Stranger Originated Life Insurance

Stranger-Originated Life Insurance (STOLI) is a life insurance arrangement, in which speculators, who have no relationship to a person, initiate a insurance policy against their life and fund the premium payments for investment purposes. [cite web
url=http://www.insurancenewsnet.com/article.asp?a=top_news&id=73113
title=Life Companies, Agents, Brokers Strongly Support NAIC Panel Vote on Stranger-Originated Life Insurance
publisher=insurancenewsnet.com
date=2006-12-11] [cite web
url=http://www.kcra.com/news/15189803/detail.html
title=Investors Could Profit From Strangers' Deaths: Legislative Hearing Planned This Month
publisher=KCRA 3
date=2008-02-01] STOLI is best thought of as a "mortality futures" transaction where certain parties have one expectation as to the future value of the article of trade that is the subject of the “futures contract”, while other parties have a different expectation as to the future value of that article of trade. In a STOLI transaction, the article of trade that is the subject of the “futures contract” is the life expectancy or mortality of the insured. While current marketing practices suggest STOLI is an easy way to make money with little if any risk and that all parties will profit, STOLI is actually a complicated transaction involving at least six parties to the transaction and where certain parties will profit and certain parties will lose, just like in any “futures contract”. As such, we will explore herein the various risks of loss and potential for profit from the perspective of each of these parties to the transaction.

STOLI is not a type of life insurance product. It is instead a marketplace term for a transaction that came into being roughly 2004 and which makes use of three legitimate but otherwise separate financial markets, namely: 1) the primary market for new life insurance products issued by an insurance company, 2) the secondary market where inforce life insurance products can be sold for more than the insurance company will pay on termination (i.e., the cash surrender value), and 3) the market of special purpose lenders who finance the payment of life insurance premiums. The basic structure of the transaction is also marketed or referred to as Investor Owned Life Insurance (IOLI), Charity Owned Life Insurance (ChOLI) and Speculator Initiated Life Insurance (SPINLife).

By any name, the transaction (hereafter referred to as STOLI) is defined as an ownership scheme in which a life insurance policy is owned (either initially or ultimately) by an investor group unrelated to the insured, where the insured (or someone with an insurable interest) pays little or nothing for the life insurance, and where someone other than the insured (or someone without an insurable interest) pays for the insurance. Further, in a STOLI transaction, the purpose of the insurance is not for protection against premature death or as a wealth accumulation vehicle, but rather for a profit on the future trading of a life insurance contract.

The basis for such profit expectations revolves around a single factor – the life expectancy of the insured. For instance, like in any “futures” contract, the different parties to the STOLI transaction have different expectations as to the future value of the life insurance death benefits that are article of trade in this “mortality futures” contract. In other words, on one side of the STOLI transaction, certain parties are calculating life expectancy one way, while certain parties on the other side are calculating life expectancy differently. Whichever party calculates life expectancy most accurately will profit, and whichever party miscalculates life expectancy will lose, as we will see below. These various parties to a STOLI transaction are:1) An insured2) A life insurance agent/broker (the distributor)3) An investor group (the viator or life settlement market maker)4) A special purpose lender5) The life insurance company6) The IRS because STOLI policies do not qualify for tax exempt treatment afforded to other forms of life insurance

A typical STOLI transaction begins with a life insurance agent/broker proposing to a prospective insured that he or she “owns” a “wasting asset” in the form of their insurability, and that they can make money “selling” this wasting asset by simply consenting to be insured under a STOLI policy. The insured, who does not need life insurance for traditional reasons such as income replacement, family protection, retirement planning, funding a stock redemption agreement or financing estate taxes, consents to being insured in exchange for the promise of either “free insurance” or some cash payment or both.

Insureds generally pay nothing towards STOLI policy premiums, and in some cases, are actually paid up front cash in exchange for consenting to being underwritten and insured. The investor group serving as market maker for the policy puts up the money to pay premiums (either directly or indirectly through borrowing) and/or to pay the insured this up front cash (again either directly or indirectly through borrowing), all for the exclusive purpose of earning a profit from the collection of STOLI death benefits, which are expected to be greater than the amount they paid for the policy, plus an expected minimum rate of return on the market maker’s STOLI investment.

Regulatory issues make it impractical for the investor group to own the STOLI policy and pay premiums directly during the first two years. As a result, STOLI transactions involve a finance company during this two-year interim period. These special purpose lenders loan funds for the payment of premiums to the insured (or a trust created by the insured) often on a non recourse basis (i.e., the insured can default on repayment and the lender has no recourse for recovering loaned amounts from the insured) at interest rates as high as Prime plus 5% or more (for example, 12% to 14% compound annual loan interest).

The typical proposal for a STOLI transaction suggests that, after these first 2 policy years, the market maker will purchase the policy from the insured for it’s “fair market value”, but the market maker is not generally required to purchase the policy nor is this purchase price guaranteed. While the insured is generally entitled to repay the loan during the first two years and keep the policy, this is unlikely for reasons discussed in “The Insured” section below. Also, while this “fair market value” is presumed to be enough to repay premium loans, pay above market interest, and pay the insured a profit, this “fair market value” is actually a function of the market makers calculation of the life expectancy of the insured at the that time (i.e., 2 years after the date of the initial policy purchase).

“Fair market value” is, by definition, the price at which a willing seller will sell and a willing buyer will buy. The seller of a STOLI policy is the insured (or the trust of the insured), and the buyer is the viator or investor group formed to make a secondary market for life insurance policies. Both are willing sellers/buyers when they expect a profit. The insured seller does not generally perceive a need for the life insurance for traditional reasons, and has no investment in the STOLI contract (beyond the tax cost which may or may not be disclosed in the sales process), so the insured is a “willing seller” at almost any price given there are few if any other exit strategies out of the STOLI transaction.

For instance, an insured has only three (3) options under a STOLI policy, namely: 1) continue the policy by repaying the premium loan and accrued above market interest and start paying above market premiums, or 2) surrender the policy for its cash value after repaying the premium loan and accrued above market interest and take the difference as a loss, or 3) sell the policy to the life settlement market maker for an amount presumably greater than the cash surrender value and hopefully also enough to pay off the premium loan, pay accrued above market interest, pay termination fees (if any), recoup taxes paid and earn the promised profit. Of course, unless the insured decides they need life insurance for traditional reasons, the only practical option is to sell the policy to the life settlement market maker, and thus the STOLI insured will generally be a “willing seller” at any price.

On the other hand, for the market maker buyer to be a willing buyer, the purchase price of the STOLI policy must be low enough such that the investor group still profits when death proceeds are collected some number of years in the future. For example, an investor group seeking a 12% return on its investments over a 10 year holding period could pay up to $370,000 for a $1 million STOLI policy (ignoring taxes for the moment) provided the life expectancy of the insured was 10 years or less. In other words, a $370,000 investment earning 12% for 10 years is equal to $1 million. As such, the maximum price a market making buyer will pay for a STOLI policy can be estimated using simple time value of money calculations using the insured’s life expectancy as the holding period (n), the “hurdle rate” of the investor group (typically in the 12% to 14% range) as the discount rate (i%), the amount of the death benefits expected in the future as the future value (FV), and solving for the present value (PV).

Of course, the less a market maker pays for a given policy and the shorter their holding period until they receive STOLI death proceeds, the greater their profit. It is thus important to remember that life settlement market makers are in business to pay as little as possible when purchasing STOLI holdings in order to maximize investment returns to their investor group. Also, while life insurers generally reserve the right to change their calculation of life expectancy over time by adjusting the pricing of their life insurance policies to reflect actual mortality experience, life settlement market makers “lock in” their calculation of life expectancy at the time they purchase a STOLI policy, and thus risk either reduced profits or even a loss if they miscalculate life expectancy.

For these reasons, and given the current lack of regulation of the life settlement secondary markets, the amounts these investor groups pay for STOLI policies is often far less than their intrinsic “fair market value” of a given policy as calculated above. In other words, after the insured consents to being underwritten and insured under a STOLI policy, the market maker has no obligation and little or no financial incentive to purchase the policy from the insured for an amount that is sufficient to repay premium loans, and pay above market interest, and pay the insured a profit, and are not required to purchase the policy at all. This is not to say that life settlement market makers won’t deliver on the promise to purchase the STOLI policy and pay an amount sufficient to pay a profit to the insured, but is to say that there are financial forces working against the insured receiving such a profit.

One way investor groups may be able to ensure their profit targets while also paying profits promised to the insured is by selling STOLI holdings to a 3rd-Party rather than holding STOLI policies until death benefits are paid. Selling STOLI holdings shortens the holding period of the investor group to something less than the life expectancy, and thereby eliminates the risks associated with different life expectancy calculations. For this reason, certain STOLI investor groups have been seeking to securitize STOLI holdings for sale on Wall Street in the same way real estate developers pooled real estate holdings and sold them as Real Estate Investment Trusts (REITs), and the way mortgage companies bundled mortgage holdings and also sold to the community of public investors.

If STOLI holdings are securitized and sold to the general public, then the number of parties in the STOLI transaction increases to include #7 the investment banking firm that securitizes individual STOLI holdings and sells them to #8 the public market of individual investors. As such, STOLI transactions involves at least six parties, and potentially as many as eight, each involved for the purpose of turning a profit. Each party thus represents a “friction point” whose profit erodes a portion of the economic benefit otherwise available to other parties in the transaction but further down the line.

While there may be transactions other than STOLI that involve eight or more parties/friction points, few involve a financial product that is generally available in the market usually with only two parties seeking a profit from the transaction (i.e., the life insurance company manufacturing the product and the life insurance agent/broker distributing the product, but not the insured who is actually a consumer who is paying for insurance coverage in a traditional life insurance transaction and not seeking a profit and thus not a friction point). In other words, implied in the STOLI transaction is that there is a sufficiently large profit margin in a non STOLI transaction that this “excessive” profit can be divided among an additional four to six parties, and all will still profit, which is simply not possible.

While certain parties to a STOLI transaction do profit without regard to life expectancy (e.g., the life insurance agent/broker and the investment banking firm if STOLI holdings are securitized), certain other parties will profit while certain other parties must lose depending upon the ultimate accuracy of their respective life expectancy calculations. For instance, if life settlement market makers are correct in their calculations of life expectancy, then these investor groups will profit along with those parties on the same side of the STOLI transaction (e.g., the insured, the special purpose lender, and potentially the public investor), and the life insurance company must lose. On the other hand, if the insurance company is correct in its life expectancy calculations, then the insurer will profit and all other parties on the other side must lose.

For an indepth analysis of the underlying economics of the STOLI transaction as well as a list of the top-10 questions to ask before entering into a STOLI transaction, see [http://www.theinsuranceadvisor.com/?id=181&openwindow=http://www.theinsuranceadvisor.com/documents/STOLIWhitePaper-Final.pdf "Stranger-Originated Life Insurance: Free insurance? Found money? A good investment? A scam? What is it anyway?" by THEInsuranceAdvisor.COM] .

External Links

[http://www.theinsuranceadvisor.com/?id=181&openwindow=http://www.theinsuranceadvisor.com/documents/STOLIWhitePaper-Final.pdf "Stranger-Originated Life Insurance: Free insurance? Found money? A good investment? A scam? What is it anyway?" by THEInsuranceAdvisor.COM]

References