VIATICAL SETTLEMENTS

Subject: Some Viatical Sales Transactions Raise Insurable Interest and Other Issues

AAUL Bulletin Nos.: 96-83

Although originally designed to enable terminally ill individuals to accelerate the receipt of payments from life insurance policies prior to death, viatical sales transactions have recently changed to encompass the sale of unneeded policies by healthy, and generally wealthy, older individuals. Where the policies are sold shortly after their issuance, as is sometimes now the case, an issue is raised as to whether the insured has made an invalid assignment of his insurable interest that may cause the policy to be void or voidable. In addition, if the sale is recast as a "wagering transaction," it is possible that favorable tax consequences afforded to life insurance may be lost.

Analysis:

Viatical settlement companies have carved out for themselves a niche in the life insurance industry in the past decade (initially triggered in substantial part by the AIDS crisis.) They typically purchase life insurance policies from terminally ill policyholders by making discounted purchase price payments to those policyholders. Because the insureds are terminally ill, payments by the viatical settlement companies often reflect discounts of 10% to 50% of the face amount, depending on the insured's life expectancy. Upon the death of the insured, the investor's profit is derived from the difference between the discounted purchase price of the insurance contract and the death benefit collected, less transaction costs, premiums, and other administrative expenses.

The attractiveness of viatical settlements was increased by the passage of the Health Insurance Portability and Accountability Act of 1996 (HIPAA), which largely exempted from federal income tax accelerated death benefits and viatical settlements received by terminally ill and chronically ill individuals from insurers and qualifying "viatical settlement companies."

Under HIPAA, a "terminally ill" individual is one who can reasonably be expected to die within 24 months of a physician's certification. A "chronically ill" individual is one who has been certified within the previous 12 months as being unable to perform at least two enumerated functions of daily living, or who has a severe cognitive impairment resulting in a threat to his or her health and safety. Payments made to chronically ill individuals must be applied to the otherwise uncompensated costs of qualified long-term care. Per diem type long-term care benefits for the chronically ill are limited to $175 per day.

Recently, however, viatical activity has moved beyond the purchase of existing policies from the chronically or terminally ill to the purchase of existing - or, in some cases, newly issued - policies from healthy, and generally wealthy individuals. While many of these transactions are noncontestable purchases of "aged" policies - i.e. those beyond the general 2-year contestability period - after those policies are determined to be no longer needed by the insured, the sale of newly issued policies appears to raise substantial insurance and tax law issues. AALU member Ralph Solomon has brought to AALU's attention several issues with respect to this type of transaction involving viatical companies, insurable interest, and, in some contexts, charitable organizations.

In this potentially vulnerable new type of viatical transaction, an insurable individual, normally age 70 or older, takes out the insurance policy naming himself, a corporation, or a charity as the owner. After at least one premium is paid (thus binding the coverage), the insurance policy is sold (usually via a transaction arranged by an intermediary broker) in a viatical company or to a newly formed or existing investor group that may pay to the owner a "cash bonus" over the amount of the initial premium (usually based on a percentage of the death benefit.) Although viatical settlements paid to healthy individuals do not have the same favorable tax consequences, as do viatical payments made to terminally ill individuals, if the owner is a charity, the receipt of the cash payment is tax free. If the owner is not tax exempt, the payment is arguably taxed as capital gain to the extent that it exceeds the greater of the cash surrender value or the federal income tax basis of the contract. To the extent the payment reflects the excess of cash surrender value over contract basis, it is taxable, pursuant to existing authority, as ordinary income.

We hold that the sale of newly issued policies involving an immediate assignment of the insured individual's insurable interest may result in the characterization of the transaction as a wagering contract. Numerous cases have held that such assignments are invalid and the insurance contracts themselves may be declared void under governing local law. For this reason, some viatical companies will not take a policy that is less than two years old (and thus beyond the contestability period.)

In addition, the state insurance law considerations inherent in the assignment of an insurable interest may implicitly raise a possible estate tax issue - to wit, will the contract, as a "wagering" rather than "insurance" contract, not qualify as life insurance for purposes of the §7702 federal tax definition? If the contract is not life insurance for this purpose, proceeds may not be excludible from the insured's estate under §2042, but may have to qualify for estate tax exclusion, under other potential applicable Revenue Code sections.

Even where these issues are absent, other considerations may diminish the attraction - from the agent's standpoint - of viatical sales. We have heard that at least one life insurance company, finding an inherent conflict of interest in the sale to a viatical company of an "unneeded" policy on the life of a healthy individual, has prohibited its agents from participating in fee-based referrals or sales of clients' life insurance policies to viatical companies or from representing firms that market viatical policies to the public as an investment.

The development of this area of life insurance has been recent and quite rapid. It should be approached with some care and circumspection.

Gerald H. Sherman, Stuart M. Lewis, Diane J. Fuchs, Deborah M. Beers

VIATICAL SETTLEMENTS: (1999) This commentary of mine was printed in the SF Chronicle You may find it useful.

"I would suggest a terminally ill consumer contact a viatical company only AFTER the owner had contacted their insurance company FIRST. Even policies without riders may have had them recently approved. In fact, a 1994 study of 230 companies holding 70% of the life insurance in force in the U.S. show they either make or were planning to make some type of accelerated benefits available and one certainly has nothing to lose by making a phone call. Further, most insurance companies are offering "buyouts" at more than a viatical company would (normally never higher than 75%, if that). The National Association of Insurance Commissioners has adopted model regulations of at least 50% of a policy's benefits if the individual is expected to die within a two year period. If the individual is expected to die within six months, the payments are to be at least 80%. Unfortunately, these are NOT mandatory requirements by viatical companies so one should do a lot of homework before using.

An even a better solution would be to contact the beneficiaries, relatives and friends to see if they want to pay instead since they could be recipients of the entire policy. Better they get it. Further, there would be far less stress on the ill person- though that might/should still require an attorney to document everything properly. The beneficiaries might provide the payments through home refinancing, home equity loans or other- but they would/should be more than reasonably compensated by the full value of the policy.

I would also note that some companies offer payments for catastrophic illness- not just terminal."

VIATICALS: (1999) If you are terminally ill, you can sell your insurance policy to a company and receive a lump sum to use in any manner you desire- pay off medical bills, etc. You need to recognize that you will effectively disinherit your current beneficiaries since you will give up ownership of the policy. Of course you won't get face value- you get paid a discount and the final purchaser makes- what could be- a substantial profit when you die. Part of the problem is the middle man, Viatical Company, that in most states is an unlicensed entity that may bend (sometimes break) codes of ethics. The Florida Insurance commissioner has gone after some where they told elderly terminally ill "clients" to hide their illness from the insurers in order to get insurance. They then bought the policies at discount, sold them and made a tidy profit. (The practice is called "cleansheeting".) Further, agents who have had their licenses revoked or suspended have been allowed to "sell" viatical. Before engaging a viatical company, check with your insurance company first about possible premature payments. Second, ask your beneficiaries for a "loan" against the policy (they can become an irrevocable beneficiary for security purposes). Also talk to friends and relatives- they might be able to help as well and provide far more money than the viatical company. Again, just make sure everything is in writing.

Viatical Settlements (2/2000)

Minimum Pricing Guidelines*

* Minimum payouts from this chart may be lowered in some states due to several factors.

2/9: Viatical State Regulations (2/2000)

Status of State Viatical Settlement Legislation and/or Regulation

The National Association of Insurance Commissioner's Viatical Settlements Working Group has submitted its final suggestions for additions and changes to the Viatical Settlement Model Act (2000).

2001 NAIC changes in viatical settlements instituted by Ohio.

Viatical Fraud:  (2001) The Florida Department of Insurance noted, "We discovered during the investigation that most of the insurance policies were nonexistent."

National Association of Insurance Commissioners Amends the NAIC Viatical Model Regulation (2007)

In December 2006, the Life Insurance and Annuities (A) Committee of the National Association of Insurance Commissioners (“NAIC”) voted to amend the NAIC Viatical Settlements Model Regulation (“Model Regulation”). The Model Regulation is one of the many model laws and regulations promulgated by the NAIC that states may use as models when drafting legislation. The Model Regulation can be drafted so that it is applicable to both viatical settlements and life settlements.

Viatical settlements allow a terminally ill person (one with a life expectancy of two years or less) to sell his/her life insurance policy to collect cash while he/she is alive. A life settlement transaction is similar to a viatical settlement except the insured’s life expectancy is generally between two and ten years and the names of the players in the transactions are slightly different. The viator (known as the “insured” in a life settlement), sells his/her life insurance policy for more than the cash surrender value but less than its net death benefit to a “viatical” or “life” settlement provider. In return, the settlement provider pays the future premiums to keep the policy in force and receives the face amount of the life insurance policy when the viator/insured dies.

The viatical settlement market emerged in the 1980s as a way to give terminally ill AIDS patients access to their life insurance death benefits. Now a secondary market has developed in which viatical and life settlement providers sell interests in a large policy to investors (settlement purchasers) or create a pool of purchased policies and then sell shares of the pool in the anticipated payout (i.e., death benefits when the viators/insureds die). This secondary market has captured the attention of the NAIC, as well as securities regulators and legislators, due to a steady stream of bad press involving accusations of sales abuses. For example, viatical settlement providers have been accused of making secret payments to suppress competitive bids and not disclosing extraordinarily high commissions that significantly cut into what the seller could have received. Settlement brokers have been accused of, among other things, failing to disclose the risks associated with investing in viatical settlements and selling “wet-ink policies.” (“Wet-ink policies” are life insurance policies that were applied for to sell immediately after being issued, before the “ink has time to dry.”) The North American Securities Administrator Association (“NASAA”) listed viatical settlements in its 2005 list of top ten threats investors face.

The Model Regulation attempts to address some of these abuses with a particular focus on deterring a form of a life settlement transaction called stranger-originated life insurance (“STOLI”). In a STOLI arrangement, individuals are approached by “strangers” (speculators) to apply for life insurance policies on themselves in return for cash. Premiums are paid by the insured but are funded by a loan during the two year contestability period so the insured doesn’t experience any out of pocket loss to pay the premiums. At the end of two years, the investor group will offer to buy the policy at its fair market value or the insured can choose to pay back the loan for the premiums and keep the policy. To deter this practice, the Model Regulation amendment restricts the sale of a life insurance policy for five years (previously two years) when the policy is purchased for the purpose of selling it into the secondary market.

In addition to the NAIC, other regulators such as the National Association of Securities Dealers (“NASD”) and the Securities and Exchange Commission (“SEC”) are taking notice of the viatical and life settlement market. While it is relatively clear which regulators oversee transactions in the primary market (i.e. when someone purchases a life insurance policy from a life insurance company), regulatory oversight in the secondary market by state departments of insurance, NASD and the SEC can be less clear. State insurance departments have differing views on whether or not sales of interests in viatical or life settlements are securities. Depending on a particular state’s point of view either the state’s securities division or insurance department may oversee these transactions.

The NASD made its position on life settlements clearer with the publication of NASD Notice to Members (“NTM”) 06-38. The NTM reminds NASD members that life settlement transactions involving the recommendation to sell an existing variable life policy to a third party is subject to applicable NASD rules. More interestingly, the NTM closes with the following comment “…entities participating in the sale and marketing of interests in life insurance policies, variable or not, for investment purposes may trigger broker-dealer registration requirements under the Securities Exchange Act of 1934.” This statement may foreshadow a time when all viatical and/or life settlement transactions, whether they involve fixed or variable policies, will be subject to NASD rules.

The SEC argued in a recently settled civil case against a Florida based viatical company that investments in viatical settlement contracts are securities and under the jurisdiction of the SEC. The company was accused of cheating investors out of nearly $1 billion by using false projections of how long the insured people would live and not informing investors of the risks in investing in viatical settlements. The defendants argued that interests in viatical settlement contracts were insurance products and did not come under the purview of the SEC. However, their motion to dismiss was denied when the courts concluded that viatical settlement contracts are “investment contracts” within the meaning of the Securities Acts of1933 and 1934.

Viatical and/or life settlements involve sick and elderly people (aka “constituents”), a demographic of particular interest to regulators because of their vulnerability to deceptive sales practices. As the market expands and complaints of abuses are brought to the regulators attention, viatical and life settlement companies can expect more scrutiny around sales practices, supervision, suitability and more from both state insurance and securities departments and the NASD and SEC. The recent amendments to the NAIC Viatical Settlement Model Regulations represent only the beginning of increased scrutiny in this unique market.