Stranger-owned life insurance (STOLI) is exactly as it sounds – life insurance originated by a stranger. Typically, they are initiated by a third party looking to own and control a policy from the beginning.
Here are some issues to keep in mind when reviewing a STOLI transaction:
If the maximum amount of life insurance were purchased on a single life, then that insured would probably not be able to ever purchase life insurance again.
This is an especially important factor – as the capacity for life insurance is shrinking both in the U.S. and around the world, it is becoming difficult it not impossible to write large amounts of life insurance (partially due to STOLI).
There are ethical and moral concerns with selling your life insurance and/or insurability – used life insurance capacity – to an investor group or stranger.
There are no standards disclosures at this time.
The original purchaser is not obligated to keep the policy; they can resell it.
Life settlement contracts have little protection for personal and health information.
Violations of State “Insurable Interest” Insurance Laws and Regulations
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 was purchased.
Without an insurable interest, the policy is void from inception and the death benefit will not be paid to the investors. To protect the public, all states have insurable interest statutes designed to discourage speculation on an insured’s life.
If a state insurance departments rules that an insurance interest law is violated, the insured’s trust and estate, and their agents and advisors, may become embroiled in unexpected litigation.
Premium Financing Issues
There are specials issues regarding the cost of repaying the loan and ultimately keeping the policy. It is very unusual for an insured to participate in a “free” premium financing program with the primary intent of replaying 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 have lower-cost private of 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.
Fraud and Misrepresentation
The standard life insurance application requires insureds to sign written statements regarding their health, financial circumstances, policy ownership, and purpose of the insurance. Companies reply on this information to issue coverage.
The insured, or the insured’s family, may be liable for the investors’ loss, 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 extend beyond the contestable period.
Another area of risk to insureds is the use of cash incentives to purchase the policy. The New State Insurance Department General Counsel Opinion – citing lack of insurable interest for one of these transactions – point out that “free insurance” might constitute as an illegal rebate.
Violation 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 disinterested third party. To guard against so-called wet ink viatical transactions, the NAIC’s Viatical Settlement 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.
Potential Violations of Federal or State Securities Law
Advisors must consider these programs as possible securities transactions, in addition to insurance law issues.
Failure to Comply with the Patriot Act
Some counties 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.
Unknown 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. The tax opinions will vary from advisor-to-advisor and from transaction-to-transaction.
Estate Tax on the Death Benefit
Since 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 they die during this period.
By Tony Steuer, CLU, LA, CPFFE
Tony Steuer is an author and advocate for financial preparedness. Tony Steuer, CLU, LA, CPFFE, helps people make sense of the financial world in a way that’s easy for them to understand. His books including, “GET READY!,” “Insurance Made Easy,” and “Questions and Answers on Life Insurance,” have won numerous awards. Tony is the founder of the GET READY! Initiative which includes the GET READY! financial organization system, the GET READY! Financial Preparedness Club, GET READY! Podcast, and the GET READY! Financial Principles, a best practices playbook for the financial services industry. Tony served as long-term member of the California Department of Insurance Curriculum Board. Tony is regularly featured in the media including the New York Times, the Washington Post, Fast Company, and other media. He has also appeared as a guest on television shows, such as ABC’s “Seven on Your Side.” Visit https://tonysteuer.com/ to join the GET READY! Financial Preparedness Club and access free resources.