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Viaticals: Quick Cash, But At What Cost?

You are getting ready to retire after a successful business career. With your working days over and your family well provided for, you no longer need that big life insurance policy you have been carrying. Your options include:

  • Surrendering it for its cash value.
  • Transferring it to a trust so your children can eventually collect the death benefit, free of estate taxes if you survive at least three years after the transfer.
  • Selling it to a stranger, who could then profit handsomely from your early demise.

Does that last option give you the willies? Sorry. Let’s try another scenario. You are eating your corn flakes when the phone rings. Your financial planner, Bam Bam, is calling to alert you to an exciting opportunity. An outfit called Vulture Viaticals is looking for investors who want to lock in a long-term fixed return of up to 150%. The deal is simple: You buy an insurance policy on a Mr. Schlemiel’s life. Schlemiel is “projected” to die eight years from now. The policy has a face value of $250,000, but you can own it today for $100,000. Voila! You absolutely, positively get your 150% return, assuming the unfortunate Schlemiel dies on schedule.

Now, you happen to know that Bam Bam sells life insurance, so you ask the obvious question. He cheerfully informs you that, yes, he is the agent who sold Schlemiel the policy. In fact, it is a “wet ink” policy, issued so recently that Bam Bam has not gotten around to spending the commission he received for selling it. And, yes, Vulture Viaticals will pay Bam Bam another commission for getting Schlemiel to sell it to you, with Vulture Viaticals as intermediary. Bam Bam giggles as he mentions that the commission for selling the Schlemiel policy to you is double what the insurance company paid him for selling the policy to Schlemiel in the first place.

You consider the possibilities. They are:

  • Someone pulled a fast one on the insurance company. Surely, no sane underwriter would have issued the policy if he knew that Schlemiel has less than a decade to live.
  • Someone is pulling a fast one on you, and Schlemiel actually has a normal life expectancy for his age — or maybe his age is not what you are being told it is. In any event, you may have to wait a lot longer than eight years to receive a return on your investment, assuming you ever do.
  • Schlemiel recently received some unexpected bad news. But the news can’t be too terrible, considering the miracles that medical science can accomplish in eight years.

Compassion Run Amok
Welcome to the viatical settlement industry. This business in its modern form did not even exist in this country until 1989. A decade later, an estimated $1 billion face value of life insurance was bought and sold.

This, in my opinion, is a compassionate idea run amok.

The viatical industry arose out of the misery of the AIDS epidemic. As their bodies withered and medical costs mounted, desperate patients looked to their life insurance policies as a source of funds. What these patients found, mainly, was a bitter irony that policies on young people — and most AIDS victims were in the prime of life — often have little cash surrender value, if any. A policy that would be worth a small fortune a moment after the patient’s death might be worth nothing a moment before, unless someone could be found who was willing to buy and hold the policy. Some prominent advocates for AIDS victims were among the organizers of the early viatical companies that arose to meet this need.

There were problems with viatical transactions from the beginning. One major obstacle was in the tax law. A 1994 private ruling by the Internal Revenue Service (PLR 9443020) held, as many tax professionals likewise believed, that an insured individual who sold his policy was liable for taxes on the difference between the amount he received and the premiums he had paid. Had the policy not been sold, the eventual death benefit would have been free of income taxes.

Many professionals also believed that the same treatment would apply to the insurance industry’s own answer to the problem. By the early 1990s, some insurers had begun offering “living needs benefits” or “accelerated death benefits” to terminally ill policyholders meeting certain requirements. These payments, like those being made by viatical companies, were not triggered by the death of the insured (who was not yet dead), and therefore did not seem to qualify as tax-exempt death benefits.

But the IRS, in a remarkable act of charity, issued proposed regulations late in 1992 that made insurance company living needs benefits tax-exempt. The viatical industry called for equal treatment, but this call was not answered until 1997, when Congress made viatical settlements as well as living needs benefits tax-free when received by individuals who are either terminally or chronically ill. Since then the viatical industry has grown rapidly, even as U.S. deaths from AIDS have plunged due to improved therapies.

The growth in viaticals has come largely from three new groups of insureds in addition to those who are terminally ill. The new groups are those who are chronically, but not terminally, ill; older insureds who are otherwise healthy; and people who take out new insurance policies and quickly sell them to viatical companies.

The Extreme Case
The downside risk to the insured individual of a viatical sale is obvious. In an extreme case, and I am confident that the extreme case is bound to happen sooner or later, someone is going to be killed because an investor gets a little too eager to recoup his outlay. While most viators (as individuals who sell their policies are called) will not be so unlucky, many are going to have to put up with frequent calls from buyers who are checking to see if their ship has come in.

On the other side of the transaction, anyone who pays a fair price for a single policy on someone else’s life is gambling, not investing. Sure, you might get lucky if the insured dies an early death, but except for the terminally ill, there is no statistically valid way to identify these individuals. You stand an equal chance of being unlucky and having your insured live longer than average. Remember the French landlord who gave lifetime residency rights in an apartment to a woman who lived to be 120?

If, on the other hand, you paid fair value for a pool of insurance contracts on the lives of healthy people, you would simply be stepping into the shoes of the insureds. Your expected return would be comparable to the return on stocks or bonds, which, after all, is where the insurance company is investing most of the premium money.

So is there potential for buyers of viaticated policies to consistently reap better-than-average returns? To be fair to the viatical companies, yes. A certain percentage of people will get sick and die young. Insurance companies build this certainty into their premium rates. By locating these people and persuading them to accept a higher-than-normal discount rate when selling their policies, a predictable and stable profit can be built into the investment if there is a diversified pool of policies. Basically, you turn the insurance companies’ loss into your gain.

But there is a big catch. You must have a diversified pool of lives. You must be sure that the life expectancy has been materially shortened. You must get the sellers to accept a big discount. You must have financially stable insurers who actually will pay the death benefits when due. You must have policies that are soundly structured and adequately financed even if the insureds live longer than expected, lest the policies lapse and the investment be completely lost.

Policy owners have other options besides selling to viatical companies. They can borrow against policy cash values, ask banks or other lenders to let them borrow against face values when the insured is terminally ill, or ask the insurance company itself to pay a living needs benefit. They also can shop around for the best deal among viatical companies, in which case competition may force viatical returns down to the point that they lose their appeal to investors.

So what do I think of viatical transactions? As an investor, I would stay away because of the financial risks as well as the lack of regulation and disclosures. As a policy owner, I would look closely at all the alternative ways to raise quick cash.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.