EXECUTIVE
SUMMARY
 Life 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
increasing 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.
Alan Breus , CLU, ChFC, is
principal of The Breus Group of San Jose,
Calif., a qualified member of the Appraisers
Association of America and an appraisal and
insurance adviser to the planned giving
departments of Northwestern University and
Ohio University. He can be reached at alanb@thebreusgroup.com
.
L ife 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
stranger-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 Life Insurers Fact Book
2007 , published by the American Council of
Life 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. Life 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.cfm.
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 Life Settlements Model Act that is being
introduced in at least 15 states this year (see www.ncoil.org/
press/life_settlements_PR.pdf ). A copy of
the generic NAIC Model Act can be found at www.greenwichsettlements.com/naic.pdf
. It establishes: (a) parameters for
marketing; (b) a definition of the borderline
ethics in “mortality wagering” and how premium
financing of manufactured contracts may lead to
potential tax liability due to cancellation of
indebtedness; (c) a drafting model for purchase
agreements; (d) a ban on financial settlement
within two to five years of policy issuance; (e) a
30-day right to terminate; (f) definitions of
specific terms; (g) transparency as to
commissions; and (h) penalties for exploiters.
Twenty-eight states have previously enacted
laws to govern life settlements and establish
licensing regulations. The NAIC model has been
passed, to date, only by North Dakota and, on
March 13, by West Virginia, where it was signed
into law. California has held legislative hearings
on a comparable bill. Debates and hearings also
have been held in more than a dozen other states.
Accelerated Benefit Option for
AICPA Members The AICPA Insurance
Trust allows participants who become
terminally ill while covered to receive a
portion of their life insurance benefit in a
lump sum before death through its Accelerated
Benefit Option. The CPA Life Insurance Plan is
issued by The Prudential Insurance Co. of
America. For details, see www.cpai.com
or call 800-223-7473.
CAPITAL GAINS
IRC § 72(e)(6) provides that premiums paid,
less amounts received under the contract (for
example, dividends and other prior distributions),
set the cost basis for computing gain upon the
surrender of a life insurance contract. The Tax
Code, however, is silent as to the cost basis when
a life insurance contract is sold to a third
party. Tax literature and litigation provide very
little discussion on the capital gain treatment of
sales proceeds in excess of the cash surrender
value (CSV). However, in Jules J. Reingold
, BTA Memo, 1941-319, the Tax Court supported
capital gain treatment for the excess of sale
price over the higher of the CSV or federal income
tax basis.
Reingold dealt with the disposition of a
life insurance policy subject to the
transfer-for-value provision of IRC § 101(a)(2) by
a subsequent purchaser who sold it for more than
his cost and reported the income as capital gain.
The court and the government agreed that a life
insurance contract is a capital asset within the
meaning of what is now IRC § 1221. The only points
in dispute were whether the taxpayer owned the
life insurance policy and whether a sale or
exchange took place. This case confirmed that a
life insurance contract is a capital asset. Thus,
a taxpayer should expect capital gain treatment on
the sale of a life insurance contract, except for
the requirement that any inside buildup in the
contract be treated as ordinary income. Often, as
shown in case studies below, the most advantageous
use of proceeds involves a charitable trust.
SAFE LIFE SETTLEMENTS
What are the considerations for the CPA or
planned-giving adviser concerning life settlement
for a senior client? The following list is not
exhaustive (see also sidebar “ What Every CPA Should Know About
Life Settlements ”).
 Is the purchasing entity
institutionally owned and funded and thus more
likely to yield competitive and realistic offers?
The larger institutional firms will be more likely
to provide appropriate due diligence and see to
the licensure of the broker and compliance with
state and federal regulations.
Is a rescission period offered and
are escrow services used, even where not required?
These features show the purchaser’s
professionalism and concern for ethical conduct. A
rescission period allows clients and their
advisers to review alternate quotes, review
commissions and weigh options.
Are HIPAA-compliant forms required
and procedures followed, protecting the senior’s
privacy of financial and health information?
Is next-of-kin approval required?
It’s best to involve them, to help avoid
misunderstandings by heirs and prevent future
legal battles, especially in the case of a
charitable gifting. A Global
Derivatives Market Approximately $15
billion worth of life insurance policies were
sold on the secondary market in 2006,
according to the Life Insurance Settlement
Association in its 2007 handbook. Over the
last four decades, life insurance premiums
have decreased considerably as competition
within the financial marketplace has caused
insurers to price their products based on new
mortality figures, more aggressive investment
policies and reliance on the industry’s
normally high lapse rate, as noted by the
Insurance Information Institute ( www.iii.org
). With this new prospect of secondary
market ownership reversing the high lapse
rates, the life settlement industry has caused
insurers much concern and a need to step back
from established actuarial models and to
reconsider pricing. One indication of
this trend is that large, established insurers
are forming their own life settlement
businesses, as in the case of Phoenix Life
Insurance Co., which earlier this year
announced plans to do so. Another is the
influence of life settlements on the financial
sector, as shown by the new players who have
formed the Institutional Life Markets
Association (ILMA). ILMA is a not-for-profit
trade association composed of a number of the
world’s leading institutional investors and
intermediaries in the longevity and mortality
marketplace. The group was formed to encourage
the prudent and competitive development of a
suite of evolving mortality- and
longevity-related financial businesses,
including life settlements and premium
finance. For the ILMA’s Guiding Principles
, visit http://tinyurl.com/5fb6yq
. ILMA’s membership includes some
of the largest global financial companies—
Credit Suisse, Goldman Sachs, Mizuho Bank, UBS
and WestLB—and with good reason: the secondary
market has even given rise to a tertiary
market in which policies are traded among
financial institutions individually or as
portfolios. This has led in turn to the
development of derivative yield instruments
rather than direct ownership of the policy.
The tertiary market frees up funds from the
secondary sector, while reducing the direct
liability involved in longevity trading (that
which is not reinsured), and brings more
sophisticated players into the market.
Thus, the current business of the life
settlement market is as an investment vehicle
for niche hedge funds, investment banks and
private equity firms. Future trends include
products that will be designed to meet the
needs of the broad market of pension funds and
endowments, via securitization, leading to
bond instruments and specific derivative
issues. The following is from the Oct. 2,
2006, prospectus for the Franklin Templeton
Total Return Fund: “Life Settlement
Investments. The Franklin Templeton Total
Return FDP Fund may invest in life
settlements, which are sales to third parties,
such as the Fund, of existing life insurance
contracts for more than their cash surrender
value but less than the net benefits to be
paid under the policies.” — by
Alan Breus
THE RIGHT CANDIDATE
First, however, CPA advisers should
determine that their client is a good candidate
for a life settlement and the best form of
transaction (see sidebar “ What
Every CPA Should Know About Life Settlements
”). To illustrate, the cases of two
hypothetical clients, “Mr. Harris” and his brother
“Bubba,” follow.
Mr. Harris . This 67-year-old
former business owner is in complete remission
from a bout with colon cancer three years earlier.
He has no further use for what was a “key man” $2
million term policy. Mr. Harris can:
Take ownership of the policy and
convert it to a level-premium contract so it won’t
become burdensome.
Transfer ownership of the policy to a
family member. Gifting the policy would subject it
to gift taxes, but not income taxes. Or he could
transfer it to an irrevocable life insurance
trust, and the proceeds would not be taxable.
Cancel the policy or let it lapse for
nonpayment. Mr. Harris has worked hard and
is looking forward to a comfortable retirement,
believing that his success in life is directly
linked to his religious life and his scholarship.
He would feel gratified to add to his retirement
while giving back to society.
Mr. Harris’ wishes can be met by
:
Taking ownership of the policy,
Determining the present value of the
death benefit to a sophisticated buyer through a
review by a life settlement actuary, and
Increasing his retirement income with
an investment or annuity program, while
Making a gift to a charity and, on
his tax return, deducting a charitable
contribution for whatever is determined as basis
and deducting any additional fair market value of
the policy. As Mr. Harris is now covered
by Medicare, he has canceled his group health
benefits, which include a $400,000 death benefit
that is convertible but, as often happens, was
overlooked.
Bubba . Mr. Harris’ older
brother Bubba, age 73, seems to have inherited the
family propensity for medical infirmity, having
required triple-coronary bypass surgery four years
earlier. Bubba has not been as astute as his
brother and, although not poor, is having problems
balancing his retirement with his desires for
charitable giving and obligations to his
grandchildren’s schooling needs. As a valued
employee with Mr. Harris’ company, Bubba has a $1
million universal life policy with high premiums
and standard cash values, which the company
purchased for him as an addendum to his deferred
compensation package. He can either:
Leave the insurance intact and,
rather than pay the costly premiums, let the cash
reserves pay the premium for as long as possible,
Keep the death benefit in place while
taking out the cash value as a loan—tax-free,
under certain conditions—at a modest level so as
not to cause the policy to lapse (which could
trigger dire tax consequences), or
Sell a portion of the policy through
life settlement. He could sell $500,000 of the
death benefit, perhaps through his favorite
charity. He could have the proceeds placed in a
charitable remainder trust (CRT) with life income
to him, giving him the income to pay for the
remaining $500,000 of life insurance plus a
current deduction. He also could make the retained
portion of the death benefit payable to his
grandchildren for their educational needs.
AFTER ALL, IT'S CALLED LIFE
INSURANCE These or similar
scenarios, modeling careful review and
consideration, should allow senior clients to
address many personal concerns by resurrecting an
unseen asset. The CPA is in the unique position to
approach the question of need and advisability
with clear knowledge of the tax position and
finances of a client. Senior settlement is
like reconditioning an engine whose mission has
become obsolete but whose efficiency is without
fault. By monetizing an asset normally seen as
having little or no current value, the client has
money for retirement needs or to buy a membership
in a senior community. Or, as a charitable donor,
he or she can support a favorite charity, while
reaping an unexpected harvest of tax deductions
through a CRT. While advising the client of
possible pitfalls, the CPA adviser thus can help
open many new options. 
What Every CPA Should Know About Life
Settlements by Susan J. Bruno*
For individuals 65 and older, a life
insurance policy may represent an untapped
asset that they are likely totally unaware of.
Until recently, the owner of an unneeded or
unwanted policy had two options: “sell” the
policy back to the company that issued it for
its cash surrender value (if any) or allow it
to lapse. Now there’s a third and potentially
better option in the secondary market, also
known as life settlements. Advisers who do not
inform a client of this option may not only be
harming the client but may also be negligent
of their professional responsibility to be
aware of what the market offers. CPAs,
especially personal financial specialists
(PFSs), are in an ideal position to advise
clients about life settlements, but they must
first understand the life settlement
proposition. Here is an outline of the
process, followed by guidelines for who is a
good candidate for life settlement and tips
for getting the best price for the policy from
a well-qualified settlement company.
THE LIFE SETTLEMENT PROCESS
The client provides basic
personal and financial information, along with
authorization to release his or her medical
records with a HIPPA-compliant form.
The client does not have to
undergo a medical exam.
The adviser obtains life
expectancy (LE) quotes for the insured from
independent companies.
If the LEs come back within the
qualifying parameters below, the adviser
should work through a qualified company (see
checklist below) to obtain bids on the policy.
The adviser requests a specific
insurance illustration on the policy being
evaluated as needed for pricing.
The life settlement broker
negotiates the highest possible (nonbinding)
settlement offer on behalf of the client.
(Some states require brokers to be licensed.)
The CPA/PFS evaluates the
economic and tax consequences of the offer.
Disclosures to the client may
include: The number of bidders for a policy
may be limited, and proceeds from sales of
similar policies may vary and may be subject
to claims of creditors. Receipt of proceeds
may impact eligibility for government benefits
and entitlements.
If the offer is accepted,
contracts and closing documents are completed.
Ownership transfers to the
financial institution.
Funds are released from escrow to
the seller. QUALIFYING CRITERIA FOR
CLIENTS
A life insurance policy can become
unneeded or unwanted for many reasons. Prior
to sale, the insured should consider the
continued need for coverage, impact to
estate plans, availability of insurance,
cost of comparable coverage and tax
implications. Some of the possible reasons
for relinquishment of an existing policy
are:
Beneficiaries no longer require
the protection.
Key executives retire.
Businesses are sold or closed.
Policy premiums have become too
expensive. Whatever the reason, the
CPA should assist the client in evaluating a
life insurance policy that meets the following
criteria:
Policy owner is at least 65 years
old.
The policy face amount is between
$250,000 ($100,000 in some cases) and $100
million.
Original need for the policy no
longer exists, or more cost-efficient coverage
is available.
Life expectancy is between 25
months and 20 years.
Policy is beyond the two-year
contestability period (commonly referred to as
“old and cold policies”). TEN TOP
CRITERIA FOR SELECTING A LIFE SETTLEMENT
COMPANY 1. Does the life settlement
company sell life insurance or any other
competing products? Recommended answer
: No. 2. Does the life settlement
company represent investors or the policy
owner and adviser? Recommended answer
: Policy owner and adviser. 3. Is
the life settlement with a single
provider/buyer or a brokerage firm accessing
multiple providers to promote competition and
increased bidding? Recommended answer
: A brokerage firm accessing multiple
providers. 4. Will the life settlement
company disclose the entire gross offer, which
includes commissions to the broker and
adviser? Recommended answer : Yes.
5. Has the company or any owner,
shareholder, executive, or employee of the
company ever been subject to any of the
following: - a. Currently or
previously under investigation or pending
review and/or disciplinary action?
- b. Been refused a professional license or
had such license suspended or revoked?
- c. Been charged with violating any federal
or state regulation, or been convicted of,
or have pending, any criminal action?
-
Recommended answer : No for all
three.
6. How long has
the company been in the life settlement
industry? Recommended answer : A
minimum of three years. 7. Does your
life settlement company send your client’s
policies to private buyers? Recommended
answer : No. 8. Does the life
settlement company or its management have any
ownership interest in any other life
settlement companies or providers?
Recommended answer : No. 9.
Can the company provide a copy or list of its
state licenses and availability of
state-approved forms to ensure compliance?
Recommended answer : Yes.
10. Will the company provide a copy of its
state-approved anti-fraud plan?
Recommended answer : Yes. * Some material
adapted and used with permission from Ashar
Group LLC.
Susan J. Bruno , CPA/PFS,
CFP, is principal of Beacon Wealth
Consulting LLC of Rowayton, Conn. She can be
reached at sbruno@beacon-wealth.com
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