Updated: May 3, 2013 12:15PM
Some life insurance policies are starting to haunt the living. When I warned about "premium financed" life insurance policies in a column three years ago, I called it "not exactly a scam, but dangerous." Today, that warning seems mild.
More than $20 billion of these insurance policies were sold -- and now they're starting to implode. But many policyholders don't even realize the trouble they're facing.
It was called "Spin Life" -- and the concept seemed simple when policy sales were rampant several years ago. Some agents encouraged older people to take out huge life insurance policies on themselves, even though they didn't need the insurance and couldn't afford to pay the premiums.
The salesperson promised that investors would lend them the money to pay the premiums for the first two years, until the policy was past the "contestability period." Then the policy would be sold to an investor, who would continue to pay the premiums, hoping to collect on this "bet" on the senior's longevity.
Why would any person willingly take out an insurance policy and then let a stranger become the owner of a policy on your life? It's a macabre idea -- and I said so at the time. But the answer is simple: MONEY!
The senior citizen was tempted by an upfront "bonus" -- ranging from thousands of dollars to expensive cruises -- just for letting the investor bet against the insurance industry's mortality tables and eventually collect the policy proceeds. And they were promised more money when the policy was sold after two years to investors.
At first, those loans to pay the first two years' premiums were "non-recourse" -- so there was no risk to seniors. But by 2006, the insurance companies -- torn by the desire to sell more policies but worried about what was going on -- decided that the insured should guarantee at least 25 percent of the premium loan.
Sales agents convinced the seniors that there was no risk. Well-known names in financial services were raising money to buy these policies -- essentially a bet that they would continue to pay premiums for a few years, and then collect on death -- sooner rather than later.
Among the big names in this "premium financing" industry: LaSalle Bank (now Bank of America), Credit Suisse, and funds managed by Berkshire Hathaway and Goldman Sachs.
Death bet gone wrong
Then along came the credit crunch. The pools of investor money predicted to buy these policies dried up -- along with all other financial liquidity. When the two years expired, the insureds turned to their brokers to fulfill their promises to sell the policy and collect their bonus. But there was no money to complete this deal.
Suddenly, seniors were faced with paying premiums on insurance they didn't need and couldn't afford. It wasn't unusual for a senior to take out a $5 million policy (after being coached to say it was for estate tax purposes and they had no intent to sell). The premium on that policy could be $200,000 a year.
Sure, they could simply stop paying future premiums and drop the policy. But most had signed loan documents, personally guaranteeing repayment of at least 25 percent of the loan, plus interest. That was something they never thought about when they took out the life policy in the first place.
Wealth advisers Marc Sheridan and Don Tolep of Miami-based Sheridan Wealth Advisors (sheridanwealthadvisors.com) say they're seeing more seniors whose retirement will be devastated by the need to repay these loans. And they point out that the 25 percent guarantee is only the start of the financial consequences.
Forgiven loans are taxed
Take a close look at the example of a $5 million policy with a $200,000 annual premium. The policyholder had guaranteed 25 percent of the first two years' payments, or $400,000, plus interest at 6 percent, perhaps amounting to $24,000.
At the end of two years, the senior owes $100,000 plus interest on that money, adding another $6,000 to the tab. But that isn't all that will be owed. If the senior manages to pay off the guaranteed amount, plus interest, the lender will "forgive" the $300,000 balance, and the additional interest.
But wait. The Internal Revenue Service considers "forgiveness of debt" to be income, so the lender will send you a Form 1099C, informing you that you owe taxes on the debt that was forgiven. If $300,000 plus $18,000 in interest was forgiven, then someone in a 35 percent tax bracket would owe an additional $100,000 in taxes on this "phantom" income! At this point, you need to consult your tax adviser for consequences in your own situation.
To simply walk away from this deal, the policy buyer would owe more than $200,000 -- half in guarantees to the lender, half in taxes to the IRS. Or he or she could keep paying the premiums of $200,000 a year, hoping to find a buyer who would pay something for the policy. What a choice!
Sheridan and Tolep say the IRS may be collecting as much as $1 billion in taxes on this phantom income. Meanwhile, the brokers that originally sold the policies collected fat commissions from the insurance industry. Now they're nowhere to be found. Since the policy buyer probably lied to the insurance company on the application, saying he or she had no intention of selling the policy, it will be tough to sue the insurance company!
It's estimated that more than 10,000 of these "spin life" policies were sold in recent years. For a while it looked like easy money for those willing to "share" their insurable capacity. Now they're learning an expensive lesson -- the real cost of anything "too good to be true."
And that's The Savage Truth!