Stranger-owned life insurance (STOLI) is loathed by insurance companies and loved by investors - at least those with the stomach for it. Although it can be difficult to sympathize with insurance companies – they make money by betting you'll never collect on the policy they're charging you premiums on – in this case insurers may be in the right. In this article, we'll look at the implications of stranger-owned life insurance and how it is often abused.
TUTORIAL: Introduction To Insurance
The Importance of Insurable Interest
Life insurance laws vary between states, but one thing that is universal is that there must be an insurable interest in the individual being insured. Put simply, the person's death must result in a financial loss to you if you are going to insure against it. Put another way, you must gain a financial benefit from the insured person continuing to live. These two conditions sound the same, but they can be read and used in very different ways. (Learn more in Fundamentals of Insurance.)
The first reading of it – the insured's death costing you – can be manufactured. If you give a loan to someone, you can reasonable insure that person's life for the value of the loan because it wouldn't be repaid if he or she died. The second reading – gaining benefit from the insured continuing to live – is the most common reading and cannot be easily brought about. A spouse or a business partner who is wholly or in part dependent on your income can insure your life for enough of a value to make sure they would be able to replace your yearly income. This latter reading is the more standard one, but it has been used (and possibly abused) by a very unexpected source. (Learn how much, if any, insurance you really need, check out How Much Life Insurance Should You Carry?)
Charities aren't the usual suspects when it comes to pushing boundaries to create innovative investments, but stranger-owned insurance policies are easy to generate for them. After all, wealthy older donors will die some day and there is no guarantee that their heirs will continue to give to the same organizations. As a result, a charity has a clear insurable interest in its donors. However, the situation becomes less clear when investors enter the pictures.
Charities are generally restricted by charter and won't usually spend thousands in premiums to hold policies on multiple donors. If investors or a group of investors approaches a charity to foot the premium bill in return for a share of the payout, however, the costs disappear. The charities just have to wait to collect their share after the investors have been paid out – a share they paid nothing for. Sounds like a win-win, riskless transaction at this point. (Some things shouldn't be left to chance. Find out where you need coverage in 5 Insurance Policies Everyone Should Have.)
What Actually Happens With Stranger-Owned Life Insurance
In truth, the charity is renting out its insurable interest in donors to create a dead-pool with investors' money. When the members start dying, investors are paid off to a set amount of return on investment (ROI) and the excess returns are given to the charity. While this gets the charity a donation it may not have received otherwise, there are many flaws.
One issue is that people who wish to can already make donations using life insurance they purchase and pay for themselves. In addition, this for-profit maneuver may endanger the tax-free status of non-profit charities, particularly because charities are meant to be organizations that give, not take. Finally, the longer the insured lives, the smaller the payout for the charity becomes; this is because the investors' costs, as represented by continuing premium payments on the policy, rise. As a result, a charity may end up compromising itself to rent out its insurable interest in the donors, endanger its tax-free status and then see a paltry amount when the insured lives longer than predicted.
While stranger-owned insurance policies can be suspect in a charity, they are even worse when used as investments because they can be used as a shell to hide the real interests. These investments keep cropping up under the manufactured insurable interest created by granting loans. Investors will pool money to give someone in poor health upfront cash and a deferred, non-recourse loan that can be settled simply by surrendering the life insurance policy to the investors or to a middle entity - the insured deals with a promoter and rarely knows the end investors. (Find out how different types of coverage can protect you and which policy is right for you, see Do You Need Casualty Insurance?)
This unasked-for loan and cash payment become the insurable interest for an unreasonably large policy, usually in the millions. The insured gets the upfront cash and monthly outlays to cover policy payments plus some extra. After a couple years, the insured is given the choice of paying back the value of all those policy payments or surrendering the policy. Of course, the insured hands over the policy and it joins many others of its kind in dead-pools. When the insured people in the pool die, the investors collect the money. (Pairing insurance and an annuity sounds good, but do you really need this much coverage? Read LTC Annuities: Two Safety Nets In One.)
The Legal Issues
Insurance companies consequently argue that such policies are manufactured and overstate insurable interest at best. The investors counter that, if the policy was sold and premiums collected, then contract law stands. This battle is far from over, but many of the more obvious STOLI loopholes have been closed and insurers themselves are becoming more vigilant. In this case, the majority of people should be hoping that the insurance companies succeed in closing out STOLI entirely.
Insurance rates are set to cover costs and protect a profit margin. If investors continue to invest in dead-pools that are skewed for huge payouts, insurance companies will increase life insurance policy rates across the board in response. This will make it much harder for the people who need coverage to afford it. In this worst-case scenario, the fundamental value of life insurance would be ruined and co-opted to become a high-income casino where human lives act as chips. (Find out how insurers use credit history to build an insurance score and how it could affect your bottom line in How An Insurance Company Determines Your Premiums and Investing In Health Insurance Companies.)
The Bottom Line
If investors really want to invest in death, they can arrange futures contracts or even betting rings to do so. Of course, the odds wouldn't be as good because there would be no "house" in the form of insurance companies willing to give them a discount on contracts. Instead of turning a profit, STOLI abuses the life insurance that many people depend on to protect their families. STOLI investors are not wagering with sophisticated investors as in a derivatives contract; rather, they are robbing the public of a financial tool that is desperately needed.