Virtues and Evils of Life Settlement: Under the Right Conditions, Sale of a Life Interest May Be a Good Policy

[ILLUSTRATION OMITTED] EXECUTIVE SUMMARY * settlement, in which life insurance policies are sold in a secondary market, has become a major financial market and viable opportunity for CPA clients to convert unneeded policies for more than their cash surrender value (CSV), often with favorable tax treatment. * As an indicator of interest in such transactions, an in creasing number of states are introducing model legislation to ensure they are transparent and ethical and, particularly, to protect seniors against abuses of stranger-originated life insurance (STOLI). * Although tax law provides little definitive guidance on the treatment of a life insurance policy being sold to a third party, the Tax Court has supported capital gain treatment for the excess of sale price over the higher of CSV or basis. * A safe life settlement should be made through an institutionally owned and funded purchasing entity and a contract that features a rescission period, HIPAA-compliant forms and notification of next of kin. [ILLUSTRATION OMITTED] ********** settlement, boosted by aggressive marketing, has developed into a major secondary market for existing life insurance policies. The rise of this now $15 billion annual market has brought with it fresh regulatory scrutiny to crack down on the parallel growth of strange-originated life insurance (STOLI). Given the growing importance of this segment of the life insurance business, CPAs should understand how and when life settlement can be a good investment for clients as well as the possible tax implications and hazards. Individual life insurance protection totaled $10.056 trillion at the end of 2006, according to the Insurers Fact Book 2007, published by the American Council of Insurers. This vast pool of in-force policies underscores the potential importance of life settlement. Furthermore, through lapse, more than 70% of existing life insurance policies are destined not to survive to pay a death benefit (see Life Insurance: What's It Worth? (And Who Says?), JofA, Jan. 08, page 32). Often, the policies are no longer needed to meet their original purpose of protecting a family's income stream, sending a child to college, compensating for the loss of a so-called key man or paying for a partner's share in a suddenly defunct partnership. settlement may offer seniors significantly more than a policy's cash surrender value or, in the case of term insurance, allow them to recapture or exceed their premiums (see Turn Unneeded Policies Into Cash, JofA, Sept. 05, page 39)--all in a somewhat favorable tax environment. THE DARK SIDE As the settlement industry grew, it was perhaps foreseeable that accusations of fiduciary blunders or mendacity would also spring up. The obvious virtue of finding an asset in a soon-to-be-discarded policy is countered by the potential evil of STOLI, a small but growing blight on the market where a life insurance policy is a newly manufactured commodity Investors lend money for or finance premiums for unsuspecting seniors who thus get free life insurance for the first two years (the contestable period). Sometimes seniors also retain a partial death benefit or split-dollar position. The financial investors keep the settlement proceeds, which far exceed their loaned premium, and the brokers keep the earned commissions. Note that this arrangement may leave gullible seniors with a tax liability for the loans or cancellation of indebtedness (which may not be characterized as true indebtedness) on the marketed policies. See news and information by the National Association of Insurance and Financial Advisors at www. naifa.org/advocacy/stolialert/index.cfln. A DEMAND FOR TRANSPARENCY The industry has acted in its own and its clients' best interests in demanding transparency. In December 2007 the National Association of Insurance Commissioners (NAIC) and the National Conference of Insurance Legislators (NCOIL) debated the necessary elements for an effective, transparent and ethical system for the life settlement market in preparation for proposing the new Settlements Model Act that is being introduced in at least 15 states this year (see www. …