LIFE INSURANCE FOR INDIVIDUALS OVER 70
PREMIUM FINANCING
AND
LIFE SETTLEMENTS

FizerBeck
Fizer, Beck, Webster, Bentley & Scroggins
a professional corporation
1330 Post Oak Boulevard, Suite 2900
Houston, TX 77056-3022
713-840-7710
www.fizerbeck.com
 

1. Premium Financing Historically

1. Lack of cash flow to satisfy premium requirements

2. Desire not to sell investments

3. Gift Tax Limitations

4. In addition to securing the loan with the policy cash value and death benefits, Policy owner typically required to guarantee the debt and put up additional assets as collateral or purchase a letter of credit

2. Life Settlements Historically

1. Mid 1980s at beginning of AIDS epidemic

2. Viatical settlements allowed AIDS patients to cover medical expenses by selling insurance policies prior to death

3. Investors who purchased policies through viatical settlements initially made significant returns on their investments until the AIDS treatments began to extend the patients’ life expectancies (investors effectively overpaid for the policies)

4. Mid 1990s, some innovative people determined that a large number of insurance policies were either lapsing or being surrendered to insurance companies for the cash surrender value due to lapsing of the need for insurance or inability to make premium payments (these innovators realized that the true “value” of these policies exceeded the CSV – similar to the viatical situation)

5. Institutional investors were made aware of the opportunity to purchase life insurance policies and the secondary market for policies was born

3. Structured Transactions

1. “LILAC” Transaction for Charitable Desires

1. Life Insurance Life Annuity Combination

2. Pools of Insureds Grouped Together

3. Annuity Company life expectancies shorter than Life Insurance life expectancies

4. Differences created arbitrage that allowed SPIA distributions to cover premiums and provide investors an annual return

5. Insureds simply donated insurability

6. Insureds allowed to choose charity to receive 5% of death benefit; balance goes to pay principal back to investors

7. Excise tax of 35% was proposed in a bill that never passed; regardless, this forced all structured transactions to prohibit the use of charity (even today)

2. Focus Switched from Charitable Beneficiaries to Individuals

1. 3 General Structures

1. 2-year non-recourse loan with option at end of term to sell policy, give policy to lender as full satisfaction of debt or retain policy by paying off lender (some plans used to include upfront money to insured or beneficiary)

2. Percentage of face value upfront with no sharing in death benefit

3. Some percentage of death benefit, varying based on year of death

2. 2 year non-recourse loan

1. Policy typically owned by irrevocable trust (agreement provided by promoter) of which a bank is the trustee

2. Non-recourse loan from lender to owner

3. Loan proceeds used to cover origination fee, trustee fee and premiums for 2 years

4. Trust protector or trust settlor provides direction to trustee as to desired course of action at end of 2 years

5. If policy is sold on secondary market, gain should be taxed as capital gain (ordinary income to extent cash surrender value exceeds basis). Lender paid principal balance plus interest. Interest rates typically high (12% - 14%). Interest is non-deductible. Basis in policy should be equal to premiums paid plus costs in purchasing policy. However, the IRS has ruled in a private ruling (PLR 9443020) that basis is reduced for premiums allocable to pure insurance protection when a policy is sold to a viatical company.

6. No further interest in policy after it is sold.

3. Upfront money

1. Typically, insured receives 3% of face value by allowing the investor group to own a policy on his life

2. Due to favorable insurance interest laws in Texas (see TX Insurance Code §1103.054), transaction is permitted in our state

3. Ordinary income tax on funds received

4. No further interest in policy

4. Share of Death Benefit

1. Policy typically owned by irrevocable trust (agreement provided by promoter) of which a bank is the trustee

2. Non-recourse loan from lender to owner

3. Loan proceeds used to cover origination fee, trustee fee and premiums for lifetime of insured

4. Agreement provides for beneficiaries of trust to receive some percentage of the death benefit

1. Percentage decreases as insured lives longer (more premiums paid)

2. Usually no lower than 5% of death benefit

4. Ideal Insured

1. Between ages 70 and 90

2. Good health (standard or higher rating by insurance companies)

3. High net worth relative to existing insurance

4. May or may not have need for liquidity

5. Concerns with Transactions from Insurance Companies’ Viewpoint

1. Risk to §101 tax-free nature of death benefits

2. Risk to §72 tax deferred build up inside policy

3. Increased death claims

1. Not factored into pricing of policies

2. Assumptions that a significant percentage of policies will lapse or be cashed in

3. Investors will hold policies until maturity

4. Re-insurance companies reaction

6. Concerns with Transactions from Insured’s Viewpoint

1. Insurance Capacity used up

2. “Mafia Factor” - Third Party to Benefit from Insured’s death (not true in all cases)

3. Debt Forgiveness (2 year and Shared Death Benefit Deals)

1. If no market for the policy at the end of 2 years and policy transferred to lender, loan is deemed paid off

1. Is this debt forgiveness income to Owner?

2. General rules on non-recourse financing provide that if collateral transferred in satisfaction of debt, treated as if the collateral was sold for the principal amount of the debt (see Commissioner v. Tufts, 83-1 USTC ¶9328)

3. Thus, gain should only be recognized if principal amount of debt exceeds basis in policy (should be close to equal)

4. To avoid risk, trust/owner should be structured as a non-grantor trust

2. In Shared Death Benefit Transaction, if insured lives a long time, accrued interest plus principal could exceed lender’s share of the policy death benefits

1. If general non-recourse rules apply, then should be no concern

2. Trust/owner should be non-grantor trust to avoid risk

4. Capital Gain Amount on Sale for Profit

1. Basis in policy should be equal to premiums paid plus costs incurred in purchasing policy (see IRC §72(e)(6))

2. However, as noted above, the IRS has ruled privately (PLR 9443020) that the basis must be reduced to the extent that the premiums are allocable to the cost of insurance protection when a policy is sold to a viatical company

3. Interest payments do not give rise to basis

4. No rulings confirming that profit realized on sale is capital gain

5. Documents are prepared and approved by the counsel for lenders, investors and promoters. Most cases, no changes can be made to documents. Representations and warranties must be read carefully to confirm no liability risk to insured or insured’s family members. Oftentimes, the lender (who may also be a potential buyer of the policy on the life settlement side) has some control over the life settlement process.

7. Size of the Market

1. German tax laws provide some incentives to German investors (supposedly over 20 funds created in Germany for the sole purpose of buying policies).

2. Berkshire Hathaway and AIG are significant players in the marketplace.

3. According to the Wall Street Journal (August 9, 2006), Sanford Bernstein & Co. has suggested that the market for used policies already exceeds $13 billion and could hit $160 billion by year 2030.