Investor Initiated Life Insurance Arrangements
"Free" Life Insurance Might Not Be Such a Good Deal

A secondary life insurance market has been maturing in recent years, and that is a good deal for thousands of Americans who no longer need, or can no longer afford, the life insurance policies they purchased years ago. The emergence of the secondary market has created an alternative to surrendering policies for their cash value; a policy now can be sold to investors on the secondary market, sometimes for many multiples of the policy's cash value.

But some in the life insurance industry are using the existence of the secondary market as a pitch to sell more life insurance. And that is when buyers must beware: "free" life insurance is not always a good deal.

The typical customer for this "free" life insurance is 70 years or older and wealthy. The insurance agent presents what sounds like a risk-free, no-cost life insurance plan:

· The agent will sell and the customer will buy a new life insurance policy, typically with a death benefit of several million dollars. The customer will not pay any premiums on the policy. Instead, the agent already has arranged for a finance company to advance funds for the premiums.

· The policy would be owned by an irrevocable trust, and the customer's family members would be the beneficiaries of that trust. The financing company would lend funds to the trust, which the trustee would use to pay the insurance premiums. The financing company might also capitalize the interest on that loan so that the customer would have to pay little or nothing with respect to the policy in the first couple of years. That loan would have to be repaid in 2 to 5 years.

· If the customer passes away during the initial loan term, the irrevocable trust would collect the life insurance proceeds, repay the loan, and distribute the remaining insurance proceeds to the trust beneficiaries (the customer's family members). If, on the other hand, the customer survives for at least two years after the policy is issued, then the trust could sell the policy on the secondary market, repay the loan, and distribute the remaining sales proceeds to the trust beneficiaries (the customer's family members). In either case, the agent says, the customer's family gets a windfall.

Proposals such as this – there are many variations of this basic arrangement – are known in the industry as "investor initiated life insurance," "investor owned life insurance," or "stranger owned life insurance." These arrangements are not necessarily illegal, but they are risky, and the customer bears all of the risk. Consider, for instance:

1. Not all policies can be sold on the secondary market. The buyers of life insurance policies (these typically are big investment companies) are seeking to earn a good return on their investment, so they look for policies that will require little investment and a not-too-distant payoff. That is, they look for policies on the lives of unhealthy people. A healthy insured might find that investors are not interested in buying the policy on her life. In that case, the following options would be available:

· the customer could keep the policy, using her own money to repay the loan and accumulated interest and to pay future premiums; or

· the customer could try to refinance the loan with the same or a different finance company.

2. The insurance company potentially could void the policy after it is issued, based on a theory of fraud or lack of insurable interest. Every state's laws limit the issuance of life insurance policies to those who expect an economic benefit from the continued life of the insured. The purpose of these "insurable interest" laws is to prevent the purchase of life insurance policies for mere economic speculation, wherein one might benefit from the early death, rather than the continued life, of the insured. If a new life insurance policy is issued, and then sold on the secondary market a few years later, the insurance company might have an argument that the policy should be voided because it was acquired for the purpose of later selling it to someone with no insurable interest in the insured's life.

3. The customer must have some economic risk. Some of the early investor initiated life insurance arrangements used 100% non-recourse loans. In those cases, the customer had nothing to lose if the policy could not be refinanced or sold on the secondary market or if the insurance company voided the policy. Those arrangements primarily benefited of the investor and insurance agent, and only incidentally benefited the customer or his family. For that reason, insurance companies now require that the customer (or someone with an insurable interest in the customer) have some economic risk. That usually is done either by posting collateral equal to 25% of the premium loans and accumulated interest, or by giving a limited personal guaranty for the same amount. Thus, if the policy cannot be refinanced or sold on the secondary market, or if the insurance company voids the policy, then the customer stands to lose his collateral or become liable on the personal guaranty.

4. The customer bears most of the risk. The insurance agent involved in the transaction is sure to make his commission when the policy is sold. The premium financing company is sure to make its profit on the interest (usually 12-15%) that it charges. The customer is the only one without a guaranteed payout, and he or she bears the risk of loss if the policy cannot be sold on the secondary market or refinanced after a couple of years.

5. These arrangements are document intensive. Investor initiated life insurance arrangements often involve up to 25 separate legal documents. The customer either would incur a significant cost in having a lawyer review and comment on those documents, or incur a substantial risk by signing the documents without fully understanding them. Since the documents are drafted by the finance company's attorney, they likely will be very favorable to the finance company.

6. The customer might not be able to get more life insurance in the future. The amount of insurance that can be issued on a person's life is limited. If a new policy is issued on through an investor initiated life insurance arrangement, and later sold on the secondary market, the customer might not be able to get additional life insurance in the future if the need arises.

7. The purchaser of the policy would have access to the customer's medical records. If a person sells her life insurance policy on a secondary market, she would have to agree that the purchaser (including any subsequent purchaser if the policy is resold) would have access to her medical records for the rest of her lifetime.

8. Someone else might control the sale of the policy. Many investor initiated life insurance arrangements incorporate Minnesota law in an effort to take advantage of Minnesota's liberal insurable interest and lending rules. For that reason, the life insurance policies often are held in irrevocable trusts with a Minnesota bank as trustee. The Minnesota trustee, and not the customer or the customer's family, could have ultimate control over whether the policy is sold, when, to whom, and for how much.

9. The law might change. Life insurance companies have good reasons to dislike investor initiated life insurance arrangements. First, policies that are sold on the secondary market are less likely to lapse, and that may have an adverse effect on the profitability of insurance companies. Second, life insurance traditionally has been used to provide for an insured's family or business partners (those who are economically dependent upon the insured and who have an interest in the insured's continued life). For these reasons, life insurance generally enjoys favorable tax treatment under the Internal Revenue Code. If life insurance is used as an investment vehicle, much like stocks and bonds, then Congress might be inclined at some point to eliminate the favorable income tax treatment currently available for insurance products.

Also, the National Association of Insurance Commissioners is continuing to study the life insurance secondary market, and in particular investor initiated life insurance, spurred by well-publicized abusive practices. The Financial Industry Regulatory Authority (FINRA), formerly known as the National Association of Securities Dealers (NASD), considers life settlements (the sale of life insurance policies on the secondary market) with respect to variable life insurance policies to be securities, and thus subject to suitability analysis and a host of state and federal securities laws. The National Conference of Insurance Legislators (NCOIL) has drafted a proposed model act to regulate life settlements and the Indiana General Assembly is considering legislation to make the sale of investor initiated life insurance a fraudulent act. Thus, it would not be surprising if the industry or government tightens the rules in an effort to bring some order to the life settlements industry, particularly investor initiated life insurance arrangements.

The internet is rife with reports of people who have profited through investor initiated life insurance arrangements. But those reports almost all originate with promoters of these arrangements. Though less publicized, many reputable life insurance agents have attempted to assist clients whose investor initiated policies could not be refinanced or sold at a price sufficient to repay the initial premium loans. Those agents would say that investor initiated life insurance arrangements can carry meaningful risks to the customer and his family.

Before making a decision about an investor initiated life insurance arrangement, please call Kevin Alerding, Gordon Wishard, or another member of Ice Miller's Personal Services Group.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.