“Free Insurance”: Problems and Pitfalls in the Charitable Sector
By Stephan R. Leimberg
Life insurance is a powerful and positive charitable tool—but only if used properly in the right circumstances by a charitable organization that is prepared to screen, monitor and treat its insurance investments as it treats other investment assets. There are literally dozens of legal, creative and ethical ways that life insurance can benefit charities.
Recently, however, promoters have been approaching charities with a concept that enriches private investors more than the charitable organizations. It is called CHOLI, an acronym for Charitable-Owned Life Insurance and allusion to COLI, Company-Owned Life Insurance. Promoters claim that CHOLI is “a cash windfall for charity—without paying anything at all.”
CHOLI does not refer to the classic situation where a charity is given or purchases policies on the life or lives of key supporters with the intent to buy and hold. CHOLI denotes highly complex and speculative arrangements in which investors “borrow” the insurable interests of charities to enable them to do something the law does not allow them to do directly—to speculate on the lives of the organizations’ older, wealthy and generous donors.
CHOLI seeks to enable strangers to engage in what amounts to statistical gaming, gambling on the rate of deaths of a select group of elderly insureds. In most of these “dead pool” arrangements, there is a certainty that third-party groups of investors (primarily investment banks, insurance companies and hedge funds) will receive their shares of the “return on investment” sooner—in obscenely greater amounts—than the charitable organizations for which the arrangements are ostensibly (but not really) designed.
By sidestepping or, in some cases, actively instigating changes to weaken insurable interest laws that have, for very sound public policy reasons, survived for hundreds of years, investor groups hope to make what was intended to provide security into a security and convert human life into a mass commodity investment.
This commentary will help you decide when to advise the charity to reject certain life insurance proposals outright and when to recommend that the organization give the proposal full and serious consideration.
What Is CHOLI and How Does It Work?
Although there are many variations on this theme, essentially, CHOLI works like this: An investment bank issues securities that investors purchase. The money from the sale goes into a trust (established by the participating charitable organization). The trustee uses trust funds to buy single-premium immediate annuities on the lives of wealthy, and typically older (ages 70 to 90), donors provided by the charity. The stream of annuity payments is used to buy life insurance on the same donors’ lives. Supposedly, the annuities will produce sufficient income to not only pay the life insurance premiums, but also provide a sufficient current fixed return to the investors on their investment, at least until the donor dies and the insurance proceeds are paid.
At the death of an annuitant/insured, the “life only” annuity payment ceases. The insurance proceeds are paid to the trust, and the investors recover their investment from the death proceeds received by the trust. If there is any death benefit remaining at that point, it is paid to the charitable organization.
Promoters estimate that the charity’s share of the death proceeds will be between 5 percent and 7 percent of the initial face amount. (No, that’s not a misprint. According to the marketing materials of the promoter, the charity—at most—gets between five and seven cents on the dollar!) It’s almost as if the promoter was paying the organization a commission to enable what—without the charity being involved—would in most states be illegal, as well as unconscionable.
Seldom do the promoters fully disclose to the charity or the insureds the names of the initial (or secondary market) investors, what is in it for them, or the full range of risks and potential costs to the charity and its insured patrons. Legal opinion letters rarely, if ever, offer comment on the probability of the charity’s economic success.
A Free Ride Offer for Charities
It is easy for a charitable organization to be seduced by possible profits from CHOLI-type schemes and “rent out” its charitable insurable interest and tax-exempt status to unscrupulous promoters and investors. And the charitable organization may ignore or never see how, or to what extent, third-party participants (investors) benefit from the “partnership.” The organization may appreciate only the risk it is taking by allowing its tax-exempt status to be used to enable that up-front private enrichment.
The Hidden Costs to the Charitable Organization
Charitable organizations that have been inflicted with legal and ethical but overly-optimistic charity-owned life insurance arrangements often find that premiums that were to have “vanished” not only never did, but that they climbed to such embarrassing levels that the charities’ relationships with the insured donors were strained or even threatened. In some cases, charitable organizations become victims of a scheme such as charitable split dollar (shut down by IRS Notice 99-36 and by Code Section 170(f)(1) that imposed penalties on such arrangements). These plans are similar to one that prompted Sens. Chuck Grassley and Max Baucus to state in Senate Bill 993, “These arrangements do more to facilitate investment by private investors in life insurance than to further the charity’s tax-exempt purposes” and that these are “snake-oil salesman taking advantage of tax-exempt organizations to line their own pockets with life insurance schemes.”
In addition, a charitable organization that participates in this arrangement may be faced with an unpleasant call from its state attorney general, concerned that it has “partnered” with private investors whose motive is other than a detached, disinterested generosity.
A variation of CHOLI, called Stranger-Owned Life Insurance (SOLI), suggests that a charitable organization buy one or more financed policies on the lives of donors with the express intent of selling those policies to a life settlement company at the earliest possible date. SOLI has been condemned by the National Association of Insurance Commissioners (NAIC), the National Conference of Insurance Legislators (NCOIL), the Life Insurance Settlement Association (LISA), the American Council of Life Insurers (ACLI) and numerous states’ insurance departments, and it has resulted in many policy rescissions.
How Do You Analyze a Proposal?
Asking the following questions will significantly increase the probability of a positive outcome. As an advisor, you should refuse to go further on a proposal when you reach the limit of your comfort level. But remember that you do have a professional responsibility to the donors and to the charitable organization to objectively and professionally examine reasonable proposals.
Start with a background check: Ascertain the reputation of the person trying to sell the insurance. Demand a copy of the seller’s educational, experiential and professional background. Check with charities that have actually implemented this arrangement—with this marketer—to find out their experiences, successes, problems and concerns. Ask for a written report on how many of these plans the seller has put in place.
Require clear and full explanations: Demand a step-by-step outline of the process and make a list of the questions you have. Be particularly concerned if the plan’s success is based on a multiplicity of assumptions (are they reasonable?) or “multiple moving parts,” the failure of any one of which could thwart the objectives.
Confirm that you are dealing only—and directly—with reputable, top-rated insurers: Insist on seeing information based only on the direct backing of a major and well-known highest rated insurer. Require a letter from the general counsel of that company assuring the charity that the tax and other representations provided to you are correct.
List key assumptions: Make a list of assumptions or variables that, if they do not work as projected, could significantly affect the proposal’s outcome.
Draw up a list of the disadvantages and exposures the charity and its donor(s) may face under the proposal. Demand that the seller provide a best/worst/probable case range of rewards and costs. What is the maximum downside (or upside) if interest rates, mortality assumptions and the cost of insurance increase—or decrease—significantly beyond anticipated limits?
Require a written backup plan and/or detailed exit strategy: Insist on an estimate as to any charges, penalties or other costs that will be incurred. Separate guarantees and specific promises from projections. To the extent death benefits are not guaranteed, or if there is a change in interest rates, policy performance or mortality costs, there is a significant risk that a premium-financed life insurance program will not only disappoint and fail to meet anticipated goals, but also put the charity’s other assets in jeopardy.
Ascertain and reassess the charitable organization’s risk-taking propensity: Leverage is a double-edged sword. Borrowing has the potential for great rewards—but equally great losses. Decide in advance how great the charity’s tolerance is and what will happen if implementation of the proposal entails risks beyond acceptable levels for the charity. Go slow on debt!
Determine legal and tax exposures: Do not sign a nondisclosure agreement. Such agreements are almost always an indication that the promoter doesn’t want you or the charity to share information with other knowledgeable advisors.
Investigate to see if the proposal entails securities/UBTI/private benefit/private inurement type issues: If the organization is to remain exempt, any private benefit arising from a particular activity must be “incidental” in a qualitative and quantitative sense to the overall public benefit achieved by the activity.
Check state law regarding insurable interest: Ensure that the charity has the requisite insurable interest, a major legal concern.
Discuss the psychology involved: Does a donor have to die for the organization to profit? How will its supporters react when they know the organization has a vested interest in their premature deaths (i.e., the organization is betting against donors’ longevity). Would the supporters’ answers change when it is discovered that strangers will end up having a financial stake in their life expectancies and that the organization will probably lose money or never collect what is expected if they live too long? How will supporters feel when they find that the investors will have the right to obtain confidential financial and health information on plan participants—in some cases monthly—for the rest of their lives? Would the supporters object if they knew that the policies on their lives may be sold by the present investors to other (perhaps less reputable) investors in a manner similar to the turnover in mortgages?
Gauge your loan obligations: Demand—at the outset—a complete set of the debt instruments, contracts or other legal instruments that the organization will be required to sign. Be particularly sensitive to any collateral beyond the policy that the organization will have to pledge, or other guarantees it will have to make. Consider if the organization will have to borrow money to finance insurance premiums and how that debt arrangement will affect the charity’s credit status.
Run the numbers: No one has proved that CHOLI will really benefit a charity—or to what extent. What are the up-front fees? What are the likely annual administration, legal and accounting costs? What does the charity’s independent counsel/actuary study show? (It is essential to spend the money to have the economics and tax claims of the proposed arrangement independently checked and verified.)
Who are the initial third-party investors? Who will those investors sell their interests to if another more profitable use of the investment comes along, or if they believe this investment is no longer profitable?
The Bottom Line
Objectivity, enhanced knowledge, uncommon common sense, open-mindedness, and more than a dash of personal integrity and courage will help you identify and distinguish between proposals that are pure alchemy and those that are true gold and make the right decisions on how to maintain the balance. Life insurance that is bought and held can help a charitable organization fulfill its charitable goals to a degree that might otherwise not be possible—but only if it is used wisely.
Stephan R. Leimberg, J.D., is CEO of Leimberg Information Services Inc., an e-mail and database service providing information and commentary on tax cases, rulings and legislation for financial services professionals. He is also CEO of Leimberg and LeClair Inc., an estate and financial planning software company. He is co-author of Tax Planning With Life Insurance and has addressed the Heckerling Tax Institute, the Notre Dame Law School Tax and Estate Planning Institute, ALI-ABA’s Sophisticated Estate Planning Techniques course, ALI-ABA’s Planning for Large Estates course, the NYU Tax Institute, the National Association of Estate Planners and Councils’ national conference, the AICPA’s National Estate Planning Forum, and Duke University Law School’s Estate Planning Conference. His e-mail newsletter/database www.leimbergservices.com is used daily by thousands of estate, financial, employee-benefit and retirement planning practitioners.
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