This is an important follow-up to my “post-AALU” post on the Taxation of Life Settlements. Additional posts on the other subjects covered by Larry Brody and Steve Leimberg will follow in a few days.

More on the Taxation of Life Settlements

Since my prior post, many professional commentators have expressed their opinions regarding the most important (and unfortunately adverse) holding in Rev. Rul. 2009-13: the required adjustment to basis that must be made when a policyowner sells a policy under a life settlement transaction, namely, that the “cost of insurance” charges must be subtracted from premiums paid. Since these “cost of insurance” charges have already been subtracted internally in determining the policy’s cash value, this appears to be the equivalent of a double subtraction of the same amounts, especially since the policy’s cash value is an important determinant of the purchase price a purchaser is willing to pay, because it directly affects the future premium payments required to maintain the policy.

Many commentators agree, then, that this is a very controversial holding, and I personally believe it might well be successfully challenged in court. However, I do not think any of us would encourage any of our own clients to be the guinea pig who challenges the IRS … unless, of course, a large amount of money is at stake, which might be the case if long-term capital gain rates are increased in the future. Even now, if the policy being sold is a rated policy, the actual “cost of insurance” charges will be significantly higher, meaning (if actual charges are the correct method of calculating “cost of insurance” for this purpose) a larger amount will need to be subtracted in determining adjusted basis, leading to a larger amount being subject to tax as a capital gain.

RIGHT NOW, HOWEVER, PERHAPS THE MOST IMPORTANT MESSAGE TO KEEP IN MIND IS AS FOLLOWS: THIS HOLDING WILL NOT BE APPLIED ADVERSELY TO SALES OCCURRING BEFORE AUGUST 26, 2009. THIS MEANS THAT, IF YOU HAVE ANY CLIENTS WHOSE POLICIES COULD POTENTIALLY BE CANDIDATES FOR A LIFE SETTLEMENT TRANSACTION, RIGHT NOW IS THE TIME TO ACT. SINCE THESE TRANSACTIONS DO NOT COME TO FRUITION OVERNIGHT, THE TIME HORIZON TO START THE BALL ROLLING IS VERY SHORT INDEED.

Please contact us for more information.

The final morning of the AALU meeting featured a “What’s Hot, What’s Not” presentation by two of the industry’s leading experts, Steve Leimberg and Larry Brody, who discussed three important subjects.  We will highlight these subjects in this and the next two posts.

Taxation of Life Settlements

Ever since the advent of life settlements, the tax consequences to the seller and to the purchaser have been the subject of conjecture, and while most agreed as to what those tax consequences were likely to be, there was never any authority for those conclusions.  We now have two IRS Revenue Rulings to guide us.

The first ruling, Rev. Rul. 2009-13, deals with the tax consequences to the seller (i.e., our client).  In most respects, it confirms what most had surmised would be the result, i.e., that gain over basis up to cash value would be taxed as ordinary income (the same as if the policy had been surrendered) and any gain above that amount would be taxed as capital gain.  The only surprise was the definition of “basis”, which, on a sale of the policy as distinguished from a surrender, is stated to be premiums paid minus the internal “cost of insurance” charges.  This adjustment to basis, however, serves only to increase the capital gain portion of the profit, not the ordinary income portion, which remains the same as if the policy had been surrendered.  While this basis adjustment increases somewhat the tax consequences of a life settlement, as long as the federal long-term capital gains tax rate remains at 15%, the additional tax will be relatively nominal.  Incidentally, the ruling also states that, if a term policy is sold, there is no basis other than unearned premium.

The second ruling, Rev. Rul. 2009-14, deals with the tax consequences to the buyer.  While this is not really of concern to us, here are the results in a nutshell:  (1) The buyer’s basis in the policy is the purchase price paid plus premiums subsequently paid.  (2) If the buyer re-sells the policy, the gain is capital gain.  (3) If the buyer collects the death proceeds, the gain is ordinary income.

Certainty in the tax law always stimulates interest in the underlying subject matter.  These rulings, therefore, can be expected to add even more life to the recovering life settlement marketplace.  Be sure to take advantage of this renewed interest. 

Here we have another classic example of a failing policy due to underperformance of cash values and higher-than-expected cost of insurance. The existing plan was in jeopardy of lapsing. Increasing the premiums from $50,000 per year to $103,000 was simply not an option the client wanted to consider.

Scenario

84 y/o female

Current coverage: $2,000,000 (2 universal life policies)

$1,500,000 (1993, Standard)

$500,000 (1993, Preferred)

Cash Value: $230,000

$1,500,000 = $80,000

$50,000 = $150,000

Current annual premium: $50,000

$1.5mm = $35k

$500k = $15k

Policy will fail at age 88 based on current rates

Annual premium required to extend current coverage to age 100: $103,000

$1,500,000 = $88,000 (non guaranteed)

$500,000 = $15,000 (non guaranteed)

Solution

Provada was able to negotiate a life settlement of over $200,000 for the client’s $1.5mm policy; more than doubling the current policy’s cash value of $80,000. We combined the proceeds of the life settlement along with the cash value of the second policy for our new plan.

After considering the various options available, our client decided on a new, guaranteed, single premium policy. A preferred rating was obtained on the new policy due to our relationships with over 40 different life carriers.

The following is a newsletter put out by National Underwriter on STOLI (Stranger Owned Life Insurance). 

BY MATT BRADY    
Washington Bureau — NU Online News Service, June 12, 2008, 5:07 p.m. EDT

Ohio Gov. Ted Strickland today signed into law a bill that was written in an effort to root out stranger-originated life insurance.

The new amendments to Ohio insurance law “recognize a shared responsibility of the life settlement industry, life insurance companies and the [insurance] department to protect consumers against STOLI transactions,” says Mary Jo Hudson, director of the Ohio Department of Insurance.

The bill, H.B. 404, officially amends the state Viatical Settlement Act. Under the new law, the department will have more authority over life settlements, and life settlement brokers and providers are required to give insurers more information before engaging in a life settlement.

Life insurers will have to ask specific questions aimed at uncovering STOLI schemes and report suspected schemes to the department.

The Ohio law also limits the ability of consumers who use certain types of premium financing arrangements to sell life insurance policies within 5 years of buying the policies.

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Despite the likelihood of increased regulation of life settlements and of those who play a role in arranging for life settlements, as well as longer life expectancies potentially leading to lower offers, it is expected that the life settlement industry will continue to grow and flourish, especially with more and more institutional money entering the picture. This, coupled with the potential liability resulting from a failure to discuss a life settlement when it would clearly be in the best interest of a client, makes it important that each of us becomes familiar with those situations when a life settlement should at least be considered, including when the policy to be sold will be replaced with a better performing new policy.

A recent survey by the Life Insurance Settlement Association and Agent Media determined that in 2005 only 18% of all agents engaged in a life settlement transaction.

This year, 2007, 31% intend to engage in a life settlement transaction, and near 50% of the respondents now believe “there is a substantial potential for additional income from life settlements.”

Why the change?

Although the study did not indicate the reason(s), I believe, It has mostly to do with agents discovering that they can increase their insurance production through the proper use of life settlements. In other words, agents are utilizing life settlements to produce additional life insurance premium.

Take the time to understand the life settlement “game,” and use this knowledge to generate more six-figure life insurance premiums!

Below are two examples of how a settlement/new insurance sale was the best option for the client.

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Knowing the basic timeline prior to submitting a case allows you to set expectations, which gives you and your client a better idea of what to expect. Below is the process and timeline we utilize at Provada, which is fairly typical of well-run Brokerage General Agencies. The first part of this post is specific to life insurance policies while life settlement processing is discussed at the end.

APPLICATION SUMBISSION:

• Allow 4-6 weeks for a simple application.
• Most Brokerage General Agencies (BGAs) process applications within 24 hours of receipt.
• If medical records are required, allow for 2 additional weeks. This can vary depending on the applicant’s doctor’s ability to get the records out to the BGA.

UNDERWRITING REQUIREMENTS:

• Clients are typically contacted by the paramedical firm with 24 hours of the requirements being ordered.
• BGAs are typically updated weekly by the paramedical facility.
• Once the exam is completed, results are received within 5-7 working days.
• An average turn around time of 10-14 working days for medical records ordered from doctors and medical facilities.

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Several life settlement providers have recently launched small face amount programs for policies under $500,000. Backed by large institutional funding, the "SFP" program is a simple and fast way to include Life Settlements in your insurance practice!

With just the application and illustration, your client can receive a competitive Life Settlement offer for qualifying policies!

• No medical records or life expectancy report required!
• Offer in 10 days or less!
• Move to closing fast!

How is this possible?

• Size of the Market - Policies of $25,000 to $500,000 comprise the vast majority of inforce policies. By targeting these policies, a large number of our producers should benefit from this program.
• Ease of the Process - Attending Physician’s Statements and Life Expectancy reports are not required to obtain an offer. Simply submit a special application and illustration, and that’s it!
• Tremendous Profits - The huge volume potential, combined with no out-of-pocket cost to obtain an offer, equals a highly profitable business.

WHY SELL A POLICY?

Life insurance policy owners find many reasons to consider a life settlement including:

• Underperforming policies: If a policy is performing worse than originally illustrated, the process of a life settlement can be used to purchase more affordable insurance unlikely to fail.  This is useful for both trustees of ILITs and individual policy owners.
• Unneeded policies: Policies that have outlived their usefulness are excellent settlement candidates. Changes in insurance needs, divorce, estate planning goals, and/or personal finances can make current life insurance programs obsolete.  Policy owners can settle unwanted and unneeded life insurance policies and then use the proceeds for any legitimate reason.
• Business changes:  “Key person” policies can be settled when an executive leaves the company.   Insurance used to fund “buy/sell” agreements becomes a settlement candidate when the agreement dissolves or is modified.  Failing policies within pension plans can be “rescued” in some instances with a life settlement.

WHAT TYPES OF POLICIES CAN BE SOLD?

Almost any life insurance policy, or even a variable annuity, may be sold if it meets established requirements. These include:

• Whole Life (if cash value is low)
• Universal Life (Basic UL, GUL, 2nd to die, etc.)
• Variable Life (security laws may apply)
• Term Life (once converted)
• Variable Annuities (particularly those with “high water mark” death benefits”

Policies most likely to receive higher offers have the following characteristics

• The insured is a senior with a life expectancy of less than 20 years;
• The face amount is over $100,000;
• The cash value is less than 30% of the face amount;
• There are no substantial loans on the policy; and
• There is a low premium-to-face amount value ratio.
• The policy is beyond the contestable and suicide periods.

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