Insurable Interest Under Siege

Insurable Interest Under Siege

Article posted in Intangible Personal Property on 10 May 2004| 2 comments
audience: National Publication | last updated: 18 May 2011
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Summary

For the past several decades, life insurance has been used in connection with charitable giving as both a gift vehicle and as a wealth replacement tool. In this white paper, commissioned by Leimberg Information Services, Inc., Michel Nelson from Iowa Savings Bank discusses a new arrangement whereby large numbers of individuals lend their insurable interests to a charity, which through sophisticated premium financing techniques then appears to receive millions of dollars of life insurance at no cost to the charity or the insureds. Next week we will publish Part II in this series, "Charities and Insurance: The Next Big Thing?" by attorney Larry Bell, and then let you decide.

Leimberg Information ServicesBy Mike Nelson
Edited by Steve Leimberg

Life insurance has always been and remains one of the most unique and important of all estate, employee benefit, and charitable planning tools. Unfortunately, because of the inherent complexity of both the product itself and the laws surrounding it, life insurance has been - particularly in recent years - one of the most abused of all planning tools.

The use and abuse of life insurance follows a constant ebb and flow.

FIRST WAVE: CHARITABLE TAX SCHEMES:

Lately, there have been a series of unusual life insurance plans pitched to charities. The first wave involved taxes. Just a few years ago, we witnessed the rapid proliferation of charitable split dollar plans and their mutation into reverse charitable split dollar plans that had a significant tax avoidance/evasion component. They were promptly, fiercely, and successfully attacked by the IRS. (See Addis v. Commissioner, 118 T.C. No. 32 (2002); Weiner v. Commissioner, T.C. Memo 2002-153.) These plans now reside in the graveyard of futile reduction schemes. But widespread concern remains in Congress, Treasury, and at the IRS about abuses of and by public charities and private foundations.

SECOND WAVE: SOMETHING FOR NOTHING?

The newer wave of proposed plans do not seek current tax deductions. Rather, they are pitched to charities on the premise the charity will receive a cash payment or significant future income without having to invest any money.

Leimberg Information Services commissioned Michel Nelson of Iowa Savings Bank, to draft a special whitepaper on the topic. This is Mike's most informative report.

CHARITY'S ROLE:

The charity provides two main things.

1. Supporters of the charity willing to be "insureds" on policies of life insurance where they will not personally benefit.

2. The use of the looser "insurable interest" statutes that apply to charities when they are the "owners" of life insurance policies insuring the lives of individuals.

LIFE INSURANCE CAN BE LEGITIMATE CHARITABLE PLANNING TOOL:

At the outset, it should be made clear that there are numerous opportunities for charities to appropriately and safely use life insurance within both the letter and the spirit of the law. For example, it is entirely appropriate for a charity to consider life insurance to address the threat posed by the possible death of a key donor. It is also appropriate to consider accepting existing policies as gifts in some circumstances (see 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 and Leimberg and Zaritsky, Tax Planning With Life Insurance - 800 950 1216) or to consider a life settlement for policies that the charity might own. (see Breitstein, Joel, Innovative Strategies for Using Life Insurance in Charitable Giving, Estate Planning, Vol. 31, No. 2 (February 2004).)

THE DEAD POOL:

Unlike the viatical industry, where agents and promoters seek out public investors to put up cash to purchase individual existing (or "wet") policies in the hope that an early death will provide an outsize return, the newer charitable plans are driven by more sophisticated pools of individual and institutional capital that see an opportunity to invest in pools of life insurance policies.

As quoted by Bob Plybon, President of the Association for Advanced Life Underwriting (AALU), proponents of this arrangement explain that, ".... the only way to capture the value associated with insurance arbitrage is to turn insurance into a capital markets product." Since the promoters of these pools of capital cannot safely approach individuals and "purchase" their insurability because of insurable interest requirements, they look to use charities as intermediaries to do by indirection what they can not do directly, avoid state insurable interest rules.

HOW NEW YORK'S INSURANCE DEPARTMENT REACTED:

There are infinite varieties of this arrangement but a common theme - the charity gets something for nothing when it provides a pool of individuals willing to indirectly provide a third party investor organization their insurable interest to purchase life insurance.

A description of the general idea is provided in the July 7, 2003 opinion issued by the State of New York Insurance Department in response to the question of, Does this proposal violate New York's insurable interest laws?

"One or more charitable organizations formed under New York or another state's laws and qualifying under sections 170(c) and 501(c)(3) of the Internal Revenue Code ("Sponsor") will form a Delaware statutory trust ("Issuer Trust"). The Sponsors will own the entire beneficial interest of the Issuer Trust, which will be formed as a bankruptcy remote special purpose vehicle solely for the purpose of issuing and offering collateralized endowment bonds (the "Bonds"). The Bonds will be collateralized by guaranteed premium universal life insurance policies ("Policies") and single premium immediate annuities issued with respect to the lives of individuals associated with the Sponsors ("Associates") for the benefit of the holders of the Bonds. At the close of the bond offering, the Issuer Trust will transfer the proceeds from the sale of the Bonds to the Sponsor in an amount sufficient for the Sponsor to purchase the Policies and Annuities. The Sponsor will then immediately assign all benefits and rights under the Policies and Annuities to the Issuer Trust who will in turn pledge such benefits and rights as collateral to a trustee (Trustee) under an indenture of trust (Indenture), for the benefit of the bondholders. The Sponsor remains the owner of the Policies and Annuities and the beneficiary under the Policies and Annuities while the Bonds are outstanding. After the Bonds are paid in full, the Policies and Annuities will be released as collateral and returned to the Sponsor. The transaction will require a pool of approximately 100 Associates (residents and non-residents of New York), each of whom will provide written consent to the Sponsor to purchase, own and name itself as beneficiary of a Policy and otherwise acquire an insurable interest in such Associate's life. Each Associate will also consent to the pledging of the Policy as collateral under the indenture."

The opinion letter found that the proposal was not acceptable under the New York Insurance Law.

WHY ALL THE FUSS?

Charities have a long history of lending their name to commercial entities in exchange for a consideration. For example:

· Credit card vendors issuing cards in the charity's name and using the charity's mailing list

· Providing mailing lists to casualty and property insurance vendors

· Engaging professional telephone solicitors even though only a nominal amount of the funds raised go for charitable purposes

What concerns should be raised if the product involved this time is life insurance instead of the more traditional tie-ups?

1. If significant pools of capital are seeking to engage in life insurance arbitrage, the financial threat to life companies offering mis-priced products is much higher than they are currently facing.

2. The specific aiming of the proposed pools at no-lapse guarantee universal life products almost certainly means that the promoters think that some of them are under-priced. Professor Joseph Belth1 told me that, "The whole thing depends on finding mispriced life insurance policies." Assumed lapse rates are built into the pricing of some of the available product, thereby lowering the premium charged. Where investment pools are involved, those lapse rate assumptions are almost certainly invalid because the decision on whether to continue the required minimum premium payment is not going to be made by individual insureds. In other words the main underlying economic basis of the arrangement and its probability of success (for the charity) is suspect.

3. "Wagering" on human life is contrary to long-standing public policy standards.

4. Charities urging participation by their patrons may harm the donor's personal interests since the death benefit assigned to the donor's life may prevent the donor from getting all of the death benefit coverage he/she might later need for their own personal purposes. In other words, an insurer may decline to issue future personal or business coverage if it knows about large amounts of already existing policies. There is a limit to the amount of insurance an insurance company will issue on any given life.

5. Since the charity's ownership interest in the policies serves as collateral for the underlying bonds, there is a significant (and perhaps intentional) possibility that the charity would either have to put in additional capital at a later date or lose their ownership interest to the investment pool. I say perhaps intentional, because the investment pool could be significantly more profitable if they did not have to share with the charity and if their otherwise taxable investment return could be transformed into tax-free life insurance death proceeds. Congress might view the use of life insurance to benefit private investment consortiums in this manner as a legislative excuse to diminish life insurance's current significant tax advantages under the tax code.

6. Promoters of these arrangements are strongly lobbying state legislators to amend their state's insurable interest laws to make these plans possible. That current legislative push to amend state charitable insurable interest statutes increases the risk to insurers and insureds while only nominally benefiting charities.

7. Tax qualified charities are tax exempt. Ideas that are appropriate and make sense in a non-charitable individual or taxable environment should be viewed with a jaundiced eye by a charity when tax savings are irrelevant.

UBTI AND PRIVATE BENEFIT - IS THERE A PROBLEM HERE?

In considering these charitable life programs, a myriad of issues exist. If a charity is seriously considering participating, they will absolutely have to receive assurances (READ PLR) from competent counsel regarding possible unrelated business tax income (UBTI) and whether the plan violates "private benefit" rules.

This article does not address those issues. I've attempted to focus on the core. How do these plans interrelate with fundamental insurable interest issues? Are they feasible and do they provide more than an incidental benefit to participating charities?

INSURABLE INTEREST - WHAT IS IT AND WHY DO WE HAVE SUCH LAWS?

"Insurable interest" requirements are generally thought of as a public policy arising from repugnance at the thought of wagering on human life. Pending state legislation across the country would gut the insurable interest concept and permit third parties to purchase life insurance contracts on third parties with only the most trivial requirements. (A compilation of the existing state insurable interest laws as they apply to charities is available to members at Leimberg Information Services under the STATE LAWS tab.)

ATTEMPTS TO WEAKEN INSURABLE INTEREST LAWS:

At least part of the explanation for success of those arguing for a loosening of the insurable interest requirement is the inclination of legislators to equate the rationale for insurable interest requirements to the rationale for the control of gambling and other "sinful" behaviors.

Consider the following excerpt from a bill pending in Oklahoma. The mark-up shows changes from the existing law.

State of Oklahoma - 2nd Session of the 49th Legislature (2004)

Committee Substitute for Engrossed Senate Bill No. 522

D. Life insurance contracts and annuity contracts may be entered into in which the person paying the consideration for the insurance has no insurable interest in the life of the individual insured, where charitable if:

1. Charitable, benevolent, educational or religious institutions, or their agencies, are designated as the beneficiary or beneficiaries thereof;

2. Organizations or entities to whom a charitable contribution could be made under Section 170(c)(1) of the Internal Revenue Code are designated as the beneficiary or beneficiaries thereof; or

3. A trust, corporation, partnership, association, limited liability company, or other legal entity approved in writing by a charitable, benevolent, educational or religious institution, or agency thereof, or organizations or entities to whom a charitable contribution could be made under Section 170(c)(1) of the Internal Revenue Code with the written consent of the individual insured is designated as the beneficiary or beneficiaries thereof.

In no event shall an individual be named as a beneficiary. In making these contracts, the person paying the premium shall make and sign the application therefor as owner and shall designate a charitable, benevolent, educational, or religious institution, or an agency thereof, the institution, agency, organization, or entity described in paragraph 1, 2, or 3 of this subsection as the beneficiary or beneficiaries of the contract. The application or any subsequent change of beneficiary designation shall be signed by the individual whose life is to be insured. These contracts shall be valid and binding among the parties, notwithstanding the absence otherwise of an insurable interest in the life of the individual insured.

With a statute like this, it is hardly difficult to imagine the wholesale marketing of life insurance contracts to insureds for the investment purposes of totally unrelated third parties. In exchange for a cash payment (or a sliver of the death proceeds) to the person being insured and a nominal payment to the charity, it will be possible to do what has long been forbidden - wager on human life.

MURDER SHE WROTE?

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. The proposed changes and attempts to turn life insurance into a third party investment vehicle shatter this harmony and sound philosophy.

Consider this concept in the setting of other types of insurance. Would you sell fire insurance to someone who is in favor of his building burning down because it would greatly benefit him? Would you sell car insurance to someone who announces that he hopes a crash occurs so that he can get a decent car?

A SERIOUS THREAT TO LIFE INSURANCE'S CONTINUED FAVORABLE TAX STATUS!

The second major objection to the assault on insurable interest requirements is that it poses a major threat to the continued favorable tax status of life insurance. If life insurance is transformed into an investment vehicle instead of a system to make-up for a loss, why should it not be subject to taxes in the same manner as any other investment? This would indeed be the case of killing the goose that has consistently laid golden eggs.

WHY IS WAGERING ON SOMEONE'S LIFE AGAINST PUBLIC POLICY?

Under English common law there was no prohibition against wagering on someone else's life using an insurance contract. This changed in 1774 with the adoption of the English Life Assurance Act.

The Act was composed of three parts:

· The purchase of insurance on someone was forbidden unless the purchaser/owner had an interest in the life being insured.

· The contract had to include the name of the person or entity on whose account the policy was underwritten and made for.

· Recovery under the contract was limited to the interest of the purchaser in the life being insured.

In 1845, the Gaming Act was adopted. It provided in part that, ".... contracts or agreements, whether by parole or in writing, by way of gaming or wagering shall be null and void."

It is useful to look in detail at the seminal case decided by the United States Supreme Court.

A 27 year old tanner entered into an agreement with the Scioto Trust Association. The Association agreed to pay all expenses and premiums for a $5,000 life policy in return for an assignment of the insured's interest in the policy. The Association agreed to pay 10% of the death benefits less certain expenses to the insured's widow. The following year, the tanner died.

The Court opined that:

"It is not easy to define with precision what will in all cases constitute an insurable interest, so as to take the contract out of the class of wager policies. It may be stated generally, however, to be such an interest, arising from the relations of the party obtaining the insurance, either as a creditor of or surety for the assured, or from the ties of blood or marriage to him, as will justify a reasonable expectation of advantage or benefit from the continuance of his life. It is not necessary that the expectation of advantage or benefit should be always capable of pecuniary estimation; for a parent has an insurable interest in the life of his child, and a child in the life of his parent, a husband in the life of his wife, and a wife in the life of her husband. The natural affection in cases of this kind is considered as more powerful - to protect the life of the insured than any other consideration.

But in all cases there must be a reasonable ground, founded upon the relations of the parties to each other, either pecuniary or of blood or affinity, to expect some kind of benefit or advantage from the continuance of the life of the assured. Otherwise the contract is a mere wager, by which the party taking the policy is directly interested in the early death of the assured. Such policies have a tendency to create a desire for the event. They are, therefore, independently of any statute on the subject, condemned, as being against public policy." Warnock v. Davis, 110 U.S. 775, 779 (1881).

Consider that under lax insurable interest standards available by using a charitable conduit, such as permitted by the pending bill in Oklahoma, we would have the same situation that the United States Supreme Court condemned above - with one small exception. That exception being that a qualified charity would receive some nominal sliver of the death benefit or cash.

It is to be expected that charities would be "shopped" to find the one willing to accept the smallest possible sliver. The payment would likely be very small, since something is generally perceived to be better than nothing. In weighing the balance, could a few dollars possibly be considered a great enough benefit to society to outweigh the harm caused by losing the protection of insurable interest requirements?

Other US Supreme Court cases have nibbled at the edges of Warnock (see Grigsby v. Russell, 222 U.S. 149 (1911) where an assignment years after the policy was taken out for the purpose of financing a surgical operation was permitted), but the core principle remains intact.

A LOOK AT THE PLANS

Although insurable interest concerns are paramount in this discussion, it is also appropriate to examine some of the charitable life insurance plans currently being promoted. Financial feasibility of the plans ranges from the absurd to near certainty.

One current plan promotes the combination of a single premium annuity and a no lapse guarantee universal life policy. A typical pool would include 100 such policies.

The following illustration was constructed from the actual illustrations distributed by the plan's promoter.

The Charitable *********** and ************** Plan

Male, 75, Standard, Non-smoker

  • Flat 1,000,000 death benefit
  • $47,660 premium for 24 years, none thereafter
  • $1,000,000 death benefit shown at age 104 (year 30), but goes to age 116
  • There is a "no lapse policy guarantee" if the specified premiums are paid when due





5.2%



Available




Loan
Loan
No Lapse


Death

Loan
Annuity
Repay

Interest

Guarantee

Death
Cash to

Benefit

Age

Year

Amount

Payment

- Princ.

Paid

Premiums

Benefit

Charity

for Charity


start

1,000,000








75

1

990,196

113,043

9,804

52,000

47,660

1,000,000

3,579

9,804

76

2

979,882

113,043

10,314

51,490.19

47,660

1,000,000

3,579

20,118

77

3

969,032

113,043

10,850

50,953.86

47,660

1,000,000

3,579

30,968

78

4

957,618

113,043

11,414

50,389.66

47,660

1,000,000

3,579

42,382

79

5

945,610

113,043

12,008

49,796.14

47,660

1,000,000

3,579

54,390

80

6

932,978

113,043

12,632

49,171.72

47,660

1,000,000

3,579

67,022

81

7

919,688

113,043

13,290

48,514.86

47,660

1,000,000

3,579

80,312

82

8

905,708

113,043

13,980

47,823.78

47,660

1,000,000

3,579

94,292

83

9

891,001

113,043

14,707

47,096.82

47,660

1,000,000

3,579

108,999

84

10

875,529

113,043

15,472

46,332.05

47,660

1,000,000

3,579

124,471

85

11

859,253

113,043

16,276

45,527.51

47,660

1,000,000

3,579

140,747

86

12

842,130

113,043

17,123

44,681.16

47,660

1,000,000

3,579

157,870

87

13

824,117

113,043

18,013

43,790.76

47,660

1,000,000

3,579

175,883

88

14

805,167

113,043

18,950

42,854.08

47,660

1,000,000

3,579

194,833

89

15

785,231

113,043

19,936

41,868.68

47,660

1,000,000

3,579

214,769

90

16

764,258

113,043

20,973

40,832.01

47,660

1,000,000

3,579

235,742

91

17

742,197

113,043

22,061

39,741.42

47,660

1,000,000

3,579

257,803

92

18

718,987

113,043

23,210

38,594.24

47,660

1,000,000

3,579

281,013

93

19

694,571

113,043

24,416

37,387.32

47,660

1,000,000

3,579

305,429

94

20

668,884

113,043

25,687

36,117.69

47,660

1,000,000

3,579

331,116

95

21

641,862

113,043

27,022

34,781.97

47,660

1,000,000

3,579

358,138

96

22

613,435

113,043

28,427

33,376.82

47,660

1,000,000

3,579

386,565

97

23

583,530

113,043

29,905

31,898.62

47,660

1,000,000

3,579

416,470

98

24

552,069

113,043

31,461

30,343.56

47,660

1,000,000

3,579

447,931

99

25

471,313

113,043

80,756

28,707.59


1,000,000

3,579

528,687

100

26

386,357

113,043

84,956

24,508.28


1,000,000

3,579

613,643

101

27

296,984

113,043

89,373

20,090.56


1,000,000

3,579

703,016

102

28

202,963

113,043

94,021

15,443.17


1,000,000

3,579

797,037

103

29

104,053

113,043

98,910

10,554.08


1,000,000

3,579

895,947

104

30

-

113,043

104,053

5,410.76


1,000,000

3,579

1,000,000















1,000,000

1,140,079.36

1,143,840


107,370


In the specific plan above, the promoter recites that the pool will provide $1,000,000 to be used to purchase a single premium immediate annuity (SPIA) that will pay $113,043 annually for the rest of the insured's life.

Funds remaining after payment of the life insurance premium are used to pay interest on the loaned amount at 5.2% and to reduce the principal due on the bonds. A payment of $3,579 is shown as going annually to the charity. I assume that the numbers shown are net of commissions paid to the agent by the SPIA issuer and the life policy insurer. Note: The name of the life insurance companies offering the SPIA and life policy are intentionally redacted, as is the trade name of the illustrated plan.

The illustration provided by the promoter does not include any provision for payment of administrative or trustee fees. This is not realistic. One might assume that the payment shown going to the charity could be for that purpose, except that the accompanying material touts "annual donations to the Donor's charity". Since the illustration provided did include specific issuing companies (although the illustration was an Excel spreadsheet), I checked on the premium recited and found that it was incorrect. I have modified the same basic illustration to reflect the correct premium number of $54,074.

   
Available





Loan
at 5.2%

Flat

Death

Insureds

Loan
Annuity
Available
Repay

Loan


Death

Cash to

Benefit

Age

Year

Amount

Payment

Funds

Principal

Interest

Premiums

Benefit

Charity

for Charity


start

1,000,000









75

1

996,610

113,043

3,390

3,390

52,000

54,074

1,000,000

3,579

3,390

76

2

993,043.72

113,043

3,566.28

3,566.28

51,823.72

54,074

1,000,000

3,579

6,956.28

77

3

989,291.99

113,043

3,751.73

3,751.73

51,638.27

54,074

1,000,000

3,579

10,708.01

78

4

985,345.18

113,043

3,946.82

3,946.82

51,443.18

54,074

1,000,000

3,579

14,654.82

79

5

981,193.13

113,043

4,152.05

4,152.05

51,237.95

54,074

1,000,000

3,579

18,806.87

80

6

976,825.17

113,043

4,367.96

4,367.96

51,022.04

54,074

1,000,000

3,579

23,174.83

81

7

972,230.08

113,043

4,595.09

4,595.09

50,794.91

54,074

1,000,000

3,579

27,769.92

82

8

967,396.04

113,043

4,834.04

4,834.04

50,555.96

54,074

1,000,000

3,579

32,603.96

83

9

962,310.64

113,043

5,085.41

5,085.41

50,304.59

54,074

1,000,000

3,579

37,689.36

84

10

956,960.79

113,043

5,349.85

5,349.85

50,040.15

54,074

1,000,000

3,579

43,039.21

85

11

951,332.75

113,043

5,628.04

5,628.04

49,761.96

54,074

1,000,000

3,579

48,667.25

86

12

945,412.05

113,043

5,920.70

5,920.70

49,469.30

54,074

1,000,000

3,579

54,587.95

87

13

939,183.48

113,043

6,228.57

6,228.57

49,161.43

54,074

1,000,000

3,579

60,816.52

88

14

932,631.02

113,043

6,552.46

6,552.46

48,837.54

54,074

1,000,000

3,579

67,368.98

89

15

925,737.83

113,043

6,893.19

6,893.19

48,496.81

54,074

1,000,000

3,579

74,262.17

90

16

918,486.20

113,043

7,251.63

7,251.63

48,138.37

54,074

1,000,000

3,579

81,513.80

91

17

910,857.48

113,043

7,628.72

7,628.72

47,761.28

54,074

1,000,000

3,579

89,142.52

92

18

902,832.07

113,043

8,025.41

8,025.41

47,364.59

54,074

1,000,000

3,579

97,167.93

93

19

894,389.34

113,043

8,442.73

8,442.73

46,947.27

54,074

1,000,000

3,579

105,610.66

94

20

885,507.59

113,043

8,881.75

8,881.75

46,508.25

54,074

1,000,000

3,579

114,492.41

95

21

876,163.98

113,043

9,343.61

9,343.61

46,046.39

54,074

1,000,000

3,579

123,836.02

96

22

866,334.51

113,043

9,829.47

9,829.47

45,560.53

54,074

1,000,000

3,579

133,665.49

97

23

855,993.90

113,043

10,340.61

10,340.61

45,049.39

54,074

1,000,000

3,579

144,006.10

98

24

845,115.58

113,043

10,878.32

10,878.32

44,511.68

54,074

1,000,000

3,579

154,884.42

99

25

833,671.60

113,043

11,443.99

11,443.99

43,946.01

54,074

1,000,000

3,579

166,328.40

100

26

767,558.52

113,043

66,113.08

66,113.08

43,350.92


1,000,000

3,579

232,441.48

101

27

698,007.56

113,043

69,550.96

69,550.96

39,913.04


1,000,000

3,579

301,992.44

102

28

624,839.95

113,043

73,167.61

73,167.61

36,296.39


1,000,000

3,579

375,160.05

103

29

547,867.63

113,043

76,972.32

76,972.32

32,491.68


1,000,000

3,579

452,132.37

104

30

466,892.75

113,043

80,974.88

80,974.88

28,489.12


1,000,000

3,579

533,107.25

















533,107.25

1,398,962.75

1,351,850


107,370


You will notice that the margins get very tight. An increase in borrowing, administrative, or trustee costs of approximately 34 bps on the original amount borrowed will turn the cash flow negative until the insured reaches age 100 - certainly a violation of the lender's collateral requirements.

The same increase would eliminate the availability of any death benefit for the charity until the same age - 100. The actual illustration obtained from the insurance company using the corrected $54,074 premium shows a -0- cash value at all times based on a minimum interest rate and maximum charges and a -0- cash value by year 17 (age 91) using 5.70% for 20 years, then 6.05% thereafter with current charges.

Using the same insured details, the annual premium cost from the particular AAA insurer I asked was $85,486.94 for a no-lapse guarantee (NLG) to age 100 - a NLG was not available past 100. Clearly, policy costs differ.

Where there are pools of multiple policies, consider the significant cost and difficulty of tracking the insureds. How are you going to know when they die? Probably the only practical way to do it is to reserve a significant death benefit for them so that the family will advise the current owner of the death event. Sharing the death benefit will further diminish any possible profitability of the plan.

THERE ARE LIES, DAMN LIES, AND EXCEL SPREADSHEET LIES

What Benjamin Disraeli might have said in 2004

Not all of the plans being pitched reach the feasibility level of the foregoing plan. The following plan was presented to a college development office that in turn sent it to me for comment. In summary, the proposal provided that:

· The college would provide 1,000 insurable donors who were willing to apply for a $250,000 universal life policy.

· The college would be the owner and beneficiary of the policies.

· The promoter would provide full financing in the total amount of $5,700,000 at 7% per annum that would cover all costs incurred including the promoter's upfront fee of $800,000 and an upfront $400,000 going to the lender/trustee. The college was not required to provide any funds and would not be responsible for the amount borrowed. The loan would be collateralized solely by the insurance policies.

Unlike the proposal discussed above, this plan just doesn't work. There simply aren't any insurance companies offering policies like the 1,000 described in the illustration provided to the college. (The illustration is stacked vertically in two pieces to fit the available width and maintain a reasonable type size.)



Death


Cash to

Policy Cash



Benefits

Premiums

Charity

Value

Start






End of Year

1

354,364

4,340,300

0

2,541,802

End of Year

2

557,130

0

36,913

2,330,551

End of Year

3

903,469

286,433

58,034

2,391,806

End of Year

4

1,105,692

555,115

94,111

2,439,196

End of Year

5

1,268,118

650,045

100,000

2,638,262

End of Year

6

1,462,214

582,443

200,000

2,375,174

End of Year

7

1,701,835

650,743

200,000

2,086,559

End of Year

8

1,967,698

642,681

200,000

1,692,755

End of Year

9

2,269,725

853,389

400,000

1,393,111

End of Year

10

2,614,446

1,085,956

400,000

1,336,310

End of Year

11

2,955,282

1,802,792

400,000

1,406,927

End of Year

12

3,297,136

1,850,459

600,000

1,401,722

End of Year

13

3,766,312

2,175,726

700,000

1,643,592

End of Year

14

4,321,149

2,280,034

700,000

1,566,597

End of Year

15

4,752,287

2,694,250

1,500,000

1,603,711

End of Year

16

5,173,884

3,618,008

3,810,080

1,469,143

End of Year

17

5,507,190

3,899,441

1,607,749

1,442,292

End of Year

18

5,826,659

4,170,904

1,655,755

1,465,451

End of Year

19

6,138,049

4,894,592

1,243,457

1,254,545

End of Year

20

6,428,815

5,062,011

1,366,804

969,224

End of Year

21

6,705,955

5,531,686

1,174,269

1,076,957

End of Year

22

6,963,723

4,860,204

2,103,519

923,538

End of Year

23

7,198,409

5,370,326

1,828,083

1,119,700

End of Year

24

7,398,003

5,763,587

1,634,416

1,175,858

End of Year

25

7,637,877

5,652,762

1,985,115

1,257,213

End of Year

26

8,770,541

6,037,253

2,733,288

1,027,720

End of Year

27

8,858,409

5,041,433

3,816,976

935,839

End of Year

28

8,706,900

5,019,535

3,687,365

787,595

End of Year

29

8,514,530

5,645,735

2,868,795

539,703

End of Year

30

8,350,463

5,751,268

2,599,195

402,677

End of Year

31

8,311,125

5,884,425

2,426,700

460,748

End of Year

32

7,957,638

4,972,803

2,984,835

586,961

End of Year

33

7,600,437

4,534,584

3,065,853

617,339

End of Year

34

7,243,949

4,379,934

2,864,015

610,094

End of Year

35

7,059,953

4,567,993

2,491,960

596,411

End of Year

36

7,246,551

4,463,204

2,783,347

531,259

End of Year

37

6,488,783

2,552,879

3,935,904

335,848

End of Year

38

6,074,785

2,379,722

3,695,063

270,173

End of Year

39

5,607,552

2,346,068

3,261,484

213,158

End of Year

40

5,132,556

2,308,282

2,824,274

184,796

End of Year

41

4,551,519

2,222,401

2,329,118

159,849

End of Year

42

4,985,413

1,054,991

3,930,422

48,091

End of Year

43

4,006,504

339,192

3,667,312

51,214

End of Year

44

3,740,788

322,012

3,418,776

37,883

End of Year

45

3,289,048

311,506

2,977,542

25,016

End of Year

46

2,437,467

288,574

2,148,893

7,570

End of Year

47

1,941,997

47,875

1,894,122

1,772

End of Year

48

1,771,497

0

1,771,497


End of Year

49

1,618,719

0

1,618,719


End of Year

50

1,457,456

0

1,457,456








TOTALS


240,000,001

139,745,556

95,251,216



   

Lender/


Death


Loan

Principal

Interest

Trustee

Earns 7%



Benefits

Premiums

Balance

Repayment

Payment

Fees Paid

Escrow Acct.

Start








End of Year

1

354,364

4,340,300

5,700,000

0

399,000

1,225,000

90,064

End of Year

2

557,130

0

5,600,000

100,000

399,000

25,000

92,585

End of Year

3

903,469

286,433

5,500,000

100,000

392,000

25,000

139,068

End of Year

4

1,105,692

555,115

5,400,000

100,000

385,000

25,000

95,268

End of Year

5

1,268,118

650,045

5,300,000

100,000

378,000

25,000

117,010

End of Year

6

1,462,214

582,443

5,100,000

200,000

371,000

25,000

208,972

End of Year

7

1,701,835

650,743

4,900,000

200,000

357,000

25,000

492,692

End of Year

8

1,967,698

642,681

4,700,000

200,000

343,000

25,000

1,084,218

End of Year

9

2,269,725

853,389

4,300,000

400,000

329,000

25,000

1,412,449

End of Year

10

2,614,446

1,085,956

3,900,000

400,000

301,000

25,000

1,913,811

End of Year

11

2,955,282

1,802,792

3,500,000

400,000

273,000

25,000

2,102,267

End of Year

12

3,297,136

1,850,459

2,900,000

600,000

245,000

25,000

2,226,102

End of Year

13

3,766,312

2,175,726

2,200,000

700,000

203,000

25,000

2,344,513

End of Year

14

4,321,149

2,280,034

1,500,000

700,000

154,000

25,000

2,970,744

End of Year

15

4,752,287

2,694,250

0

1,500,000

105,000

25,000

2,106,733

End of Year

16

5,173,884

3,618,008






End of Year

17

5,507,190

3,899,441






End of Year

18

5,826,659

4,170,904






End of Year

19

6,138,049

4,894,592






End of Year

20

6,428,815

5,062,011






End of Year

21

6,705,955

5,531,686






End of Year

22

6,963,723

4,860,204






End of Year

23

7,198,409

5,370,326






End of Year

24

7,398,003

5,763,587






End of Year

25

7,637,877

5,652,762






End of Year

26

8,770,541

6,037,253






End of Year

27

8,858,409

5,041,433






End of Year

28

8,706,900

5,019,535






End of Year

29

8,514,530

5,645,735






End of Year

30

8,350,463

5,751,268






End of Year

31

8,311,125

5,884,425






End of Year

32

7,957,638

4,972,803






End of Year

33

7,600,437

4,534,584






End of Year

34

7,243,949

4,379,934






End of Year

35

7,059,953

4,567,993






End of Year

36

7,246,551

4,463,204






End of Year

37

6,488,783

2,552,879






End of Year

38

6,074,785

2,379,722






End of Year

39

5,607,552

2,346,068






End of Year

40

5,132,556

2,308,282






End of Year

41

4,551,519

2,222,401






End of Year

42

4,985,413

1,054,991






End of Year

43

4,006,504

339,192






End of Year

44

3,740,788

322,012






End of Year

45

3,289,048

311,506






End of Year

46

2,437,467

288,574






End of Year

47

1,941,997

47,875






End of Year

48

1,771,497

0






End of Year

49

1,618,719

0






End of Year

50

1,457,456

0






TOTALS

240,000,001

139,745,556

54,800,000

5,700,000

4,634,000

1,575,000

You will notice that the illustration shows people dying fast enough to cover all costs. There is no way to earn enough inside the policy to cover the huge up-front charges, pay the annual $25,000 trustee fee, pay the illustrated sums to the charity, and repay the lender. Presumably, collapse is of small concern to the recipient of an $800,000 up-front fee.

WHY NOT JUST GIVE THE INSURANCE AWAY FOR FREE?

After discussing the logic of the foregoing illustrations with the VP of underwriting for a Midwest insurance company, he laughingly suggested that it might be easier to just give the policies away for free - since the presumption seems to be that having access to the insurable interest of an individual is so valuable in itself. Therefore, with tongue firmly in cheek, consider the following illustration of how everyone can make money by giving away free insurance.

XYX Life Insurance Company offers an absolutely free policy to John Doe, a 75 year old non-smoking male with a standard rating. XYZ Life borrows $1,000,000 from ABC Bank and uses it to purchase a $1,000,000 single premium immediate annuity from DEF Life & Annuity Company using John Doe as the measuring life.

The annuity income is used to pay the annual premium charge of $54,074 with the remainder used to pay on the ABC Bank loan. The policy's death benefit of $1,000,000 goes first to repay ABC Bank with the remainder going to the designated beneficiaries of John Doe. This can be illustrated as:

The Absolutely Free Insurance Plan - Everybody wins - Nobody has to work hard - It's Magic!

Insureds




Repayment

Loan

Premiums


Death

   
Loan
Annuity
Loan
Interest
w/d from
Death
Benefit

Age

Year

Amount

Payment

Principal

Paid

Annuity

Benefit

to Owner


start

1,000,000







75

1

993,031

113,043

6,969

52,000

54,074

1,000,000

6,969

76

2

985,699.61

113,043

7,331.39

51,637.61

54,074

1,000,000

14,300.39

77

3

977,986.99

113,043

7,712.62

51,256.38

54,074

1,000,000

22,013.01

78

4

969,873.32

113,043

8,113.68

50,855.32

54,074

1,000,000

30,126.68

79

5

961,337.73

113,043

8,535.59

50,433.41

54,074

1,000,000

38,662.27

80

6

952,358.29

113,043

8,979.44

49,989.56

54,074

1,000,000

47,641.71

81

7

942,911.92

113,043

9,446.37

49,522.63

54,074

1,000,000

57,088.08

82

8

932,974.34

113,043

9,937.58

49,031.42

54,074

1,000,000

67,025.66

83

9

922,520.01

113,043

10,454.33

48,514.67

54,074

1,000,000

77,479.99

84

10

911,522.05

113,043

10,997.96

47,971.04

54,074

1,000,000

88,477.95

85

11

899,952.19

113,043

11,569.85

47,399.15

54,074

1,000,000

100,047.81

86

12

887,780.71

113,043

12,171.49

46,797.51

54,074

1,000,000

112,219.29

87

13

874,976.30

113,043

12,804.40

46,164.60

54,074

1,000,000

125,023.70

88

14

861,506.07

113,043

13,470.23

45,498.77

54,074

1,000,000

138,493.93

89

15

847,335.39

113,043

14,170.68

44,798.32

54,074

1,000,000

152,664.61

90

16

832,427.83

113,043

14,907.56

44,061.44

54,074

1,000,000

167,572.17

91

17

816,745.07

113,043

15,682.75

43,286.25

54,074

1,000,000

183,254.93

92

18

800,246.82

113,043

16,498.26

42,470.74

54,074

1,000,000

199,753.18

93

19

782,890.65

113,043

17,356.17

41,612.83

54,074

1,000,000

217,109.35

94

20

764,631.97

113,043

18,258.69

40,710.31

54,074

1,000,000

235,368.03

95

21

745,423.83

113,043

19,208.14

39,760.86

54,074

1,000,000

254,576.17

96

22

725,216.87

113,043

20,206.96

38,762.04

54,074

1,000,000

274,783.13

97

23

703,959.15

113,043

21,257.72

37,711.28

54,074

1,000,000

296,040.85

98

24

681,596.02

113,043

22,363.12

36,605.88

54,074

1,000,000

318,403.98

99

25

603,996.01

113,043

77,600.01

35,442.99


1,000,000

396,003.99

100

26

522,360.81

113,043

81,635.21

31,407.79


1,000,000

477,639.19

101

27

436,480.57

113,043

85,880.24

27,162.76


1,000,000

563,519.43

102

28

346,134.56

113,043

90,346.01

22,696.99


1,000,000

653,865.44

103

29

251,090.56

113,043

95,044

17,999


1,000,000

748,909.44

104

30

151,104.26

113,043

99,986.29

13,056.71


1,000,000

848,895.74














848,895.74

1,244,618.26

1,297,776



If John Doe dies at age 92, what does the illustration show?

· John Doe's beneficiaries get a death benefit of $199,753.18.

· DEF Life & Annuity Company paid out $2,034,774, but had the use of $1,000,000 for 18 years.

· ABC Bank got back its $1,000,000 plus $861,688.82 in interest.

· XYZ Life Insurance Company pays out a $1,000,000 death benefit (first to cover the loan balance with the remainder to the policy owner), but receives premiums of $973,332 over the preceding 18 years. It deducts the interest expense from the taxable portion of the annuity. XYZ doesn't incur commission expenses - people will knock the doors down for a free policy!

SINGLE LARGE POLICY SALES:

There are a number of agents searching for older insureds willing to purchase a life policy with a death benefit of $1,000,000 and up.2 In exchange for a promised cash payment or a specified portion of the anticipated death benefits (generally, a few percent of the face amount), the insured cooperates in applying for a policy with the promoter covering all costs. The promoter will end up as the owner and beneficiary of the policy. There is no question that these arrangements can be financially viable, unlike some of the plans discussed above.

Insurable interest requirements create a problem for the promoter at this point. Initially, these transactions relied on a claim that, because the insurable interest requirement applies only at the time of acquisition, there should be no restrictions on an assignment to the promoter.

The problem is that if a court finds that the policy was acquired with the intention of then assigning it to the promoter, it will almost certainly set aside the assignment. See Grigsby, supra., and Steinback v. Diepenbrock, 158 N.Y. 24, 52 N.E. 662 (1899).

The policy itself could be found to be void or the insured's estate may be entitled to the death benefit. Relying on a fudging of the truth or the hope that no one will raise an objection over compliance with the insurable interest requirement was certainly too risky a strategy for most promoters and investors with large amounts of money at stake.

To overcome this problem, promoters have turned to charities to serve as the owner and beneficiary, at least temporarily, of the policies in exchange for a small payment. The intent is to take advantage of the considerably looser insurable interest requirements available to charitable "owners" in most states.

There is also a concerted effort underway to amend existing charitable interest statutes to make it easier and safer to ultimately accomplish the passage of ownership and beneficiary status to the promoter. The Oklahoma measure reproduced above is one example of this. Legislation has also been introduced in other states including New York, Maryland, Florida, Alabama, and Louisiana.

CONCLUSIONS:

Speculation and something for nothing have been and always will be attractive. The promise of outsized returns or "free" money and the development of programs to deliver them will continue to the end of our time on earth. Joseph Belth's description in the current issue of the Insurance Forum of the speculative "tontine" concept that gripped the American life insurance industry at the turn of the century is a wonderfully written reminder of how the pursuit of easy money can distort the life insurance business and trigger regulatory intervention.

Permitting evasion of the essential protection provided by insurable interest requirements through the device of a perfunctory pass through a charitable entity, is bad for the life insurance community, its existing policy holders, and the public in general. It is better to bring these plans to an end now rather than be "Spitzerized" later.

HOPE THIS HELPS YOU HELP OTHERS!

Mike Nelson

Edited by Steve Leimberg

CITE AS:

Steve Leimberg's Estate Planning Newsletter # 671 at http://www.leimbergservices.com

Copyright 2004 Leimberg Information Services, Inc. Reproduced by the Planned Giving Design Center, LLC with Permission. Reproduction in Any Form or Forwarding to Any Person Prohibited - Without Express Permission.

CITES:

Leimberg and Gibbons, "TOLI, COLI, BOLI, and Insurable Interests" - An Interview With Michel Nelson, Estate Planning Magazine, Vol. 28, No. 1, July 2001, Pg. 333.


  1. Retired professor emeritus of insurance in the Kelley School of Business at Indiana University (Bloomington), editor of The Insurance Forum.back

  2. Policies proposed are generally universal life policies with a no-lapse guarantee. As noted before these policies appear to have pricing that is lapse-supported. It is interesting to note that the age segment coveted by the promoters (75-84), has been singled out by one commentator as having a zero lapse rate during his discussion of lapse supported term to 100 policies. 31 Insurance Forum at p. 30 (March/April 2004)back

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Comments

Insurable Interests Under Siege

This article appeared a day after I was contacted for the second time in a year by an Insurance salesman promoting this exact concept of "No Cost - No Risk" benefits to charity by insuring large, high net worth donors. Suspicious and uncertain I had previously researched their umbrella foundation - The National Heritage Foundation and was concerned about many of the things I found there including "finders fees" fundraising commissions and "charitable employment programs". I think we are all grateful for the legitimate programs and estate planning tools that encourage and reward philanthropic behavior, and abhor schemes that may put such vehicles at risk and cause distrust for our charitable organizations and those who serve them. I will watch for continued information on this issue carefully as I'm aware that many organizations in southern Oregon are being approached with this concept.

Some arrangements are legal & appropriate policy

I respectfully disagree with the general conclusion of Mr. Nelson, which seems to be that charities should not be allowed to finance policies on their donors lives because it amounts to "wagering on human life". Although some states such as Utah do not allow a charity to own policies on the life of their donors, many other states do, such as Oregon. As for federal law, currently there is no evidence that the IRS is seeking to put a stop to the promotion of financed insurance policies owned by charities. Therefore, until states repeal their laws allowing charities to own policies, or until the IRS finds some reason to tax the charities involved, there is no legal or tax impediment to a properly crafted plan. For persons at the right age and health, if the proper mix of low interest rate financing can be coupled with a guaranteed renewable, low-cost policies, there is no legal or ethical problem with taking advantage of the arbitrage opportunity. Larry Bell's article explains this in detail. As long as the insured life is fully informed of the insurance policy and consents to the arrangement in order to provide a benefit to his or her charity I see nothing wrong with it. The key is to have an arrangement where the charity gets more benefits the longer the insured lives. In this situation the charity would have more interest in the insured having a long life than his or her death. This is precisely what the insurable interest rule requires. Any variation of these conditions could create a tax-abuse situation, or jeopardize the insurable interest of the charity. Therefore each plan should be evaluated carefully on these grounds. It would be unwise to lump them all together as improper when some clearly are not. In the interest of full disclosure, please note that I am a licensed tax lawyer and a life agent in Oregon, and I am member of the Philanthropic Solutions GroupTM that offers a fundamentally sound plan to willing & informed participants. I intend to continue to do so until I hear of any new legal developments which would change my opinion of the program I represent, or until I have hard evidence of any impropriety.

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