance Department General Counsel Opinion, citing lack of insurable interest
for one of these transactions, also made the point that free insurance might
constitute an illegal rebate. 20
Most state insurance regulations either prohibit or severely restrict the offer
of rebates to clients who buy insurance. The few states that allow this
practice require that any rebates fit within specific parameters established by
the state. Settled case law holds that life insurance rebates are generally
non-deductible by the payor and taxable income to the
recipient. 21
Clearly, any offer of cash, cars, or any other similar inducement could
constitute a taxable rebate.
In addition
to unfavorable taxation, the characterization as a rebate increases the
insured's risk of liability. While most insureds may
see this only as a technical violation of the law by the person selling the
insurance, it has potentially adverse consequences for the owner as well,
including the voiding of any professional liability insurance in the
transaction. This would make monetary recovery against the broker or agent, in
the event of a lawsuit, less likely.
Violations of state insurance statutes on `wet ink' viaticals. Many states have
enacted model statutes prohibiting the sale of life insurance as an investment
for the benefit of a disinterested third party. Furthermore, to guard against
so-called wet ink viatical transactions (i.e., the
sale of a newly-issued policy to a life settlement company "almost before
the ink is dry"), the National Association of Insurance Commissioners'
(“NAIC”) Viatical Settlements Model Regulation has
been adopted by a number of states to prohibit the sale of insurance policies
within 24 months of the policy issue date. 22
This restriction applies to both policy owners and licensed life insurance
agents and brokers. There are two risks involved:
First, unless the state
where the policy is issued has provided a written opinion to the contrary, the
"free" insurance transaction may be invalid as a “step transaction”
violation of the state's prohibition of wet ink viatical
sales.
Second, the "free insurance"
transaction may provide additional grounds beyond contract law for the state or
the insurance company to invalidate the transaction as an illegal “intent to
settle”—i.e., a disguised, illegal life settlement transaction in violation of
the insurable interest rules. 23
Proving
intent can be difficult. It can be expensive to defend, too! What are some of
the factors that might evidence an illegal intent to settle? Here are a few:
Potential violations of federal or state securities law. In addition to
insurance law issues, advisors must consider these programs as possible
securities transactions. Insureds, their advisors,
and insurance agents/brokers may face significant, long-term financial exposure
if the non-recourse premium financing transaction is a security but not
structured to be fully compliant with federal and state securities laws.
One of the
more serious and often overlooked transaction risks is the possibility that the
insured, the trustee, and the advisors are participating in the issuance, sale,
or solicitation of unregistered securities in violation of sections 5(a) and
5(c) of the Securities Act of 1933. This risk should cause great pause because
transactions falling under securities law may require very specific disclosure
in the transaction and many additional statutory remedies.
In May 2005,
the Eleventh Circuit affirmed a U.S. District Court finding in SEC v. Mutual
Benefits Corp. 25
that “...these viatical settlement contracts qualify
as `investment contracts' under the Securities Acts of 1933 and 1934....” As a
result, the directors and officers of the Mutual Benefits life settlement
company were subject to both civil and criminal penalties for the illegal sale
of unregistered securities and securities fraud.
The insured
may think, “I haven't done anything wrong if I sell my policy two years from
now and receive part of the proceeds.” Similarly, most advisors and life
insurance agents will argue that they are merely selling insurance. However,
when the entire transaction is viewed from a broader perspective, it has all
the elements of an investment under the classic Howey
26
test:
Indeed, prior
to the Mutual Benefits case, the investment firm UBS carefully packaged
several blocks of life insurance contracts as private placements under the
acronym of “LILAC” (“life insurance leveraged annuity contracts”). Most
promoters have not been so careful. Now, after the Mutual Benefits
decision, the costs of being wrong on this particular issue are even higher.
There is added risk of not only an unlimited right of rescission of the
transaction for investors, but also the possibility of criminal prosecution.
The securities classification risk is even higher if the “loan” comes from a
securities-regulated entity, such as a hedge fund. In addition, the
representations made to the hedge fund by the client, trustee, or promoters may
give a cause of action to the hedge fund and its ultimate investors as in Mutual
Benefits. Moreover, any misrepresentations can give rise to a claim of
securities fraud by the insurance company, lender, or third-party investors.
Prior to the Mutual
Benefits case, the settlement industry consistently cited a district court
decision, SEC v. Life Partners, Inc., 27
as the basis for insurance regulation of the settlement business. Despite the Life
Partners decision, the SEC has persisted in its opinion that investments in
settlements are securities. The precedent of the Mutual Benefits case
creates a cavalcade of potential securities issues for everyone in the chain of
the transaction. 28
Competent securities counsel should be part of the team assessing the risk of
any non-recourse premium loan or life settlement transaction.
The risk of failure to comply with the Patriot Act. Some countries have
more favorable tax laws regarding investor-owned life insurance that make
U.S.-issued life insurance policies particularly attractive. Consequently,
foreign investors have entered both the non-recourse premium financing market
and the life settlement arena. For any transactions funded by entities outside
the
Along with
the insurance and securities law risks, clients and advisors must consider how
the transaction will be taxed. There are many uncertainties here as well, as
the following discussion illustrates.
The
unknown tax cost of the unpaid loan. There does not appear to be any clear
or certain guidance regarding the tax consequences related to non-payment of
the loan. For example:
An argument
can be made that any “free" insurance benefit should be taxed as ordinary
income and that income tax may be due on 100% of any forgiven loan balance,
including all accrued interest and any waived fees or charges. The tax opinions
will vary from advisor to advisor and from transaction to transaction.
On behalf
of the insured, tax counsel might argue the position taken by some promoters in
their marketing materials: that the loan obligation is real and the investors
intend to enforce it by either (1) requiring full repayment or (2) transferring
policy ownership in full satisfaction of the loan. In the opinion of the
promoters' attorneys, any gain to the insured will be taxed, if at all, as a
long-term capital gain transaction. 31
Conversely,
the IRS
might argue that the insured paid nothing for the insurance and has received a
taxable economic benefit. The IRS might also argue the insured also received an
illegal rebate in the form of free insurance, cash or other compensation, and
was an investor in the transaction. As the recipient of an illegal rebate, the
insured may be liable for ordinary income tax on the value of all benefits
received, including the value of any initial inducements, advances, and the
total amount forgiven.
The Sutter
32
case bolsters that potential IRS position. In Sutter, the Tax Court held
that Mr. and Mrs. Sutter must include, as income, the total premiums paid for
the “free” insurance that was funded by an agent's commission leveraging
scheme. In this case, the agent set up a financing company to loan the first
year premium on a non-recourse basis. The agents received commissions in excess
of the loans, and the insureds received free
insurance. The insureds then allowed the policies to
lapse at the beginning of year two. The Tax Court held that the taxable value
of the “free” insurance was the premiums paid. 33
In the past,
an insured might ask his or her attorney for an opinion letter for protection
against penalties in the event of an IRS challenge. With the publication of IRS
Circular 230, however, an opinion letter may be either unavailable or
prohibitively expensive. It may expose other parties in the transaction to IRS
penalties as well. 34
The authors haven't seen any "more likely than not" opinion letters from
insured clients' counsel affirming the tax and non-tax claims of promoters of
“free” insurance.
Additional
tax risks—charitable variations of investor-initiated life insurance (`IILI'). Investors are also
involving charities in their efforts to acquire life insurance policies that
would not otherwise be available because the investors lack an insurable
interest in the insureds. One variation of
non-recourse premium financing transactions involves promising modest benefits
to a charity or university in order to market to its list of wealthy older
donors and alumni. 35
This allows the promoters to identify clusters of potential insureds
through a single source. The promoters typically convince the donors to allow
the investors to use their “excess insurability” by promising the charity an
expected payment estimated at 2% to 5% of the eventual death benefit after
payment of all expenses and a guaranteed profit to the investors. In essence,
the charity is paid a modest finder's fee. Meanwhile, the charity may not be
aware of its potential exposure under the securities laws, the potential 100%
excise tax on money going into one of these schemes, 36
the potential harm to its reputation, or the risk to its tax-exempt status.
The risk of estate tax on the death benefit. Because the investors
are looking for insureds with a projected life
expectancy of 120 months (ten years) or less, advisors must evaluate the risk
that the death benefit will be included in the insured's taxable estate if he
or she dies during this period. For example, do the mechanics of the loan and
any options or veto rights given to the insured or his trustee constitute
retained powers under IRC
Section 2042 , or other Code sections, causing
inclusion of the policy in his or her estate? If Section
2042 applies, is there a possibility that Section
2035 may also apply when the policy is transferred to the investors? This
can add three years to the risk of estate inclusion.
Furthermore,
if the insured must approve the transfer of the policy to trigger loan
forgiveness or to repay the loan, will this possibility include the policy in
the insured's taxable estate under
IRC Section 2042 or 2036
until the transfer and thereby cause Section
2035 to apply? If the insured has a sincere desire to continue this life
insurance as part of his or her estate plan (as opposed to selling the policy
for a profit), the added tax risk of inclusion in the estate is a high price to
pay for this flexibility.
In addition
to the tax, regulatory, and liability risks with these transactions, there are
other potential drawbacks. Some are documented in the details of the
transaction. In fact, most of the programs require the insured and the trust to
formally acknowledge certain transaction costs, including the following.
Confidentiality and qualifying for the non-recourse loan. The investor group
will require your authorization to obtain your client's medical records,
evaluate your client's life expectancy and, assuming the loan is not repaid,
have the right to continue to monitor your client's health until the death
benefit is paid. While the insurance company wants your client to live a long
time, the investors want your client to live only more than two years from the
date the insurance becomes effective. Because many of these arrangements allow
re-sale to a group chosen by the lender or investors, there is no way to
guarantee that these buyers have adequate safeguards to protect the
confidentiality of the client's health information and to prevent or veto the
re-sale of the policy to undesirable individuals or groups.
Although the
risk of an investor arranging for an insured's death may be very slim, it is
greater when the owner-investors may sell or re-sell their policies to
individuals or other parties without complying with the confidentiality
safeguards required of reputable institutions. Also, there are "clearly
litigated cases where one party has procured life insurance on the life of
another, and then engaged in nefarious, life-altering actions to facilitate the
death benefit payments under the policy." 37
The cost of repaying the loan and keeping the policy. It is very unusual
for an insured to participate in a "free insurance" premium financing
program with the primary intent of repaying the loan after two years and
keeping the insurance for the originally stated “insurable interest” purpose.
In general, the purpose of the repayment option is to give apparent legitimacy
to the insurance transaction and not to encourage repayment. In fact, the
insured usually has lower-cost private or commercial recourse financing
available as an alternative. The decision to use higher-cost non-recourse
financing is yet another indication that the insured never intended to pay
premiums after the second policy year.
Even the most
compliant and professional non-recourse premium financing programs generally
expect to earn at least a compounded 15% return on equity for the investors.
Many programs impose a much higher actual cost of repayment through a
combination of exit fees and other charges to dramatically discourage
repayment. While a violation of state usury laws does not create direct
liability for the insured participating in the transaction, the high rate of
interest charged should give pause for advisors to review the economics and
give added weight to the concern that the transaction may actually be
classified as an investment governed by the SEC.
The
`zero future insurability' risk. Does the insured clearly understand
that the use of his/her “excess insurability” may do more than prevent him/her
from obtaining additional insurance in the future? It may also prevent the
insured from replacing his or her personal and estate planning insurance if
updates are desired. In a tightening reinsurance market, the total of all
insurance—both existing and applied for—is used to determine the amount of new
or replacement insurance available. While this is almost universally disclosed
in the documents for these transactions, the implications—especially with
regard to replacement coverage—may not be fully understood.
The lack of errors and omissions coverage risk. The many regulatory
issues identified above are heightened for an advisor with an insurance or
securities license. All professional liability policies have prohibitions and
coverage exclusions for transactions involving rebating, “wet ink”
transactions, providing false information to insurance
companies, and securities violations. In addition, most liability policies
exclude coverage for any work involving settlements or viaticals.
In the event of a problem, the insured and his or her trust are not likely to
be able to look to the promoter's errors and omissions coverage for recourse
because most of these issues fall outside the policy coverage as exclusions.
Thus, the advisors and, ultimately, the insureds will
bear these risks alone, and clearly, the insureds who qualify for and participate in these transactions have
much to lose.
Reputable
agents with clients whose primary objective is to acquire permanent life
insurance as part of their estate plan will continue to ask with regard to
premium funding, “Are there any `good' non-recourse premium loan transactions
that adequately address the risks and preserve my client's options?”
Even if
clients and advisors can get comfortable with a particular transaction from a
legal, tax, and regulatory point of view, and have reasonable certainty that
the transaction does not pose significant liability, traditional planning
techniques may offer lower costs to provide insurance coverage with far more
certainty and less potential litigation liability. For example, assume that a
75-year-old man wants to purchase $10 million of life insurance for estate
planning purposes. For comparison with non-recourse premium financing loans
accruing at 15% per year, the advisor might consider the following options:
• Alternative
#1: A high early cash value policy. The client could purchase a high cash
value product instead of non-recourse premium financing. The annual premium on
this policy is $675,373. After two years, the client will have paid a total of
$1,350,746 in premiums. If, after two years, the client decides he no longer
needs insurance coverage, he can surrender the policy for $1,114,063—the cash
value at the end of policy year two. This enables him to walk away with a net
balance sheet cost of only $236,683 for the two years of insurance plus the
option of continuing it. By choosing a traditional alternative, the client has
the additional option to keep the insurance after year two simply by paying the
year three premium, because there is no loan to repay.
• Alternative
#2: A minimum premium guaranteed universal life (`GUL') policy with a
`catch-up' option. With this alternative, the client could pay the minimum
premium required to purchase a GUL policy with a catch-up provision. The
premium catch-up provision would allow the client to extend the policy's
premium and death benefit guarantees either to a designated age or for life.
In this
example, the minimum annual premium to maintain the policy for two years is
$279,655. If, after two years, the client decides that he no longer wants the
insurance, he can walk away, having paid total premiums of only $559,310.
However, if the client decides to keep all the insurance, he can "catch
up" to an age 100 guarantee by paying level annual premiums of $477,570
beginning with policy year three. 38
By comparison, if the client is allowed to repay the non-recourse premium
financing loans, the cost to continue the policy will include not only the
premiums and the loan repayment, but also the accrued interest and any other
charges imposed by the lender-investor.
• Alternative
#3: Second-to-die convertible term insurance. If the 75-year-old man is
married and his wife is also age 75, they can apply for a survivorship life
(“second-to-die”) policy. Some carriers offer this type of policy on a term
basis with an option to convert to permanent insurance later. In this scenario,
the client would purchase a second-to-die convertible term policy with an
annual premium of $77,100. If, after two years, the client decides he no longer
needs the insurance, his total cost is only $154,200.
On the other
hand, if the client decides to keep the insurance, he can convert the term
policy to permanent insurance in year three without taking a new medical exam
or providing any additional underwriting information because the conversion to
a permanent policy is contractually guaranteed. The premium on the converted
permanent insurance is $297,772 annually, making this the least expensive
option. In addition, most estate plans defer the payment of estate tax until
the second spouse's death, making second-to-die coverage the policy of choice
to provide tax-free cash when it is needed.
• Alternative
#4: Non-recourse premium financing. In a “clean,” “fully disclosed” premium
financing transaction, the client would take out a premium loan on a
non-recourse basis. Using the numbers in the earlier example, when the
premiums, loan interest, loan insurance, trust fees, and exit fees are factored
into the loan, the client would be faced with a repayment obligation of
$1,434,523 and out-of-pocket origination fees of $14,064.
If the client
does not want the insurance after two years, his costs will include both the
amount paid in origination fees and income tax on some or all of $1,434,523
when the loan is forgiven. Assuming a 35% tax bracket, the client could pay as
much as $502,083 plus $14,064 in fees—a total cost of $516,147. However, if the
client decides to repay the loan after two years and keep the insurance, he or
she must repay $1,434,523 plus the year three annual premium of $442,838. In
this example, the client's three-year average outlay after repaying the loan is
$630,475.
Considering all the potential drawbacks and the attractive
alternatives that offer the same flexibility without the risks, one might ask,
“Why would anyone consider one of these transactions?” The first word that
comes to mind is “greed.” Promoters of these “something for nothing” insurance
schemes expect to earn millions of dollars in commissions by selling and then
re-selling large amounts of insurance. Similarly, greed can induce clients to
act on the promise of something for nothing without an adequate understanding
of the risks. It is natural to seek out the “best deal,” but advisors must also
ask, “Is the best deal the right deal for my client and what are
my potential exposures?”
The following
list of questions, although not comprehensive, can help clients and advisors
analyze most non-recourse premium financing transactions:
1. Is there any direct, indirect, or potential violation of the
applicable state's insurable interest rules? 39
(Consider who might have and who has standing to bring this issue up.)
2. What is
the risk of the policy being contested due to a material or fraudulent misrepresentation
or omission by any party in the transaction?
3. Will the
two-year incontestability provision be unenforceable due to either lack of an
insurable interest or compelling circumstances, such as fraud or adverse impact
on the public interest?
4. What
indemnification provisions have the client or the trustee signed that might
make the insured, the insured's trust or the estate liable for the investors'
losses if the death benefit is not paid?
5. What is
the potential for, and estimated cost of, litigation with the insurance
company, the SEC, the state attorney's office, the IRS, the investors, or
disinherited beneficiaries?
6. Are there
any cash payments or other inducements that may be treated as (1) illegal
payments to an unlicensed insurance agent, (2) illegal rebates, (3) benefits
making the insured an “investor” subject to civil or criminal penalties under
securities law, or (4) payments making the insured liable for improperly
participating in a private securities transaction?
7. Have all
parties—insured, trustee, advisors, and insurance agent/broker—made full
disclosure of all requested and relevant details to the insurance company and
its representatives?
8. Is the
insured both aware of, and comfortable with, the loss of confidentiality
regarding his or her health status and medical records until the death benefit
is paid to the investors?
9. Does the
program violate the state's prohibition on viatical
settlements as an illegal “intent to settle” or as a two-year “step
transaction”?
10. Do the
marketing materials—including faxes, correspondence, and e-mails—increase the
risk that the transaction may be challenged by the state insurance department,
state or federal attorneys, the SEC, unhappy future owner-investors, or others?
11. Is the
loan truly non-recourse or do transaction circumstances or details create a
recourse loan situation? Does the fact that the arrangement is structured as a
recourse loan make a meaningtul difference in the
outcomes?
12. What are
the tax costs for any benefits received, insurance provided, and loans
forgiven?
13. What is
the full repayment cost if the insured decides to keep the insurance? Does the
transaction make ecomonic sense? Will the client,
after all costs and tax exposures, and lacking a guaranteed market at a set
price, make or lose money? How do you know?
14. Does the
transaction (including any subsequent re-sale) constitute the illegal sale of
an unregistered security with potential liability against everyone who assists
or participates in the transaction?
15. Will a
100% federal excise tax be imposed in the case of a charity?
16. Is a
participating charity risking its reputation or tax-exempt status in the
transaction?
17. Will the
death benefit be included in the insured's estate?
18. Is the
insured comfortable with giving up the right to purchase new insurance and to
replace existing insurance for his or her own personal
planning?
19. Does the
transaction comply with the Patriot Act?
20. What
risks to the advisor's reputation and liability are associated with the
transaction?
21. Will the
transaction be covered under the errors and omissions insurance policy of the
advisor, insurance agent, or broker?
22. Is the advisor comfortable legally and ethically with the
transaction?
23. Is it the
right thing to do?
By being
fully informed of what lies beneath the iceberg of non-recourse premium
financing, advisors and their clients can arrive at the best
solution—personally, legally, and ethically—for all concerned.
One serious
risk of a `free insurance' premium financing transaction is the possibility
that the insured, the trustee, and the advisors are participating in the
issuance, sale, or solicitation of unregistered securities in violation of
sections 5(a) and 5(c) of the Securities Act of 1933.
For additional information about these programs, see
Silverman, "Letting an Investor Bet on When You'll Die—New Insurance Deals
Aimed at Wealthy Raise Concerns," Wall Street Journal, p. D1
(5/26/05); Leimberg Information Services
Estate Planning Newsletters 619, 670, 671, and 676; Davis, "Death-Pool
Donations," 143 Tr. & Est. (May 2004); Leimberg,
"Stranger-Owned Life Insurance—SOLI: Killing the Goose That Lays Golden
Eggs," 32
ETPL 43 (Jan. 2005) ; Baldwin, "Free Insurance? Caution!,” J. Retirement Plan. p. 5 (Mar.-Apr. 2005); Leimberg, “TOLI, COLI, BOLI, and Insurable Interests,” 28
ETPL 333 (July 2001) ; Leimberg Information
Services Estate Planning Newsletters 782 (“Proposals on SOLI, CHOLI, and
COLI”), 818 (“Bill Attacks Snake Oil Salesmen"), 914 (“New York Insurance
Department Opinion on Non-Recourse Insurance Transactions”); and Plevin and Silverman, "Investors Seek Profits in
Strangers' Deaths," Wall Street Journal (5/2/06).
There are also recourse loan arrangements coupled with
special trusts or partnerships designed to accomplish the same objectives.
This article refers to the insured as the policy
owner. However, many transactions are structured so that the insured's portion
of the insurance death benefit is owned by and/or payable to a
"non-grantor trust," an irrevocable trust created especially for the
premium financing transaction. Other programs may use limited partnerships or
limited liability companies, instead of trusts, to own the policy and
purportedly insulate the insured from tax and other liabilities.
A “life settlement” is the purchase of a life
insurance policy by an investor while the insured is alive, and does not
involve an insurable interest in the continued life of the insured. The
investor benefits only from the insured's death. Typically, the policy
owner-seller receives more than the cash surrender value of the policy as the
primary inducement to sell the policy.
At a minimum, most programs include additional fees and
payment requirements that make the repayment option much more expensive than a
traditional loan. Even programs that make repayment a reasonable option
typically include additional charges to provide the lender-investor with a 15%
or greater compounded return.
This article later addresses the potential securities
issues if the parties to the transaction are not accredited investors or if the
promoters fail to comply with applicable securities laws and regulations.
The promoters refer to “excess insurability” because
they are looking for clients who do not want or feel they have a need to
purchase any additional life insurance as part of their personal, business, or
estate planning. For example, if the insured has a potential estate tax of $10
million and various insurance companies already have $4 million of life
insurance in force on the insured's life, then the
insured may have $6 million of excess insurability.
One promoter apparently placed a newspaper ad offering
qualifying individuals two years of free life insurance and a Bentley!
Each policy contains a provision that basically says
that after the policy has been in force for two policy years, the insurance
company may not cancel the policy due to any misstatements or
misrepresentations made by the insured.
Obviously, courts will examine the actions of the
insurer, the insurance agent or broker, and other parties. In some cases, the
courts may bar the insurer from asserting a lack of insurable interest if those
actions—or failures to act—constitute a waiver by, or an estoppel
against, the insurance company.
Insurable interest laws vary widely from state to
state. A summary of a more liberal and broad insurable interest law reads, in
part, as follows: Insurable Interest as to personal insurance means that (1)
every person has an insurable interest in him or her self; 2) in the case of
individuals related by blood or law, a substantial interest engendered by love
and affection; 3) an employer has an insurable interest in an employee to the
extent of economic loss; 4) a party involved in an option or contract to
purchase or sell a business has an insurable interest in the other parties to
the transaction; 5) a trust has an insurable interest in the life of the
grantor or anyone else who is treated as owner of such trust for federal or
state income tax purposes or in that the trust beneficiaries have an insurable
interest in the grantor; 6) a creditor has an insurable interest in an
insured's life to the extent of the debt insured. Del. Gen Stat. Title 18
§2704. See www.leimbergservices.com under State Laws for a summary of every
state's insurable interest laws.
In addition, the investors intentionally structure the
“free” insurance period to extend beyond the two-year contestability provision
of the insurance contract and with the intent to avoid running afoul of each
state's prohibition against the sale of life insurance as “wet ink” viatical transactions.
See “Opinion from the Office of the General Counsel,”
12/19/05, representing the position of the New York State Insurance Department,
published 1/9/06.
Each state has its own incontestability provision
designed to assure the payment of benefits on validly issued policies. A
typical incontestability clause stops the insurer from contesting the death
claim after the policy has been in force for two years. See “The Incontestable
Clause in Life Insurance Policies—A Statute of Limitations, But Not a
Confession of Judgment,” 7 Newark L. Rev. No. 2 (June 1942), for the
traditional approach to the question. Also see Link, “Viatical
Settlements: What Do the Courts Have to Say?,”
presentation at the ABA Tort and Insurance Practice Session (1/11/01), for a
more contemporary discussion of the issue.
See, e.g., Chawla
v. Transamerica Occidental Life Insurance Co., 440 F.3d 639 (CA-4, 2006), aff'g in part 2005 WL 405405 (E.D. Va.,
2/3/05).
See, e.g., Horowitz v. Federal
Kemper Life Assurance Co., 57 F3d 300 (CA-3, 1995).
It is not sufficient to rely on the promoter's
assurances that the insurance company knows all the details and has approved
the transaction. Even those relatively few insurance companies that have
intentionally allowed policies to be issued with non-recourse premium financing
have also refused to “endorse” or “approve” the promoter's program or the
specific transaction. The advisor and the insured must confirm and document
that full disclosure has been provided in the event the insurance company
subsequently decides to file an action to void the contract or deny the death
benefit. See SEC v. Mutual Benefits Corp., et al., 408
F3d 737 (CA-11, 2005), and the accompanying state actions on this case for
examples of legal transactions involving fraudulent applications. See also the
fraud provisions of the NAIC Viatical Settlements
Model Act, ¶¶1F(1) and 1F(2)(4).
For instance, as the Office of the General Counsel
Opinion for the New York State Insurance Department noted, "The policies
are arguably not obtained on [their] own initiative as required by New York
Insurance Law."
Query: Does the trust or other entity have a Chawla-type insurable interest issue? See note 15, supra.
See note 13, supra.
Haderlie, TC
Memo 1997-525 , RIA TC
Memo ¶97525 , 74 CCH TCM 1254 ; Wentz, 105
TC 1 (1995).
NAIC Viatical Settlements
Model Regulation Rev. 3/16/04; 27 states have adopted the NAIC Viatical Settlements Model Act, and it is pending in eight
others. Section 10 provides, “It is a violation of this Act for any person to
enter into a viatical settlement contract with a
two-year period commencing with the date of the issuance of the insurance
policy or certificate....”
In its advisory opinion,
See, e.g., SEC v. W.J. Howey
Co., 328 US 293 , 90 L Ed
1244 (S.Ct., 1946), and SEC v. Edwards, 540 US 389 , 157 L Ed 2d 813
(S.Ct., 2004), regarding whether a transaction
involves a “security” or an “investment contract” covered by the Securities Act
of 1933 and the Securities Exchange Act of 1934.
SEC v. Mutual Benefits Corp. et al., 408 F3d 737 . (CA-11, 2005), aff'g 323 F Supp 2d 1337 (S.D.
Fla., 2004). Technically, a viatical
settlement is a life settlement transaction involving insureds
with a life expectancy of less than 24 months. In the opinion of the authors,
the finding in the Mutual Benefits case applies to all life settlement
transactions, including the possibility that many—if not all—non-recourse
premium financing transactions may be classified as disguised life settlements.
SEC v. W.J. Howey Co., 328
SEC v. Life Partners, Inc., 87
F3d 536 (CA-D.C., 1996), rehearing den., 102 F3d 587 (CA-D.C., 1996).
For an expanded discussion of these issues, see
Rowland, “The Brewing Storm: Securities Regulation and Lifetime Settlements,”
J. Financial Service Professionals, pp. 76-84 (May 2003).
See Gans and Soled, "A
New Model for Identifying Basis in Life Insurance Policies: Implementation and
Deference" (to be published), which notes that the IRS may take the
position that "The Participant's basis in a life insurance policy must be
reduced by the entire acquisition cost." Therefore, "the basis is
likely to be very low at the two year point—indeed most of the premium is
typically devoted to such costs during the policy's early years."
Some analysts suggest that, at a minimum, these
transactions will be governed by the split-dollar Regulations, with annual
reportable income determined under either the economic benefit regime or the
loan regime for each year that a death benefit is provided until the loan is
repaid or cancelled.
Some transactions are structured to disguise the loan
and treat the insured as an investor in a partnership or limited liability
company. In those cases, the insured's investment interest terminates at the
end of policy year two when the insured chooses not to purchase the other
investors' interests.
TC
Memo 1998-250 , RIA TC
Memo ¶98250 , 76 CCH TCM 59
The solution recommended with some non-recourse
premium transactions is to draft a non-grantor irrevocable trust to isolate any
tax liability within a trust whose only asset is the insurance policy. After
two years, the trust signs over the policy in full payment for the loan,
leaving the trust with no assets to pay any income tax or penalties. The
promoters tell the insured this will insulate him from personal liability.
However, this may give rise to a potential IRS tax shelter attack, particularly
if anyone other than the client's attorney makes this recommendation. It may
also be considered a conspiracy to evade income tax.
Circular 230 (Rev. 6-2005) (31 C.F.R. Subtitle A, Part
10 revised as of 6/20/05) basically allows the IRS to hold accountants and
attorneys legally responsible not only for what they present in their tax and
legal opinions, but also for any omissions of material information.
In
The Senate passed S 20-20 which would impose a 100%
federal excise tax, retroactive to 5/4/05, on charitable death benefits
associated with versions of investor-initiated life insurance. On 5/8/06, the
Board of The American Council of Life Insurance ("ACLI") voted 26 to
4 in favor of a 100% excise tax on the resale of life insurance policies less
than five years old.
See Harrison, “Casey Jones, Who's Driving That
Insurance Train,” a very thorough paper presented at the 2005 ACTEC Summer
Meeting. See also DiMassa and Winton, "Two
Arrested in Homeless Life Insurance Scam. Pair are accused of obtaining
policies on two men who later died in hit and run accidents," LA Times
(5/19/06).
If the insured's advisors can accurately estimate life
expectancy, they may recommend paying a lower premium in order to maintain the
death benefit for a reduced number of years instead of age 100 (or longer).
Some states are revising their laws to prohibit
investor-initiated life insurance as a violation of the insurable interest, viatical settlement, and life settlement rules.
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