Beware: Stranger-Originated Life Insurance Policies

Florida insurance officials are raising the alarm about a growing and controversial niche of the secondary life insurance market known as stranger-originated life insurance (STOLI) policies. Unsuspecting seniors nationwide could be lured into committing fraud and losing their ability to ever get life insurance again.

STOLI transactions are arrangements in which investors pay the elderly -- especially those with limited life expectancies -- to buy life insurance policies and then resell them to the investors. The investors often pay the policyholder's insurance premium, typically for two years, at which point the policy is "sold" to the investors, who collect the proceeds of the policy when the policyholder dies. The policies are bundled together as "death bonds" by Wall Street in packages similar to the notorious mortgage-backed securities.

STOLI transactions are different from life settlements, in which policyholders who cannot or do not wish to maintain a life insurance policy sell it to a company that collects the death benefit when the policyholder dies. They are also distinguishable from viatical settlements, in which an individual or company purchases policies from policyholders who are terminally ill. Unlike these two arrangements, STOLI transactions involve a plan to initiate or originate a life insurance policy for the benefit of investors.

The Florida insurance commissioner has issued a report on STOLI arrangements, saying the practice is illegal in the state and creates the potential for older people participating in them to be "victimized." In Minnesota, meanwhile, some of the state's largest insurance companies are urging passage of a bill to outlaw STOLI.

Florida's insurance commissioner warns that while STOLI may seem like a "can't lose" proposition for the elderly, there are "undisclosed risks" to seniors who participate in these transactions. For one thing, by participating the policyholder may exhaust his life insurance purchasing capability and not be able to protect his own family or business in the future. In addition, any cash payments received from investors are taxable as ordinary income and selling a policy to a stranger could raise a "discharge of debt" tax issue.

Insurers Fight Back

Then there is the possibility of legal repercussions. Understandably, life insurers are less than thrilled about the growth of STOLI transactions because the insurers rely on a certain percentage of policyholders stopping their premium payments and the policies lapsing. As a result, these types of deals could result in higher insurance rates for all persons over age 65. Some insurance companies are suing to have STOLI transactions rescinded on the grounds that the policyholder misrepresented facts on the insurance application. If such a suit is successful, the policyholder could find herself liable to all parties for costs, including the insurance agent's commission.

A federal court recently ruled that one insurance company's lawsuit attempting to revoke an alleged STOLI policy may go forward. Lincoln National Life Insurance Company v. Calhoun (D.N.J., Nos. 07-4698 & 08-2917, Jan. 27, 2009). Although the facts of the case are in dispute, at some time before July 2006, 75-year-old Walter Calhoun was allegedly approached by Joshua Weinberger, an "individual in the insurance business," with a proposal to purchase a $3 million life insurance policy from Lincoln National Life Insurance Company using funds raised by outside investors.

According to Lincoln National, Mr. Weinberger and Mr. Calhoun created a life insurance trust to hold the policy for two years, at which point the trust would transfer ownership of the policy to the investors in exchange for a large cash award. While the trust owned the policy, the investors would also pay the insurance premiums.

Lincoln sued Mr. Calhoun and his trustee, alleging that Mr. Calhoun had made material misrepresentations on the life insurance application by not admitting that they had been approached about selling the policy, and that the policy was invalid in other ways. Mr. Calhoun and the trust moved to dismiss the suit, arguing, among other things, that Lincoln could not prove that the trust was actually planning to sell the policy to anyone in the future.

The U.S. District Court for the District of New Jersey ruled that Lincoln could proceed with its case. The court found that Lincoln would not have issued the policy if Mr. Calhoun had indicated that he was planning to sell it.

To root out STOLI transactions like the one alleged in this case, life insurers are asking applicants questions like, "Is there intent to sell the policy?"