Thursday, February 10, 2005 Posted: 11:25 AM EST
Stranger-Owned Life Insurance ("SOLI"): Killing the Goose That Lays Golden Eggs!
Earlier this week, Treasury released the Bush Administration's Fiscal 2006 Revenue Proposals which include a provision that, if adopted, would impose a 25% excise tax on distributions from certain investor owned charitable life insurance contracts. In this article from the January 2005 issue of Estate Planning Journal, Stephan Leimberg describes these plans and why they represent a "dangerous and disturbing" trend.
This article is reprinted with the publisher's permission from ESTATE PLANNING, a monthly journal on strategies for saving taxes, building wealth, and managing assets published by RIA under the WGL imprint. Copying or distribution without the publisher's permission is prohibited. To subscribe to ESTATE PLANNING or other RIA journals please call 800.950.1216 or visit http://www.riahome.com/journals/. For information on ESTATE PLANNING, click here.
The 'something-for-nothing' 'no risk' pitch
Yo Buddy, want some free life insurance? Better yet, we'll not only pay all the premiums on the policy but we'll also pay you!
Promoters are placing huge policies on the lives of total strangers, people on whose lives they have no insurable interest -- no previous economic or family relationship or interest in the continuation of the insured's life--with a pitch that goes something like this:
"You purchase $10 million of insurance on your life. We'll advance the premiums for two years at an interest rate of 12% to 15% and take a collateral assignment on the policy. You pay nothing. You don't even have to pay any interest--it accrues with the loan. At the end of two years, if you want to continue the coverage, you pay us the interest you owe and repay the principal. It's a non-recourse loan. That means you risk nothing. If you don't want the coverage at the end of two years, no problem. We'll take over the policy and you have no liability. You owe nothing. Best of all, we'll pay you $250,000 in cash up-front to sweeten the deal."
Of course, this "free insurance for two years" scheme is a thinly disguised attempt to skirt the insurable interest laws and create a market for huge amounts of insurance on foolhardy individuals' lives. (Would you allow a stranger or group of totally unknown individuals to purchase a $10 million policy on your life? How about a $1 million policy? Would you believe $100,000?)
Stranger-Owned Life Insurance ("SOLI") is a rapidly spreading virus that is infecting both individuals and charities. The end result is likely to be a lose-lose-lose situation for the public, the insureds, their families, and the insurance and estate planning communities. In fact, everyone is likely to lose--except the promoter-marketers and third-party investors they assemble to finance what is clearly an end-run around centuries old insurable interest laws.
on insurable interest. The legal concept of insurable interest dates back to
early 18th century
By the mid-18th century, purchasing policies on strangers had become a popular form of gambling. Investors often placed their money into "dead pools" insuring the lives of well-known public figures, particularly those with such problems as gout or alcoholism, or those who were likely to be challenged by political enemies and engaged in duels. Such "investors" would often offer targeted insureds lavish dinners and "a drink or two on me"--or would use other means to assure the certainty and accelerate the realization of their investment.
In 1774, the English
Parliament enacted laws to put an end to such gambling on human lives. Similar
anti-human life trafficking laws were adopted very early in the
While the insurable interest laws vary widely from state to state,1 in general, they deal with three main issues when a policy is purchased on another person's life:
1. The owner must have an insurable interest in the insured when the policy is purchased (but unlike property and casualty insurance, the interest generally is essential only at the time the policy is issued and need not exist when the death benefit is paid);
2. The informed written consent of the insured is required in most states before the insurance can be purchased; and
3. The buyer must have a reasonable expectation of benefit or advantage from the continued life of another person. A child, for example, would have an insurable interest in the life of a parent.
SOLI in a charitable context
Here, the promoter's claim is that this arrangement is "a life insurance windfall for charity--without buying a policy or paying anything at all." These are highly complex and speculative arrangements in which investors "borrow" the insurable interests of charities to purchase insurance coverage on the lives of the organization's older, wealthy, charitably-minded, and generous donors. (In some versions, those who permit the purchase of insurance on their lives are allowed to name personal beneficiaries of a relatively small amount of "free coverage" as an additional incentive. 2)
Although there are numerous variations on this charitable "win-win" theme, essentially, it works like this:
Step 1: An investment bank issues securities--such as bonds--that investors purchase.
Step 2: The money from the sale of the securities goes into a trust (established by the participating charity).
Step 3: The trustee uses trust funds to buy single-premium immediate annuities on the lives of wealthy--and typically older (ages 72 to 90)--donors provided by the charity.
Step 4: The stream of annuity payments is used to buy life insurance on the same donors' lives.
Step 5: Supposedly, the annuities will produce sufficient income not only to pay the life insurance premiums, but also to provide a sufficient current fixed return to the investors on their investment--at least until the donor dies and the insurance proceeds are paid.
Step 6: At the death of an annuitant/insured, the "life only" annuity payment ceases.
Step 7: The insurance proceeds are paid to the trust.
Step 8: The investors recover their investment from the death proceeds received by the trust.
Step 9: If there is any death benefit remaining at that point, it is paid to the charity. Promoters estimate that the charity's share will be between 5% and 7% of the initial face amount.
Under Steps 3 and 4, the investment bank and participating insurance agents receive fees and commissions, in most cases, years before the charity can hope to receive any meaningful amounts.
Why would a charity get involved? There are various reasons why charities are at critical risk of willingly or unknowingly becoming parties to sophisticated life insurance transactions that are not in the best (and long-term) interest of either the charities or their patrons (or the general public, for that matter). Many charities became involved with charitable split-dollar and charitable reverse split-dollar, and for numerous reasons, others may be in danger of doing so with these new "too-good-to-be-true" arrangements. 3
First, we are currently in an era when donations for many charities have dropped--in some cases precipitously. There are many causes for this; undoubtedly, the stock market uncertainty and volatility of the past few years have greatly slowed and/or reduced the rate and size of charitable contributions.
Second, stock market weakness has diminished, and in some instances ravaged, the value of charities' own investment portfolios, particularly those heavy in telecommunication (read WorldCom) and energy (read Enron) stocks.
Third, competition among charities for donors' dollars has increased significantly. There are more worthy (and some not so worthy) charities and causes than ever before--all aggressively seeking money.
Fourth, strained and drained staff coupled with shrinking investigative budgets have hobbled and/or crippled many federal and state regulatory agencies. In many cases, other governmental problems and priorities have overshadowed the need, or dampened the will, to provide the necessary oversight of charities and policing of charitable abuses. This was highlighted in testimony at the Senate Finance Committee hearings on 6/22/04. Promoters of edgy schemes know that there is statistically minimal risk of serious regulatory audits (although this is likely to change soon).
Fifth, of all financial tools, life insurance is among the most complex and least understood. Almost none but the largest charities have staff with sufficient time, knowledge, and experience to investigate both the tax and non-tax implications of the many new life insurance-related plans and arrangements that have been presented to them recently. Few charities have--or can afford--either the highly competent in-house or outside counsel, and/or other professionals needed to adequately evaluate and judge the efficacy and workability of every scheme that someone wants to sell to them or their supporters. This is particularly true where, in schemes such as charity-based SOLI, it would require high-powered legal, accounting, actuarial, and investment expertise to judge the credibility and potential viability of the various proposals.
In difficult economic times, it is easy for a charity to be seduced by possible profits from life insurance-related schemes and consequently to "rent out" its charitable insurable interest and tax-exempt status to unscrupulous marketers and promoters. All too easily, ethical and moral elements of the decision-process may be subverted in favor of what looks like a free and easy ride to boosting a charity's financial bottom line. And the charity may easily ignore or never see how, or to what extent, third-party participants (investors) benefit from the "partnership"--and the risk the charity is taking by allowing its precious tax-exempt status to be used to make possible that up-front private enrichment.
Life insurance as a charitable planning tool
There are literally dozens of legal, ethical, and creative ways life insurance can be used to benefit charities.4 These range from the very simple and easy naming of a charity as sole or partial revocable beneficiary to the sophisticated but specifically Code-sanctioned use of life insurance inside (or in conjunction with) a charitable remainder unitrust or charitable lead trust. In many cases, individual life insurance owned by a charity on the life of a key supporter will be a wise and prudent investment. But broad-based SOLI goes well beyond the normal.
Diving in the shallow end of the dead pool. Although many charitable uses of life insurance may be both legally and ethically proper, there are those for whom such bounds are not sufficient. SOLI empowers complete strangers to engage in what amounts to statistical gaming, gambling on the rate of deaths of the insureds. SOLI would fast-forward us ahead to the past--to a super-size modernized and sanitized version of the long outlawed dead pool.
By sidestepping--or in some cases actively instigating changes to--insurable interest laws (which have, for very sound public policy reasons, survived for hundreds of years), big-moneyed high-powered investor groups hope to make life insurance into a mass commodity investment. The investor groups form vast pools of insured lives (namely, supporters of various charities) to capitalize on the unique benefits of life insurance and, by doing so, profit enormously from it.
In most of these so-called dead-pool arrangements, the odds are high that third-party groups of institutional investors (primarily investment banks, insurance companies, and hedge funds) will receive their share of the "return on investment" sooner--and certainly in a significantly greater amount--than the charity for which the arrangement is ostensibly designed.
Under such an arrangement, the annual guaranteed payments to investors assure them of gain--almost without exception--long before any money is ever paid to the accommodating charity. Yet, without participation by the charity (and the "rented" insurability of its supporters), the net financial gain enjoyed by the private investors, promoters (their up-front fees), and insurance and annuity sellers (in commissions) would be unlawful, socially unpalatable (reprehensible? unconscionable?), and therefore un-achievable.
How the game works
There are infinite varieties of this ploy. But in every one, after the promoter and the seller of annuities and life insurance policies receive their up-front fees and commissions, the investor pool--i.e., the nameless private individuals and companies who finance the initial purchase of annuities (and subsequent life insurance policies)--receives a steady stream of fixed income. Eventually, if the life insurance policies perform as illustrated, if the insureds die as predicted, and only after the investors recover their capital investment, the charity might receive a (relatively small) percentage of the insurance proceeds.
Some variations give the insured the right to name the beneficiary of a small portion of the death benefit as an inducement to allow the purchase of the policy on his or her life. Promoters claim that "the insureds pay nothing and it is possible for the charity eventually to receive a large amount of money for what amounts to brokering a `rent-a-life' arrangement on a mass basis."
Seldom do the promoters fully disclose to the charity or the insureds the names of the initial (or secondary market) investors, what is in it for them, or the full range of risks and potential costs to both the charity and its insured patrons. Furthermore, the opinion letters rarely, if ever, offer comment on the probability of the charity's economic success.
Life insurance/annuity combinations. One of the variations of SOLI involves annuities and life insurance on the same individuals. The money raised from the sale of bond-like securities is used to purchase single premium immediate straight life (i.e., "life only" payout option) annuities on the lives of supporters of the charity. The income from these annuities is then used to buy life insurance on the lives of the same individuals.
The promoters may try to obtain annuities with exceptionally favorable "impaired risk" rates by presenting those individuals as having lower than standard health. Then, they approach a different insurance company to purchase life insurance on the same individuals and, by showing the prospective insureds in the most favorable light, try to negotiate the lowest possible life insurance premiums. Part of the financial success of the dead-pool arrangement depends on this actuarial (and perhaps unethical, if not fraudulent) arbitrage.
The charity--if it sets up the insurance trust and is the recipient of the annuity income--benefits by receiving the tax "arbitrage" from the program. That is, the totally untaxed annuity income received by the tax-exempt trust created by the charity is--at least according to promoters--certain to be greater than the cost of the life insurance premiums paid each year, as well as sufficient to provide an annual payment of fixed income to the institutional investors. So in essence, the charity is sharing its tax-exempt status to assure a sufficient level of payments to the private lender/partners in this arrangement.
as the very limited partner. It is very important to remember that this entire
transaction would not be sanctioned by law or the courts, and would not hope to
enjoy a favorable public opinion--if it took place in another context (be it
corporate or government sector). We learned from cases such as Wal-Mart,
Rice, and Mayo5--and
from scathing and pejorative comments about "dead peasants" and
"janitors' insurance" in The New York Times and The
Wall Street Journal.6
Less publicized, but equally disturbing, are reports in the
None of these third-party institutional investors could engage in this transaction without the protective cloak of the charity. In essence, the promoters act as brokers in "renting" what insurable interest the charity has to the investors in return for a possible eventual payment to the charity of a relatively exceptionally small percentage of the investors' overall investment return.
So what is wrong with a charity leasing lives of supporters? Two central themes of charitable tax law are: Charity is about giving, not taking, and The tax-exempt status of a charity is not for sale or private benefit. A charity's tax-exempt status is not to be used to enrich or benefit anyone other than those for whom the charitable status was granted and intended. That group certainly does not include wealthy private investor groups who have no familial or business loss at the insured's death and have no interest in the insured's continuing life.
Nonetheless, the argument is that the charity will now receive money that would be otherwise unavailable. "If you don't go along with this arrangement, you'll get nothing."7 This sounds all too similar to the phrase used by promoters of the now extinct charitable split-dollar, specifically banned by IRC Section 170(f)(10).
Don't worry about the law, we'll get it changed! The amounts of money involved are so high and the players are so powerful that they are quite willing and able to spend the money and time to convince lawmakers to change state insurable interest laws that are not flexible enough to accommodate their dead-pool schemes.8
Promoters of these plans
have been actively lobbying at the state level to have officials loosen
insurable interest laws to allow these programs. Two states (
We are talking about a huge investment where a group of third-party investors stand to gain financially on policies on a large number of unknown, unrelated individuals' lives--and not a single one of those insureds has ever met that "someone," or even knows who he/she (or they) is (or are)! And of course, even if the investor pool is totally ethical, honest, and well-meaning, there is no guarantee that--failing a reasonable profit (perhaps because deaths are not occurring in the real world at the same pace they were assumed to happen statistically)--the investors' interest may be sold to others who are yet even more distant (and perhaps less ethical and well-meaning) strangers.
If state governments manipulate the laws to circumvent the consumer protection purpose behind the rules, it is a game we all lose.
ACLI, AALU, and NAIFA all speak out--loudly
In an unprecedented move,
three of the most representative organizations in the
They did so, wisely and with good reasons! All three organizations have roundly criticized moves made by state legislators to loosen insurable interest laws. The American Council of Life Insurers, joined by the Association of Advanced Life Underwriters and the National Association of Insurance and Financial Advisors, has made it clear they are each against state law changes that would allow third-party institutions with no familial or other relationship to the insured to use charities to enable the purchase of life insurance on individuals in mass numbers.
These three organizations have stated, in no uncertain terms, that life insurance contracts should be issued only to persons or parties with a familial or recognized economic relationship with the insured, and the issuance of life insurance should not be distorted and allowed to become a mere commoditized investment process.
The proposed state legislation, in short, would weaken modern-day insurable interest laws to the point that they could no longer effectively serve any meaningful, practicable purpose. The proposed state legislation would facilitate transactions that purport to benefit participating charities when, in fact, they provide large, up-front fees to the promoters and annual guaranteed payments to investors, long before any money is sure to be paid to the charity.
Risking the tax-exempt status of the charity. Promoters of these arrangements have no stake in the long-term success of the charities other than as facilitators of their sales efforts. So the loss of a charity's tax-exempt status is of no personal and immediate concern--once the sale is made.
Charities may believe that there are no adverse income tax consequences as a result of their participation. However, it is unknown if the charities, as tax-exempt entities, may unwittingly be imperiling their tax-exempt status or incurring unrelated business income tax ("UBIT") unexpectedly.
At a minimum, questions have arisen as to whether the charities are compromising and jeopardizing their ability to attract major supporters who can make real and concrete donations to the organizations with which they have relationships.
Does (or can) this arrangement really work, and at what cost?
No one has yet proved that this ploy will really benefit a charity--or to what extent.10 There are those who have serious doubts.11 They question whether the insurance policies are, in fact, "priced right," to assure that the investor receives his/her/their investment, and provide a significant payoff to charity. In other words, for money to be left over for charity, it would take (at least on a present value basis) a death benefit that is higher than the premiums paid.
Yet, for the insurer to survive and pay its shareholders a profit and its agents a commission, it would have to charge sufficient premiums to account for expenses and leave a profit margin. Stated differently, the insurer would have to take in at least as much in premium dollars--and preferably more--than it pays out.
Here are some very basic threshold questions:
Will there be attempts by
investors to "accelerate" their interests? Think it can't happen?
Think again. The Washington Post reported that a federal grand jury in
The big risk to the life insurance and estate planning community
The individual and charity-based SOLI arrangements described above transform life insurance into a third-party investment vehicle, a commodity. Once that happens, there is little reason or justification for Congress and the states to continue the multiplicity of unique tax advantages accorded life insurance (e.g., income-tax-free buildup of cash value, and the generally unlimited income-tax-free nature of death proceeds).
Absent the tax-free nature of life insurance proceeds, many businesses will not be able to afford adequate key employee coverage, will not have sufficient cash to fund a non-qualified deferred compensation agreement, a death-benefit-only plan, or will not be able to provide a sufficient level of post-retirement health coverage for employees. Similarly, on the personal level, it will become more difficult or impossible (and certainly more expensive) to obtain adequate life insurance for our clients to pay off debts, assure a standard of living and college education to survivors, or pay state and federal death taxes. Greater insurance costs translate into doing with less or doing without--and would divert funds from investment and retirement savings. Everyone loses if either the death proceeds or the internal buildup in a life insurance policy becomes taxable.
A more subtle but equally damaging aspect of the development of life insurance as a marketable third-party investment commodity is the havoc it would wreak on the pricing of life insurance. As one of the quotes near the end of this commentary notes, "sound underwriting presumes that the owner of the policy and the insurer both are better off if the insured continues to live"--a presumption essential to the creation and maintenance of life insurance premium structuring as we know it.
But don't take my word for it. Following are notable quotes from some of the most recognized authorities and commentators in the fields of estate and charitable planning.
In her article, "Death-Pool Donations," author Wendy Davis states, "For Donors, the value of their lives is put, literally, in someone else's hands--and it's hard to say whose."12
Jerry J. McCoy, co-author
of the Family Foundation Handbook and former Chair of the
Craig Wruck, Chair of the National Committee on Planned Giving's Government Relations Committee, opined: "Charities are being told they can create money out of nothing and you know intuitively that that's impossible."
Vaughn Henry, nationally known charitable consultant, stated: "It's because life insurance protects widows, widowers, and children from becoming paupers when the breadwinner dies that it isn't taxable. But that may change if Congress or the Treasury Department thinks life insurance has become nothing more than a wager."
Laura Kalick, Chair of The American Bar Association's Subcommittee on Unrelated Business Income Tax, noted: "If the charity borrows money to buy the life insurance policies, the charity will likely have to pay the IRS tax on unrelated business income--because charities have to pay tax on debt-financed income."
Mike Nelson of the Iowa Savings Bank, author of the special white paper entitled, "Insurable Interest Under Siege,"13 said: "The objection is not that wholesale murder will ensue. Such an assertion only trivializes the debate. The objection is that the third party owner of the policy benefits only from the death of the insured. The essence of sound underwriting is that the owner of the policy and the insurer both are better off if the insured continues to live. Yet the proposed insurable interest changes and attempts to turn life insurance into a third party investment vehicle shatter this harmony and sound philosophy."
Larry J. Rybka, President of ValMark Securities, suggests that the securities aspects of Stranger-Owned Life Insurance are often overlooked by the parties. He points out that "the ultimate vehicle for funding and raising the money is a security. Although some promoters have in fact filed them as private placements for accredited investors, others have not. Life insurance agents who promote and engage in SOLI transactions risk involvement in putting in front of charities and donors materials that represent the benefits that may flow from these securities products--without the knowledge or permission of their own broker-dealer. This is likely to trigger a charge of 'selling away,' marketing a security for a broker-dealer other than the one the person is registered with. Equally troublesome, if the transaction is not registered, the agent is then involved in not only selling away but also the distribution of an unregistered security. This potentially could trigger both criminal penalties and a right of rescission of the 'investors' personally against the sales person. Either charge could result in personal liability not covered by errors and omissions coverage as well as an NASD ban from the business. Those who hold a securities license and proceed without the written permission of their broker-dealer are in great peril and risk their professional career, reputation, and entire personal net worth."
The bottom line. Stranger-Owned Life Insurance is a dangerous and disturbing trend. Left unchecked, this short-sighted, too-good-to-be-true ploy could (1) adversely affect the charities it is promoted to benefit, (2) trigger a sea of change in the way life insurance is taxed and priced, and (3) in some few cases, encourage criminal activity of the worst kind. At risk are individuals' lives as well as their wallets.
Copyright 2005 Leimberg Information Services, Inc. Reproduced by the
 Leimberg Information Services, Inc. (LISI) has insurable interest laws for all states. Log into LISI at http://www.leimbergservices.com. There is a free-look button if you are not already a member. Once logged in, click on the State Laws tab at the top on the right. The topic of insurable interest is covered in more detail in Tax Planning With Life Insurance (800 950 1216) and Tools and Techniques of Life Insurance Planning (800 543 0874).
 Testimony of J. J. MacNabb to Senate Finance Committee, June, 2004. "Hearings on Charity Oversight and Reform: Keeping Bad Things from Happening to Good Charities," 108th Cong., 2nd Sess. (June 22, 2004) (Committee Print), Tax Notes Doc. No. 2004-12925, 2004 TNT 121-29 (June 22, 2004).
 See for example Tools and Techniques of Charitable Planning (800-543-0874) and Leimberg and Gibbons, "Life Insurance as a Charitable Planning Tool: Part I", Estate Planning, March 2002, Vol. 29, No. 3, Pg. 132 and "Life Insurance as a Charitable Planning Tool: Part II", Estate Planning, April 2002, Vol. 29, No. 4, Pg. 196
 These cases are reported on in detail in Tax Planning With Life Insurance: (800 950 1216) and in Leimberg Information Services (http://www.leimbergservices.com ) Click on the FREE LOOK button if you are not a member.
 See also Tamez v. Certain U/W, 999 S.W.2d 12 (Tex. App.-Houston 1999).
 Baskies & Samuels in "Aggressive Viatical Settlement Transactions: Gambling on Human
Lives," 28 Est. Plan. 76 (Feb. 2001). Mayer, Brown & Platt, The Financial Services Regulatory Report, Vol. 8, No. 2
(March/April 2001). J. Blattmacher, "Assigning
Insurance Policies to Charities," CPA Journal (
 "Disbelief greets state plan to profit from Dead Teachers Society," San Antonio Express News 12/13/2003; "Betting on the Lives of Teachers," Houston Chronicle 12/11/2003; "Texas could turn a profit by insuring Dead Teachers Society," San Antonio Express News 12/10/2003; "Former Senator Proposes Teacher-Pension Venture," Knight Ridder 12/05/2003; "Texas Considers Teacher Pension Plan that Depends on Death," Houston Chronicle 12/05/2003.
 For an extensive guideline in the banking field which provides many of the same questions that should be asked in the charitable area, see OCC Bulletin 2000-23, "Bank Purchases of Life Insurance: Guidelines for National Banks," dated July 20, 2000, OCC 2002-19 Unsafe and Unsound Investment Portfolio Practices.
Blum, "For Charities, a New Twist in Raising Money: Corporate Investors in
Life-Insurance Policies," Chronicle of Philanthropy, August 12, 1999. Theo
Francis and Ellen Schulz, "Dying to Donate: Charities Invest in Death
Benefits," The Wall Street Journal, February 6, 2003; Tom Gascoyne, "Death Dividends or Creative
 Wendy Davis, "Death-Pool Donations", Trusts and Estates, May 2004.