| 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 . AICPA RESOURCES JofA articles
“ Life Insurance: What’s It Worth? (And Who Says?) ,” Jan. 08, page 32
“ Turn Unneeded Policies Into Cash ,” Sept. 05, page 39 OTHER RESOURCES Web sites
National Association of Insurance Commissioners, www.naic.org
NAIC Viatical Settlements Model Act, http://greenwichsettlements.com/naic.pdf
Institutional Life Markets Association, Guiding Principles , http://tinyurl.com/5fb6yq
Ashar Group LLC, www.ashargroupllc.com | 
