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Is your excess insurance capacity for sale? Should it be?

Posted by Michael Kitces on Friday, March 28th, 8:06 pm, 2008 in Insurance

The pitch goes something like this: "You are eligible for more insurance than you currently have, giving you "excess capacity" for insurance on your life. Why don't you sell that capacity, since you're not using it anyway, and put the extra money in your pocket to meet your own goals?" And if it wasn't against public policy, the strategy might even work!

Stranger-Owned Life Insurance (SOLI, STOLI, And IOLI)

In recent years, there have been an increasing number of so-called "Stranger-Owned Life Insurance" transactions (also known as SOLI, STOLI, or sometimes IOLI {investor-owned}), that focus on buying an individual's excess insurance capacity. Typically involving seniors who are 65 or older (or more typically, about 75-85 years old), the standard approach is for the individual to take out a life insurance policy, with the intention up front of selling it to an outside investor after the two year contestability period has expired. Often, the deal is financed by the third-party investor as well, so for the individual with excess insurance capacity, there is no cost out of pocket, and a cash payment after two years when the deal is completed (or alternatively, in some structures the insured individual is paid up front for the deal).

From a theoretical perspective, your excess insurance capacity is an asset you are certainly entitled to monetize, just like any other intangible asset of value. However, life insurance (and its associated tax benefits) exist primarily to serve a certain public policy purpose around protection against premature death or for other estate planning reasons; speculative investing on the timing of someone's death (from the third-party investor's perspective) does not, to put it mildly, fit within that purpose. And although many individuals knowingly enter into such transactions, there appear to also be many instances where the insured claims afterwards that the details weren't even fully disclosed, including a recent high profile allegation involving talk show host Larry King.

As a result, there is a growing wave of anti-STOLI sentiment emerging, backed by legislators in more than 25 states and now the National Association of Insurance and Financial Advisors as well. In their latest release, NAIFA, working with the AALU and the ACLI, announced the release of a STOLI Primer, entitled "STOLI: The Problem and the Appropriate State Response."

Economic Risks Within The Contestability Period?

Beyond the public policy issues, there are also some economic concerns with the transaction as well, particularly in the "no out of pocket" version where the transaction is financed by the investor. In theory, the approach works because the market value of the policy at the end of the two-year incontestability period is higher than the balance of the loan at that time - but it may turn out that the market values shift, and that the policy isn't actually enough to cover the loan amount, and then the insured is suddenly on the hook.

This can also be an issue if interest rates rise by too much in the intervening time period, because the financing for the deal is typically a variable interest rate. Beyond that, there can also be a risk that for some reason the policy is rescinded (particularly notable in situations where the insured is induced to lie on the insurance application just to get the money for the policy sale), and if that's the case the insured usually ends out with a return of premiums that are less than the amount of the loan, again a negative financial result.

And of course, anyone considering this approach needs to be aware that the selling their excess insurance capacity also means that if their own needs change, they may be unable to get more coverage for their own goals (because they've already sold that insurance capacity!).

Losing Out On Lapse-Based Insurance Pricing?

Insurance companies have also become concerned with the practice, particularly because investor-owned life insurance is virtually always held until the insured dies; this is problematic for companies, because almost all insurance is priced with the assumption that some number of policies will lapse before death as individuals have changing needs and may not wish to maintain coverage forever. A significant decline in lapse rates ultimately means the policies must be priced more conservatively, which can translate into higher premium rates for life insurance for everyone as a result of the few who engage in (typically very large) STOLI transactions.

All of this doesn't mean that selling your life insurance is bad. The life settlements market - the secondary market for the sale of no-longer-desired insurance policies - serves a valuable function in our marketplace. However, there's a big difference between selling a policy you acquired for your own purposes that you no longer need, and acquiring a policy with the sole intention of selling it (or having another party effectively buy insurance on your life right from the policy's origination, as an investment/gamble on the investor's part).

But for now, the industry, regulators, and legislators are coming together to codify this distinction into laws that will end (or at least severely curtail the practice). For those considering such insurance-sale transactions going forward from here, let the seller beware!

Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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