Earlier this year I wrote an article with a similar title.
One reader asked: "How can this be possible, because it
sounds too good to be true."
Both the "'too-good-to-be-true" quote and the "How"
question deserve answers. So, here goes.
Let's start by explaining the TIP investment.Chances are
you have never heard of this investment. What is the
investment? Life Settlements (LS) --- Also called
Transferable Insurance Policy or TIP(s). The best way to
understand how a TIP (TIPs is plural) works is by an
example, which follows:
EXAMPLE: Joe, age 67, owns a life insurance policy with a
$500,000 death benefit and a $55,000 cash surrender value
(CSV). Joe would like to stop paying premiums. Of course,
he can cancel the policy and get the $55,000 CSV from the
insurance company. An investor (really a group of
investors) buys Joe's policy for $150,000, paid in cash to
Joe immediately. The investors now own the policy. The
group of investors will receive the $500,000 death benefit
when Joe dies. This transaction (Joe selling the policy and
the investors buying it) is called LS. A TIP is a
fractional interest in a LS. Let's say Rick is one of the
investors. Say Rick invests $100,000. He will wind up with
a diversified portfolio of TIPs (about 5 to 10). Each one
of the TIPs will be a fractional interest in Joe's $500,000
policy, say 3 percent or $15,000. This TIP (Joe's) will pay
Rick exactly $15,000 when Joe dies.
A public company (trades on the NASDAQ) invented TIPs.
Twice a year the company publishes its average rate of
return for the years (now 16) it has been in business.
A common question is, "What are the tax consequences of a
TIP?" All taxes are deferred until the TIP is paid. In the
above example, Rick would not have any taxable income. A
TIP is always ordinary income. It is not payable until he
receives the $15,000. If Rick had invested his $100,000
from a qualified plan (401(k), profit-sharing, IRA or the
like) the income would stay in the plan (like all other
investments) and all income taxes deferred until funds are
distributed to Rick.
First, a little background about the life insurance
industry. There are basically two types of life insurance:
permanent [has cash surrender value (CSV)] and term (no
CSV). According to Milliman and Robertson, an international
actuarial firm, 89.5% of Universal Life policies never
result in a death claim. The policies are either
surrendered, or worse, allowed to lapse. Note: Universal
life is the most common type of permanent life insurance
sold in the United States.
And what about term insurances? These facts are, although
true, almost unbelievable: According to Tax Planning With
Life Insurance, authored by Zaristky and Leimberger, Ten
years after issue, there is only a 15 percent probability
that at term policy will be in force at the insured's
death. There is less than a 2 percent probability that term
insurance bought twenty years before an insured's death
will be in force. So, on average 93% of all life insurance
policies sold never pay even $1 in death benefits.
Amazing! Think about it, life insurance companies deposit
premium dollars year after year and about 93% of the time
keep all of the dollars, while the insured or his heirs get
nothing in return. One exception, the policy owner
terminates a policy by getting back the CSV. Long story
short, LSs to the rescue. However, before the invention of
TIPs, LSs were the sole profit playground of institutional
investors: large companies with deep-cash pockets, like
giant insurance companies (such as AIG and CNA).
Even Warren Buffet's Berkshire Hathaway has been in the LS
game for about 15 years and recently announced a $400
million loan to a new wholly owned subsidiary to invest in
LSs. TIPs are the bridge that allows the little guy to get
into the LS profit game.
Go back to Joe's LS/TIP example. If Joe had cashed in his
policy for the $55,000 CSV, the life insurance company
would have been off of a $500,000 death benefit hook. It's
easy to see why Joe is delighted with his $150,000 LS. Of
course, the insurance company is anything but delighted and
would like to keep LSs secret.
The pure economic fact is that the investor stands tall in
the profit shoes of the insurance company. The investor
stands to profit with a gross of $350,000 ($500,000 death
benefit less an acquisition cost of $150,000), reduced by
future premiums (until Joe passes on). The LS side of the
transaction with Joe is handled by the NASDAQ company,
which then arranges for little-guy investors to purchase
TIPs. The potential profit percentage calculated on each
TIP investment is based on the projected life expectancy of
each LS policy seller at about 16% plus.
Generally, the NASDAQ company only completes LSs where the
insured's life expectancy is actuarially five years or
less. The result of how a TIP transaction is structured
allows the TIP investor to earn an average annual historic
rate of return of 15.83%.
No worrying about "Wall Street" volatility or whether "The
Market" goes up, sideways, or down.
Now you know how it's done.
You also know because of the strange economics (no death
benefit are paid about 93% of the time) of the insurance
industry and the ingenious way TIPs are structured that a
15.83% average annual rate of return is indeed, not too
good to be true.
----------------------------------------------------
Irv Blackman is both an experienced CPA and lawyer. He
founded Blackman & Kallick, the largest independent CPA
firm in Illinois, and is the founding Chairman of the Board
of New Century Bank of Chicago, Illinois. His website is:
http://www.taxsecretsofthewealthy.com . He is the author of
8 books, and is published in 59 trade magazines in the US.
If you want to contact Irv, please visit the website or
call 888-278-3623.
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