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Wednesday, December 3, 2008

Is the STOLI a Faustian Bargain?

All our times have come
Here but now they're gone
Seasons don't fear the reaper
Nor do the wind, the sun or the rain..we can be like they are
Come on baby...don't fear the reaper
Baby take my hand...don't fear the reaper
We'll be able to fly...don't fear the reaper
Baby I'm your man...

"Don't Fear the Reaper"
Blue Oyster Cult

A new "fad" of auctioning off your "life insurance capacity" is something you may wish to think about before doing it. You should think long and hard.

Promoters and investors are selling the idea of Stranger Owned Life Insurance (STOLI) to healthy seniors with the promise of earning extra cash. The strategy has other names: Spectator Initiated Life Insurance (or, SPINLIFE) and Investor Owned Life Insurance (IOLI).

Whatever the acronym, here is how it works: Investors (or, promoters) locate a senior who is willing to have his or her life insured by strangers, usually with the lure of "free" insurance coverage, or a lump sum cash payment. The investors then take out a non-recourse loan from a lender to purchase a high premium life policy. Naturally, given the advanced age of the insured, the premium is high. However, the senior must be healthy to pass insurer underwriting requirements, minimizing the cost of the policy to the investors.

Because the loans used to purchase these policies are non recourse, they are also purchased from the lenders at a premium. Usually, the interest on these loans are around 10% to 15%.

The investors (as the policy owners) have several options as the notes expire. First, of course, if the insured passes away beforehand, it's bad for the elderly insured, but great for the investors: The investors pay off the note and pocket the balance of the policy death benefit. If death does not occur, however, the investors may also sell the policy in the institutionally funded life settlement market. If the insureds health begins to fail, the investors may opt to simply keep the policy, and hope for the best (or hope for the worst -- depending upon who you are speaking of).

If this sounds like a pyramid scheme -- it is. Obviously, the investors are betting against the life of an insured. However, for those considering entering into this bargain, think for a moment about all who have a hand in this "pie":

1. The Lender. The lender is usually a bank or hedge fund which charges a usurious insurance rate to hedge against the high cost of the non recourse loan sold to the investors.

2. The insurance agent/broker. The broker earns a substantial commission on the sale of the policy. Such policies need to have a significant death value to offset the investors' risks -- and to make it worthwhile for all concerned.

3. The life insurance company. At least one party is cheering on the insured: The insurer. The insurer is betting on the insured having a long life, with either continued payment of premium and/or continued use of the single premium payment before the death benefit is paid.

4. The promoter. There is also a promoter who puts together the "package" who must also be paid. The services provided by the promoter include integrating the transaction, and obtaining financing.

And of course there is also the insured -- who takes the investment and income tax risk. One story of a STOLI gone awry was told by Harry Jenkins, a healthy 80 year old who spent his life in the exercise business, and has done four such deals. His wife, Anna (who was Jack Lalanne's exercise partner in the 60s) was skeptical from the onset. As reported by KTKA:

"Somebody out there is waiting for me to die," Jenkins said.

"I really had a lot of skeptical feelings about what was going on," his wife, Anna, said.

Harry did four of these deals, making about $600,000, but things got complicated. He had to pay income tax on the money he made, but also an additional $50,000 tax on mysterious amounts of interest that were not actually paid to him. And when he tried to buy out the fourth policy himself, he was told he would have to pay another $1.2 million in interest. Now, he's in a lawsuit over that fourth policy.

Thousands of older Americans have entered similar deals, and inevitably some believe they were misled.

"There's a lot of people that got hurt on this, big time, and I think it's wrong," Jenkins said.

Even though they did make some money, Harry and Anna have regrets.

"Forty-nine years I've been telling him to listen to me. And to trust my intuition," Anna said.

"I'll be the first guy to say it probably was a mistake," Jenkins said.

As is usually the case, if something seems too good to be true: it probably is. An excellent summary of this practice is addressed in an article by David Wexler in the Wealth Strategies Journal.

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