Life & Viatical Settlements
Chapter 6
Stranger-Oriented Life Insurance & Insurable Interests
Defining STOLI
Stranger-originated life insurance (STOLI), also known as speculator-initiated life insurance or SPIN-Life, is life insurance policies taken out on strangers. In other words, these arrangements try to circumvent state insurable-interest statutes. Such laws are intended to assure that people who buy life insurance have a true and meaningful interest in the life being insured.
Stranger-originated life insurance policies are a specific “loan-to-life settlement” technique. Investors are primarily interested in the insured’s date of death, since their profits are directly tied to the length of the insured’s life. Other names for the same or similar investments include investor-owned life insurance, two-year free insurance, charity owned life insurance, speculator-initiated life insurance and investor-initiated life insurance.
The generally accepted purpose of life insurance is the protection of individuals who depend upon the insured for financial support. Obviously, strangers would receive no financial support from the insured, so they would not be financially dependent upon the insured.
Establishing an Insurable Interest
There are reasons life insurance policies require an “insurable interest” on the life being insured. If life insurance could be taken out on any individual, without any direct connection to the person buying the insurance, it becomes a form of gambling. The policy owner (the one buying the policy) could potentially be looking for people with a short life expectancy and then buying insurance gambling that the insured would soon die, leaving the policy owner with a financial windfall.
Well: surprise! That is exactly what a STOLI potentially does.
There is another element to requiring an insurable interest. People not subject to financial loss do not have an insurable interest, so it stands to reason there is also no emotional connection as would exist between spouses and other family members. Insurable interests, at least in theory, protect the insured individuals from intentionally harmful acts that might cause their deaths.
Generally speaking, life insurance is purchased to protect people the insured loves and wishes to protect from financial hardship. The payable benefits of life go to those the person buying the insurance cares about. That is also why the insured is usually a person who produces an income. If that person died, the income would stop. So, life insurance would then replace the lost income.
Life insurance is a simple concept, but it can become confusing when the basic elements that we have always connected to life insurance are used in different-than-typical ways.
There are some basic “traditional” requirements when buying a life insurance policy. One of those requirements is an insurable interest. This is a requirement that STOLIs bypass.
An insurable interest is present when a person receives a financial benefit of some kind that is based upon the continued existence of the person insured. A wife would have an obvious financial interest in the income of her husband and vice versa. A child would have a financial interest in the care received by a parent. In short, when the death of an individual financially impacts another person, an insurable interest exists. There is an interest in having the life of another person continue. Death of that person would be a disadvantage.
When it comes to STOLIs, the opposite is true: the advantage is having the insured person die, not live.
Stranger-originated life insurance, or whatever name is attached to it, means the owner of the policy wants the insured individual to die because that results in a financial gain for the investor.
STOLIs are not the same as viatical life policies because the policies did not already exist, as in the case of Viaticals. With STOLIs, the policy is initiated by the investor. STOLIs generally mean any act, practice, or arrangement, at or prior to policy issuance, to initiate or facilitate the issuance of a life insurance policy for the intended benefit of the investor, who does not have an insurable interest in the life of the person being insured. Insurance companies want there to be an insurable interest to prevent fraud against the issuing insurer.
The primary characteristic of a STOLI transaction is that the insurance is purchased solely as an investment vehicle, not for the benefit of the insured’s beneficiaries. The most common targets for STOLI arrangements are individuals between the ages of 65 and 85. It must be possible, from an underwriting standpoint, for the applicant to secure insurance, but the investors are clearly looking for individuals who are likely to die within a short time. When looking for insurable individuals, the plans may be marketed with names that sound inviting, such as “zero premium life insurance,” “estate maximization plans,” “no-cost-to-the-insured plans,” “new life issue settlements,” “high-net-worth settlements,” or even “death bets.” These are often marketed through promotional activities where individuals attend seminars that are advertised as financial planning events.
The legality of stranger originated life insurance policies depends upon the state. In the U.S., life insurance is mostly regulated by the states, not the federal government. States typically require an insurable interest be present, but that is not difficult to get around. In the case of a married couple, the STOLI promoter might initially list the beneficiary as the spouse, but as soon as legally possible, have it changed to an entity or person without an insurable interest. In many cases, the change does not take place until after the two-year contestability period has passed. Once transferred (sometimes earlier), premiums are paid by insurance agents, brokers, or investors.
In Canada, the trafficking of life insurance products is illegal in many provinces under the anti-trafficking laws. In the United Kingdom STOLIs are considered a form of gambling.
Generally speaking, most governing authorities do not like Stranger-Originated Life Insurance contracts. It is a form of “investing” that life insurance was never intended for. However, Florida’s Supreme Court, for example, ruled that once the contestability period has passed, a STOLI arrangement cannot be cancelled. It was not that the state favored them; Florida simply could not find legal grounds to forbid it.
Over three quarters of American families own some form of life insurance, whether through employer sponsored plans or individual policies. It involves more than $20-trillion in business. In the past, once a life policy was no longer needed the only options were to allow the policies to lapse, or if available, cash out any values that existed and cancel the policies.
Viatical settlements brought a third option: selling the policies to investors. Most legal analysts find no objection to selling policies that were initially taken out for the right reasons but are no longer needed (viatical settlements). It is when policies are applied for expressly to sell to investors that legal objections arise (STOLIs).
A Wharton Business School study found that more than 20 percent of policyholders over the age of sixty-five held life insurance policies that were worth more when sold to viatical companies than the cash values they held. Obviously, that gives viatical companies a solid selling point. As far back as 2004, viatical settlements were a $100 billion business.
Many prominent life insurance companies have attempted to block the viatical and STOLI markets. They directly compete with the profits of policy surrenders. The problem is not one of greed on the part of the insurers, however. Their risk analysis that sets premium rates are based on the assumptions that a specified percentage of policies will never pay out benefits because they are allowed to lapse or are surrendered. When viatical companies buy these policies, selling them to investors, that insures that benefits will be paid when the insureds eventually die. Many insurance companies prohibit agents from discussing viatical settlements with their clients (it is actually in the contracts agents sign with the companies), even when that might be the client’s best financial option.
It is legal to change beneficiary designations following policy issuance and it is legal to sell insurance contracts. What is not legal is fraudulent statements in policy applications, fraudulent marketing strategies, and failure to follow state and federal insurance laws.
Some states have banned STOLI contracts and limited the use of viatical settlements, under specific conditions, all primarily based upon the concept of insurable interest laws. It is important to separate applying for a new policy specifically for the purpose of selling it and selling an established policy after the initial insurable-interest period has passed. Convincing a person to fraudulently buy a policy for the direct purpose of selling it is different from selling a policy that was originally bought with a viable insurable interest involved.
Insurable interest requirements have always been part of our modern life insurance industry. It is important to the issuing insurance companies that the policies have an insurable interest to protect their underwriting risk base and it is important to law enforcement agencies that there not be a motive for someone to die, although many great novels have been written on that premise. Despite this, a secondary market for life insurance has developed. Most financial scholars believe that preexisting policies and unwanted policies should have the option of assigning or selling the benefits to viatical companies. Note that we said “preexisting and unwanted” policies, meaning they were not purchased expressly to sell, but rather already existed for other reasons.
Part of the problem in regulating the secondary markets is the difficulty in legally separating STOLIs from other viatical sales. Since STOLIs are often schemes that are fraudulent, deceitful and lack any bona fide insurable interest in the initial application, there is little about them that seems valuable to anyone outside of the marketers. On the other hand, viatical companies that purchase policies from those who no longer need them should be able to continue since the practice benefits everyone, especially the policy owners. It is a difficult task for the states.
Life insurance generally includes all policies where payment is contingent upon the death of a specified person. Historically, life insurance contracts have been validated by the courts from a legal, economic, and social perspective as a financial planning device to shift risk of loss to the issuing insurers. A constant in this legal validation has been the insurable interest requirement. Therefore, when STOLIs go around this requirement, it has typically been considered illegal and even fraudulent activity. Insurable interest legal requirements prevent forms of gambling on life and longevity and even the possibility of homicide. As a result of this view, nearly all American jurisdictions, by judicial case law, legislative statute, or both, require a bona fide insurable interest to exist for all life insurance contracts. Otherwise, the policy would be declared null and void based upon past legal practices. This insurable interest requirement can be applied to viatical settlements, life settlements and STOLIs as well as typical insurance contracts. Therefore, many of the prohibitions placed on STOLIs are based on the fact that they are applied for with the fraudulent intent to sell to those without an insurable interest.
Insurable interests have not always been viewed this way. Before the end of the eighteenth century, English courts allowed and enforced various gaming and wagering contracts made by individuals who had absolutely no insurable interest in the life of another person. Gambling on the longevity of others was a relatively common practice in England, where the institution resembled modern day sports betting. Policies would be bought on individuals being tried for capital crimes, for example, and betting on whether the person would be convicted and executed or exonerated. Well known people were also insured by those who had never met them, so obviously had no insurable interest, with the focus on whether they would live through an illness or other life event. Even people involved in an upcoming duel were the focus of life insurance policies.
This practice eventually lost favor, with the public demanding change from their law makers. As a result, in 1774 the British Parliament passed a statute requiring an insurable interest in order for a life insurance policy to be issued. It specified that any contract issued without an insurable interest would be considered null and void.
Because it was vaguely worded, it fell on others to interpret and enforce the Act. While there have been many legal changes in wording and individual state enforcement, the basis of the law has survived. American courts and state legislatures continued the requirement with the stated purpose of discouraging use of life insurance as a gambling or wagering device and to remove incentives for homicide. This requirement for life insurance was adopted by a vast majority of state courts and eventually ratified and confirmed by state legislatures. Today, by case law, statutory law, or both, an insurable interest at the inception of a life insurance contract is required in every state. It should be noted that the actual wordage varies among the states, but the end result is the same. While not stated the same in all states, they all basically require a “love and affection” insurable interest for individuals closely related by blood or affinity and for all others, a “lawful and substantial economic interest in the continued life, health, and bodily safety of the person insured.”
Individuals can insure their own lives, being both the insured and the policy owner. In other words, it does not have to be the spouse who buys the insurance; it can be the individual him or herself. Insurers use two categories: (1) policies taken out by an individual on him or herself and (2) policies purchased by someone on the life of another person. We all are considered to have an insurable interest in our own life, but policies purchased by another must have an insurable interest in order to buy the contract.
Although having an insurable interest through “love and affection” is assumed to mean that homicide is not the intent, we know that is not necessarily the case. According to statistics, those who should have love and affection do, in fact, murder in order to get the insurance proceeds. It is typically held from a legal standpoint that intentionally killing to collect insurance proceeds will prevent receipt of the money if their act is discovered. Under law, the funds go instead to the next beneficiary in line. This is often referred to as the “slayer statute.” It applies to assignees of life insurance policies as well as beneficiaries.
In a case of Kramer v. Phoenix Life Insurance Company, Arthur Kramer bought multiple policies on his own life, with the intent of selling them to investors who did not have an insurable interest in his life. When Kramer died, his widow, as personal representative of her husband’s estate, brought action against the various life companies, trustees, brokers, and “stranger” life settlement investors seeking to have the proceeds paid to her instead as his primary beneficiary.
The court ruled that when insuring one’s own life, the wagering aspect is overridden by the recognized social utility of the contract as an investment to benefit others. It is not the same as a third party insuring the life for speculative reasons. New York law allows an individual to buy insurance on his or her own life and then transfer it to a person or entity not having an insurable interest. It is notable that NY is a state that restricts STOLIs. In the decision, the court said that while they do not sanction the use of life policies as gambling vehicles, his right to sell the policy he owned remained, even though it seemed evident he bought the policies with the intent to immediately sell them.
It was argued that Kramer never hid his intent to sell them (although it is likely the insurer was not aware of it). In other words, he did not commit fraud on the insurer. Because he was buying the policies on his own life, he had an absolute insurable interest.
Not all agreed with the court’s decision. Many felt the fact that he did not expressly tell the insurer he would immediately sell the policies was a form of fraud. However, only one of the judges dissented. Many application forms for life insurance now specifically ask if the policy will be sold.
In the original application of insurable interest, it did not specify that the interest had to continue throughout the policy, just at its inception, but it was widely believed that it should continue to the insured’s death. It was left to the various courts, however, to determine if that interest had to continue or not. Insurers played the biggest role in this determination when they paid benefits whether an insurable interest was present upon death or not. It is said that the “life insurance custom conquered the law” according to Professor Edwin Patterson.
Life insurance speculators who do not have an insurable interest in the policies they are buying and selling often use incontestability clauses in the contracts to protect their investments. This is true even if the policy was purchased fraudulently by misrepresenting the intent to the issuing insurer. It is why STOLIs and other third-party companies often wait out the incontestability period before putting them up for investors. Most state laws require policies contain incontestability provisions as protection for consumers. It prevents insurers from refusing to pay benefits after two years have passed following policy issuance. Although not the original intention, it also protects investors as long as premiums continue to be paid.
However, it is not absolute protection for investors. In the case of Sun Life Assurance Company of Canada v. Berck, the court held that under Delaware law, an insurer was entitled to contest the validity of a STOLI life insurance policy on the grounds of fraud and misrepresentation, rendering the policy void, upon the lack of a bona fide insurable interest, even after the expiration of the two-year incontestability period. This was based on previous public policy and a majority of case law that supported the determination.
The goal, in most law, is to prevent wagering through the use of insurance contracts, as well as prevention of homicide. From this standpoint, many states have laws that restrict the use of life insurance without an insurable interest for the listed beneficiaries. In most jurisdictions, it is felt that only the issuing life insurance company has the ability to raise the question of insurable interests when it comes to paying benefits, which might be why the widow lost and Sun Life prevailed.
Professor Martin wrote that life settlement companies know they are acting illegally when they participate in STOLI contracts. Even if an insurer takes premiums for years, only to refuse to pay in the end, who is at fault? The insurer who did not completely investigate the situation at the time of policy application or the STOLI company who sought to get a policy by that would be a wagering action? Professor Martin feels neither the STOLI company, nor its investors, should be allowed to profit since it is well known by this time that there must be an insurable interest. Additionally, he feels the insured should not be able to have it both ways: receiving money while alive from the STOLI company and, if that does not work, receiving proceeds upon his death for his beneficiaries. The insured is participating in an illegal activity and there should be repercussions, he feels, for all involved. Of course, not all insureds are aware of the legal issues, but many are.
Most courts have not agreed with Professor Martin. In Illinois, for example, in Penn Mutual Life Insurance Company v. GreatBanc Trust Company, the STOLI scheme was voided because it was purchased through material misrepresentation and in the absence of a valid insurable interest. The investors wanted a return of their premium payments, but the federal district court, applying Illinois law, held that the equitable remedy of rescission did not apply in this case because there was no valid contract to begin with (because there was never a valid insurable interest).
There has been continued disagreement regarding third party involvement and life insurance policies. While many legal minds feel people should be able to sell a life policy that was acquired legitimately, others feel it is not possible to stop fraudulent STOLIs without also stopping viatical settlements and life settlements, since all involve stranger-owned life insurance.
Overall, many of the cases have allowed assignment of policies, as long as there was no fraudulent intent and no wager involved. Most courts have looked at policy issuance (policy inception) to determine whether fraud was involved. Who later paid the premiums have been given less importance. One court stated that the policy must have been purchased in good faith and was not, at its inception, a wagering transaction. This view has generally been applied to viatical settlements, but every court case is unique in some way.
Another court put it this way: the insured must obtain a life insurance policy “on his own initiative” and in good faith, that is, with a genuine intent to obtain life insurance protection for a family member, loved one, or business partner in order to validly assign the policy to someone else who does not have an insurable interest in his life (Clearing LLC v. Angel).
This would normally constitute a valid assignment for viatical and life settlements, since they tend to be policies that have been issued for many years prior to selling them. It is not typically the case when it comes to STOLIs.
Stranger-originated life insurance is not something that is just now being used; they have existed in some form for more than 100 years. What has changed is the current aggressive trend to market policies that once were considered illiquid assets. In other words, consumers did not previously think of their life insurance policies the same way they thought of stocks or annuities. Marketing companies are using advertisements to encourage consumers to view their policies differently than they previously did. Investors hope to receive between 9 and 12 percent returns, so it is easy to see why interest has risen.
Policy owners have always assigned life insurance policies to third parties for various reasons, and few objected to the practice. It was not until the practice turned into an industry that protests began. Viatical settlement companies began buying life insurance policies from those who were terminally ill. Initially the policies purchased were primarily bought from AIDS patients to help them finance their medical costs and general costs of living. Many of these individuals had lost their jobs by this point, so their medical insurance also eventually lapsed. This practice did not raise many eyebrows and there was some positive publicity in fact.
As instances of fraud were disclosed to the public and with advances in medical care, viatical settlement investments lost favor during the last half of the 1990s. Today, they are popular.
Actuarial Life Expectancies
Insurance rates are based on actuarial life expectancy tables as well as other measurements that have been tracked for decades, allowing accurate predictions of the insurer’s risk. The insurable interest requirement allows insurers to make these life expectancy predictions and establish premiums that accurately reflect their risk of benefit payout, especially as it might apply to adverse selection (where sicker or riskier individuals seek life insurance with the purpose of selling the policy). A primary objective in requiring an insurable interest is economic – to be certain that parties to a life insurance policy are not likely to adversely affect the statistics of an insured’s survival. The insurer’s insistence of an insurable interest at the inception of the life insurance contract is an effort to preserve the integrity of the risk pool and the avoidance of adverse selection. Insurers will be more likely to investigate death claims that occur in the first two years of the policy, looking for undisclosed facts on the original application. When they find undisclosed information, they are more likely to deny claims. That same motivation will make it more likely that insurers will look for a lack of insurable interest when applications are made, or claims presented.
State Legislation
State insurance regulators and other consumer groups have shown their commitment to deterring STOLI programs by providing model legislation that is intended to be enacted by state legislatures. The first model act (the Viatical Settlements Model Act) was approved by the National Association of Life Insurance Commissioners (NAIC) in December 2006 and amended on June 4, 2007. The National Association of Insurance Commissioners is a voluntary organization of the chief insurance regulatory officials of the 50 states, the District of Columbia and five U.S. territories. It assists state insurance regulators in protecting consumers and helping maintain the financial stability of the insurance industry by offering financial, legal, actuarial, computer, research, market conduct, and economic expertise.
The second model act (the Life Insurance Settlements Model Act) was approved by the National Conference of Insurance Legislators (NCOIL) in November 2007.
The NAIC model act would end STOLIs and strengthen consumer protection in the life settlement area. It addresses the most obvious and blatant form of STOLIs - the direct sales of life insurance policies specifically initiated for the purpose of allowing investors to purchase them. The NAIC model act established a five-year moratorium on the settlement of policies having STOLI characteristics and required life settlement brokers to disclose vital information about settlement transactions, such as commissions and other purchase offers. There are very broad exceptions to assure legitimate non-STOLI transactions would not be within the scope of the five-year ban.
If one or more of the following conditions are met within the five-year period, the ban would not apply:
The viator or insured is terminally or chronically ill;
The viator’s spouse dies;
The viator divorces his or her spouse;
The viator retires from full-time employment;
The viator becomes physically or mentally disabled and a physician determines that the disability prevents the viator from full time employment; or
A final order, judgment or decree is entered by a court of competent jurisdiction, on the application of a creditor of the viator, adjudicating the viator bankrupt or insolvent, or approving the petition seeking reorganization of the viator or appointing a receiver, trustee or liquidator to all or a substantial part of the viator’s assets.
Yet another exception in A3 of Section 11 provided that the five-year ban on settlement does not apply if the seller has paid policy premiums exclusively with unencumbered assets. This would include an interest in the life insurance policy being financed only to the extent of its net cash surrender value, with full recourse liability incurred by the insured that has no agreement or understanding with any other person to guarantee the liability or purchase the policy. This would include forgiving of the loan. Neither the insured nor the policy should have been evaluated for settlement, meaning no life expectancy analysis has been performed.
The National Conference of Insurance Legislators (NCOIL) is an organization of state legislators whose primary focus is insurance legislation and regulation. Many legislators active in NCOIL either chair or are members of the committees responsible for insurance legislation in their respective state houses across the country. The NCOIL model act serves as an alternative to the NAIC model act. It attempts to address all manifestations of STOLI, whether they involve direct settlements of life insurance, or indirect sales of life insurance to investors through a sale of an interest in trust (or LLC or FLP) or through other practices.
Life Settlement Participants
Consumers had such a positive reaction to selling their policies that the potential for a secondary market for life insurance contracts grew despite the potential pitfalls. A life settlement involves buyers, sellers, brokers and investors who provide the funding for the purchase of the life insurance policy. The seller in a life settlement is the policy owner, but not necessarily the insured since the two may be different people. While it varies, today the insured is typically 65 years old and probably in deteriorating health with a life expectancy of less than fifteen years. The policy generally has a face value of $100,000, is past the two-year contestability period, and has been issued by an insurance company with a rating of “A” or higher. The buyer (life settlement provider) will evaluate the medical records of the insured, determining the insured’s life expectancy and establishing a price for the life insurance policy. The broker may be the policyholder’s financial planner or insurance agent and matches buyers with sellers. Investors supply the capital to purchase the life insurance policy.
From the perspective of the seller, a life settlement has several stages: the realization of need, application, documentation, review, policy match, offer, closing package, notification, and funds transfer. If the life settlement provider resells the policy, the pooling and securitization process adds an additional layer to the transaction. Life settlement providers generally pool together the in-force life insurance policies that they purchase and sell fractional interests to institutional investors. Collectively, these policies are expected to pay out certain amounts of money over a certain time period. Because there tends to be a large number of diverse policies in the pool, on average, the payout expectations hold true. Essentially, life settlement providers (LSP) are reselling the life insurance policies that they have purchased. This resale of the policies replenishes the provider’s supply of capital, allowing it to continue purchasing more life insurance policies. The securitization of life settlement portfolios has become so popular that some financial institutions have funded LSPs with the intention of securitizing the final life settlement portfolio.
Life settlements are being used to dispose of life insurance policies that are no longer needed, wanted, or affordable. Prior to an organized secondary market, a life policy owner could either let their policy lapse or surrender it back to the life insurance company for the surrender values. Traditionally, only the insurer had the ability to provide cash from a life insurance policy, which is why it was considered an illiquid asset. It should not surprise anyone that money is the primary reason for selling a life insurance policy in the secondary market. When the seller will receive a higher payout in the secondary market than he or she would have by surrendering the policy to the insurance company, viatical are sure to appeal to consumers. The payout from the secondary market will be higher where the life expectancy of the insured is less than that originally forecast when the policy was originally issued. There are two primary reasons that this could happen: the insured is in deteriorating health, or the mortality tables upon which the policy was originally based no longer fairly represent the value of the policy. Life settlement providers have the benefit of current medical assessments and mortality tables, while the issuing life insurance company was making a long-term prediction based on less accurate data.
Individuals decide to sell an existing policy for several reasons. The policyholder may no longer be able to afford the premium payments, for example. He or she may need to fund something else, such as long-term care, making continued premium payments difficult. The intended beneficiaries may have predeceased the policy owner or now be in a better financial position, no longer needing financial protection through policy proceeds. If the intended beneficiaries were minor children at the time the policy was purchased, they may now be grown and financially independent.
Estate and financial planning often play a role in determining the suitability of selling a life insurance policy. It may be determined that a life policy is no longer needed or even wanted. In some cases, it may be determined that a new policy covers the goals more effectively, outdating the existing policy. Perhaps some goals and estate planning needs have changed. Other investment vehicles, either not considered or not available at the time the policy was issued, may offer the types of returns desired by the policyholder. If the existing policy represents considerable premiums already paid in, selling it to a third party for more than the surrender values will obviously be favorably considered by the policy owner.
Viatical firms often perform services that are well received because both the sellers and investors are likely to feel they gain personally. With stranger-originated life insurance many professionals feel the sellers may not fully understand the transaction they are entering into or realize the potential for industry abuse.
Stranger-originated life insurance (also referred to as stranger-owned life insurance) makes use of three separate but legitimate markets:
The primary market for new life insurance products issued by the insurer,
The secondary market where in-force life insurance products can be sold, and
The market of special-purpose lenders who finance life insurance premiums.
There are at least six parties to a STOLI transaction, including the insured individual, a trust and trustee, a life insurance broker, an investor group (life settlement market maker), a special-purpose lender, and the life insurance company. The IRS may be a party as well because STOLI policies do not qualify for tax exempt treatment afforded to other forms of life insurance. Not all STOLI transactions involve a trust but many do. The insured and the policy owner are not always the same individual so each individual may be a separate component to the process or a single component, depending upon the specific circumstances.
STOLI transactions can be outlined in four basic steps:
Step 1
The insured is likely to be 70 to 80 years of age, in good health (but not perfect), and has already been an insurance buyer.
Step 2
A policy on the life of the insured will then be purchased by an irrevocable trust or some other entity naming the insured’s family or favorite charity as the beneficiary.
Step 3
Next, a special purpose lender will loan the trust a sufficient amount to cover the first two years’ premiums. The loan may also cover the policy origination fee as well as the trust administration fees and other expenses related to the transaction. The short-term loan interest rate is generally on a prime-plus basis, which might be as high as 12 to 18 percent because of the non-recourse nature of the note and the lack of sufficient collateral.
Step 4
After two years when the loan has matured, the trustee is given a choice:
The trustee may pay off the loan with any additional fees and interest that have accumulated since origination, thereby retaining possession of the policy. In this case the trustee may sell the policy to an investor group, paying off the loan and keeping any profit thereafter; or
The trustee may walk away from the loan and let the lender foreclose on the insurance policy as collateral. The typical expectation is that the trust will sell the policy to the market maker. After the first two policy years, the market maker will purchase the policy from the insured for its fair market value. The market maker is not usually required to purchase the policy and the purchase price is not guaranteed.
It is easy to understand why investors find STOLI transactions attractive; there is the opportunity for providers to view current medical records to make current estimates of life expectancy of the insured. The insured is motivated by the offer of two years’ “free” insurance; if he or she dies in the first two years, while the policy is owned by the trust, his or her beneficiary will receive the death proceeds less the outstanding loan.
Important note: these are generalities. It is always necessary to view the actual contract since contracts can and do vary.
There are many elements of concern for stranger-originated life insurance. The first primary concern is confidentiality, especially for the insured that may be ill or nearing death. The financial interest the investor has in the insured’s death is often referred to as “accelerated mortality.” If the premium financing loan is not a non-recourse loan, the insured’s personal assets may be at risk as well. By selling one’s excess insurability, the insured may be limited in future purchases of personal insurance, meaning he or she may not be able to purchase additional coverage for personal needs.
If the practice of providing cash incentives to the insured is deemed to be rebating, the insured could face taxation at ordinary income levels for these payments. Charity-owned life insurance (CHOLI), a practice similar to STOLI, was targeted in the Pension Protection Act of 2006 and now requires charities involved in CHOLI transactions to report such activity to the IRS for two years (an attempt to impose a 100% excise tax on the cost of CHOLI acquisition failed).
Several other significant tax issues exist including calculation of basis and characterization of gain, should either the insured or the trustee sell the policy. That is why the characterization of “loan-to-life settlements” as “free” insurance is filled with assumptions that could cause some very unpleasant consequences, including whether the purchaser of the policy has an insurable interest in the insured.
Policy Transfers and Insurable Interest
Each state might have different laws, depending upon the basis used. Most states will utilize either or both the NAIC and the NCOIL model viatical acts, but each state may also insert language specific to their state. Those selling viatical or life settlements must know and follow their own state’s laws. Of course, any federal requirements must also be followed.
The decisional law regarding the validity of life insurance assignment to a party without an insurable interest varies from state to state; the prevailing view is that the assignment is valid, and, where no unlawful purpose is shown, the agreement of the assignee to pay future premiums does not invalidate the assignment. Under other authority, however, the assignment of a valid life insurance policy to an assignee lacking an insurable interest is invalid, at least where the assignee agrees to pay all the premiums, although under some, but not all, authorities the rule does not apply where insured pays all the premiums.
In 1939, the Minnesota supreme court held in Peel v. Reibel that an insurable interest is unnecessary to establish the validity of the gifting of an individual’s life insurance policy where the assignment was made “in good faith and not as a mere cover [for taking out insurance in the beginning in favor of one without insurable interest].”
In 1937, the First National Bank of Saint Paul had insured a subsection of its employees under a group life insurance policy issued by the Minnesota Mutual Life Insurance Company. One of the insured was George Peel who had designated his estate as his beneficiary. Conceding “the general rule that a policy of life insurance may be the subject of a valid gift,” the defendant failed to convince the court that the plaintiff’s lack of insurable interest invalidated the gift. The Supreme Court observed that “if there were proof that Peel procured his insurance with a view to making plaintiff, with no insurable interest in his life, the beneficiary, we would have a different problem.” Without such evidence, “to hold [in favor of the defendant] would…put upon the insured’s right of disposition of his policy conditions which are justified by neither law nor by the contract.”
As early as 1871, the Supreme Court had announced that life insurance is not a mere contract of indemnity; Justice Clifford wrote:
Life insurances have sometimes been construed in the same way, but the better opinion is that the decided cases which proceed upon the ground that the insured must necessarily have some pecuniary interest in the life of the cestui qui vie are founded in an erroneous view of the nature of the contract, that the contract of life insurance is not necessarily one merely of indemnity for a pecuniary loss, as in marine and fire policies, that it is sufficient to show that the policy is not invalid as a wager policy, if it appear that the relation, whether of consanguinity or of affinity, was such, between the person whose life was insured and the beneficiary named in the policy, as warrants the conclusion that the beneficiary had an interest, whether pecuniary or arising from dependence or natural affection, in the life of the person insured.
The focus on whether the policy itself was a wager policy was evident in Connecticut Mutual. Life Ins. Co. v. Schaefer, in which the Supreme Court held that an ex-wife who continued to pay premiums for a life insurance policy on her ex-husband was entitled to receive death proceeds despite her insurable interest terminating upon finalization of the divorce.
In 1911, the Supreme Court drew a distinction in Grigsby v. Russell between the need for a beneficiary’s insurable interest in the insured at the time a policy is issued and the need for the assignee of the same policy to have an insurable interest in the insured’s life. In Grigsby v. Russell, the insured, John Burchard, in need of money for surgery and facing an overdue premium payment, assigned his life insurance policy to Dr. Grigsby in exchange for $100 and the assumption of the payment of the premiums. Because Dr. Grigsby had no insurable interest in the insured, the Sixth Circuit Court of Appeals, relying on a previous ruling of the Supreme Court, “held the assignment valid only to the extent of the money actually given for it and the premiums subsequently paid.” The Supreme Court, however, found Grigsby v. Russell to be different from those upon which the Sixth Circuit relied – Burchard’s policy had not “been taken out for the purpose of allowing a stranger association to pay the premiums and receive the greater part of the benefit, and having been assigned to it at once.” The distinction was important because the Supreme Court, recognizing life insurance to be an important form of investment and saving, found it desirable, as “far as reasonable safety permits, … to give to life policies the ordinary characteristics of property.” The value of the life insurance policy, the Supreme Court observed, is “diminished appreciably” if it can be sold only to those with an insurable interest in the life of the insured.
The Supreme Court has, therefore, established that when the motive of assignment is to circumvent the law, the assignment is void. The Supreme Court has held that the assignment of a policy after issuance “would not render it void, whatever the lack of insurable interest on the part of the assignee.” Cammack v. Lewis is one of the Supreme Court’s earliest cases addressing the simultaneous issuance and assignment of a life insurance policy. The insured, being in poor health and owing the plaintiff, Cammack, a note for $70, obtained a term life insurance policy at Cammack’s suggestion for $3,000. As soon as the policy was issued, Lewis assigned it to Cammack, who proceeded to pay the first year’s premiums of $25 after having agreed in writing to pay one thousand dollars to Lewis’ wife should there be a payment made from the policy. Seven months after the policy was issued, Lewis died. The Supreme Court remarked that “the disproportion between the real interest of the creditor and the amount to be received by him ($70 debt plus the $25 premium versus the $2,000 received) deprives it of all pretense to be a bonâ fide effort to secure the debt.” Unwilling to conclude that the acquisition of the policy was itself fraudulent, the assignment to Cammack was held to be valid to the extent of the debt owed to him by Lewis plus the premiums paid to keep the policy in force.
Similar facts were presented to the Supreme Court nine years later in Warnock v. Davis in which the deceased had procured a policy on his life with the intent to assign it to a creditor. The Supreme Court expressly disapproved of prior decisions by the New York Court of Appeals which had held that the assignee of a life insurance policy is fully entitled to collect on the full sum of the policy regardless of consideration given for the assignment or insurable interest in the insured. Recognizing that “many other adjudications” supported this view, the Court went on to note:
if there be any sound reason for holding a policy invalid when taken out by a party who has no interest in the life of the assured, it is difficult to see why that reason is not as cogent and operative against a party taking an assignment of a policy upon the life of a person in which he has no interest.
To hold the assignment valid beyond the debt owed to the creditor, any premiums paid, and reasonable interest thereupon, would “encourage the evils for which wager policies are condemned.”
The task of deciding whether public policy allows for an assignee with no insurable interest to recover debts under a life insurance policy has been left to the states, although the Supreme Court has provided significant guidance in determining what may qualify as an insurable interest.
Recent Regulatory Changes
In the spring of 2006, the NAIC began to discuss changes to the Viatical Settlements Model Act aimed specifically at stranger-originated life insurance. While several changes directed toward consumer protection in general were made, a five-year ban on settling a life insurance policy where “specified elements indicative of a STOLI transaction are present” was the most controversial amendment to the Model Act. Only if the viator certified to the viatical settlement provider that at least one of several specified conditions existed within the five-year time frame could they be sold or assigned to a third party that did not have a traditional insurable interest. The qualifying conditions include terminal or chronic illness of the viator, death of the viator’s spouse, divorce from the viator’s spouse, retirement from full-time employment, physician-corroborated mental or physical disability, preventing the maintenance of full-time employment, bankruptcy, insolvency, or other approved reorganization of the viator. The five-year prohibition is also relaxed where the viator enters into a viatical settlement contract more than two years (the contestability period) after the date of policy issuance and three criteria are met at all times between the date of policy issuance and the incontestability clause of two years: (1) the funding of the policy premiums must have been made with unencumbered assets, with any interest in the policy financing extending only to the cash surrender value; (2) there has been no agreement or understanding with any person to either guarantee the liability for or purchase the policy, including assumption or forgiveness of a loan; and (3) neither the insured nor the policy was evaluated for settlement.
Prior to the drafting of the Section 11 language, the NAIC Life Insurance and Annuities Committee received testimony for and against the five-year ban. It is not surprising that those involved in viaticals felt the five-year ban was unfair to policy sellers (viators). They voiced concerns that the property rights of policyholders would be affected by this ban. With the five-year prohibition now adopted as part of the Model Act, NAIC members are obliged to “devote significant regulator and association resources to educate, communicate and support the model.”
Life insurance companies generally favored the NAIC’s five-year prohibition. All states were urged to adopt the NAIC Viatical Model Act for the protection of consumers and insurers. While it may seem logical for all states to adopt the NAIC Model or some type of similar legislation, it is not a simple matter. Viatical settlements were previously regulated in many states, but not STOLIs. As stranger-owned life insurance becomes increasingly a public issue, the states must pass appropriate legislation without stepping on consumer’s rights to sell their property, including life insurance policies.
Stranger-originated life insurance is still something most Americans have not heard of, but this will change if it becomes widely used by investors. Since STOLIs may encourage obtaining life policies under fraudulent conditions, insurers have a stake in regulating these transactions. The public also has a stake in STOLIs since they have the potential for causing higher premiums for the legitimate life insurance buyers wanting to protect their families from loss of financial security. Public policy regarding the transfer and assignment of life insurance policies by the insured to a third party is not new changing little since the Supreme Court decision in 1911. Stranger-oriented life insurance transactions, as investor vehicles, create an interest in the death of the insured rather than the life of the insured. Because such transactions leverage primary markets, secondary markets, and the market of special-purpose lenders, state legislators not only have to reconcile conflicting industry interests but decide how those interests should be balanced considering the numerous STOLI abuses that have taken place. State legislatures must consider whether the five-year ban on the settlement of life insurance policies is in the interests of their constituents, be they purchasers or providers. Three options are available to the states: take no action, adopt the amendments to the Model Act as written, or adopt the amendments to the Model Act with modifications.
The primary question has to do with intent: was the life insurance policy purchased with the intent of selling it upon policy issuance or at some point following the two year incontestability period? Although the insureds intend is the prevailing question, how can that intent be known? Imposing a time factor, such as a five-year ban on selling the policy, is not a guarantee that the policy was purchased with a genuine insurable interest. Although some policy purchase factors certainly indicate intent to sell the policy following issuance, placing restrictions could still penalize those who do not have that intent.
There is probably no fool-proof way to know a purchaser’s intent so states have traditionally deferred to the property rights of the assignor. Unfortunately, with the secondary market for life policies changing and abuses rising, states are being forced to reconsider their previous position. Past Supreme Court decisions may no longer apply in today’s growing stranger-oriented life insurance market.
The decision in Warnock v. Davis reaffirmed that any semblance of a wagering policy, one where “the party taking the policy is directly interested in the early death of the insured,” one “that [tends] to create a desire for the event….is, therefore, [independent] of any statute on the subject, condemned as being against public policy.” Just as in Cammack, the Supreme Court forcefully stated that “the extent in which the assignee stipulates for the proceeds of the policy beyond the sums advanced by him, he stands in the position of one holding a wager policy.” The Supreme Court did not do an about-face in Grigsby v. Russell as suggested by the Life Insurance Settlement Association. In fact, Grigsby added little to what we accept as an insurable interest. Finding that the insured had assigned his policy to a party without an insurable interest in his life, the Supreme Court said that “cases in which a person having an interest lends himself to one without any, as a cloak to what is, in its inception, a wager, have no similarity to those where an honest contract is sold in good faith.” Warnock, then, with contemporaneous application, issuance and assignment of the life insurance policy, has no similarity to Grigsby v. Russell, where the insured had contemplated neither present nor future assignment at the time of applying for the life insurance policy in question. The Supreme Court’s announcement that it is “desirable to give to life policies the ordinary characteristics of property,” did not contradict the holdings of previous cases; rather it reinforced a forty-year-old prohibition on wagering contracts by defining what is not a wagering contract.
Each state will eventually determine when and under what circumstances public policy against wagering contracts trumps the insured individual’s right to sell property, in this case their life insurance policy. Unless the federal government becomes more involved, which could happen, state policies will vary to some degree, although it is likely they will all be uniform in their intent to limit abuses. There are some indications that the federal government is interested in taking over state control of insurance regulation, although it is also likely that the states will oppose such actions.
A Speculative Contract
As we know, stranger-originated life insurance policies are a speculative contract on the life of the insured. The investor is interested in the death of the insured, not his or her life. The insured taking out the contract merely to sell it is interested in the income they receive. Neither party is interested in financially protecting a beneficiary with an insurable interest. It is a complex situation: viatical settlements and life settlements are secondary market transactions, and limitations on a policyholder’s ability to dispose of his or her policy conflict with the recognition of ordinary property rights in a life insurance policy. Life settlements take place for several reasons: the policy may no longer be needed or wanted because the intended beneficiary has passed away; a better policy may provide greater coverage at reduced cost; premium payments may have simply become unaffordable whether due to unemployment or rising health care costs; or some other estate planning need may over-ride the policyholder’s willingness to keep the policy in force. Recognizing the value life insurance plays in an individual’s overall financial portfolio, restricting the liquidity of life insurance policies by cutting off avenues to the secondary market would unfairly put upon the insured’s right to dispose of her policy when it was deemed appropriate.
With one exception, the NAIC’s amendments to the Viatical Settlements Model Act do not unreasonably restrict a policyholder’s ability to dispose of his or her life insurance policy. The NAIC Model Act allows disposal of life insurance policies in the secondary market after five years. Any issue regarding loss of property rights primarily hinges on the restrictions in place after the two-year period of contestability and the five-year anniversary of policy issuance. The language of the five-year ban creates an assumption that, where a viator or insured enters into a viatical settlement contract between the issued policy’s second and fifth year, sufficient evidence then exists that the life policy was a wagering policy. Unless the viator or insured can submit independent evidence to the viatical settlement provider of a terminal or chronic illness, the death of or divorce from a spouse, retirement from full-time employment, inability to sustain full-time employment, or a final order or adjudication of bankruptcy or insolvency, he or she will be assumed to have intended to settle the policy at the time of the original application.
Unfortunately, these conditions do not help less catastrophic changes in a viator’s financial situation that may require cash. The Life Insurance Settlement Association and the Life Settlements Institute, proposed several revisions, recommending what would have been an additional exemption to the five-year ban where a viator or insured could submit independent evidence to the viatical settlement provider that “the viator experiences a significant decrease in income that is unexpected and that impairs the viator’s reasonable ability to pay the policy premium.” With this exception to the five-year ban, a viator or insured would be able to dispose of an unneeded or unaffordable life insurance policy where substantial changes to the health, welfare or economic condition have occurred.
The amendments to the Model Act allow for the increasing prevalence of stranger-originated life insurance while conforming to the Supreme Court’s requirement of insurable interest and wagering policy cases. A viatical settlement contract is generally a written agreement to exchange anything of value, at any time, for the viator’s assignment or transfer of an insurance policy. Such an agreement would be prohibited within five years of issuance of the policy unless certain criteria are met. Entering into a viatical settlement contract within five years of issuance of the respective policy is evidence that the policy was applied for as a wagering policy. This is certainly true for the one transaction explicitly included in the new definition: premium finance loans made for a life insurance policy on, before, or after the date of issuance where the viator or insured on the date of the loan receives a guarantee of future settlement value or promises to sell the policy on that or any future date. Just as in Warnock, where the agreement to assign was made on the same day of policy application, it is reasonable to assume that such a quid pro quo is evidence of a wagering policy. Section 11 of the NAIC Viatical Settlements Model Act clearly prohibits this.
Loan proceeds made solely to pay premiums for the policy or other costs are explicitly excluded from the definition of a viatical settlement contract, and not subject to the five-year prohibition. Also excluded from the definition of a viatical settlement contract are those agreements where all parties are related by blood, law, or have a lawful economic interest in the continued life health and safety of the insured, recognizing the decisional law including affinity and certain pecuniary interests in the definition of insurable interest.
If an exception to the five-year prohibition for an unexpected inability to pay the premiums for an otherwise appropriately obtained life insurance policy is included, the five-year settlement prohibition would not remove a policyholder’s property rights in the policy. The prohibition would create a refutable assumption that entering into a viatical settlement contract within five years of policy issuance is evidence of a wagering policy. Given the predatory nature of many stranger-originated life insurance and the various consequences that are still unknown, it puts pressure on the states to put consumer protections in place. Both the insurance and life settlements industries are likely to benefit by preventing investors from wagering on the lives of consumers, particularly senior citizens.
End of Chapter 6
United Insurance Educators, Inc.