Spotlight on life settlement transactions: Getting the best value.

• Author: Mendelsohn, Jason T.

The law known as the Tax Cuts and Jobs Act (the TCJA) (1) contained two provisions that affect life settlements. First, the TCJA increased the estate tax exemption (it is $11.4 million per individual and $22.8 million for married couples for 2019). (2) This provision will sunset in 2026. Wealthy families who are affected by the increase's pending expiration have concerns about what they should do with life insurance put in place for estate protection. Another provision changed how life settlements are taxed, making life settlements more favorable for sellers and making the tax due on the proceeds from a life settlement easier to calculate for CPAs. (3)

Both of these new provisions did not go unnoticed by life settlement providers/investors, igniting a renewed level of direct marketing to consumers. Direct marketing exploits a crack in the chain of fiduciary oversight and places senior clients in a position where they might enter into a contract to sell their life insurance policy without having anyone to protect their best interests in the life settlement transaction.

This article discusses factors that have affected life insurance owned by senior clients and why so many seniors are selling their life insurance policies when they are not represented by a fiduciary at a time when they may need one the most. The article ends with a list of best practices to alleviate the confusion that has caused many fiduciaries to avoid discussing life settlements with their clients, leaving them vulnerable to direct-to-consumer marketing on the subject.

Tax practitioners who are wary about discussing life settlements are not alone

In 2018, Ashar Group conducted a survey of 454 CPAs. Of those survey respondents, 48% held job titles of owner, partner, principal, president, CEO, or shareholder. The first question on the survey was designed to find out why more CPAs do not discuss life settlements with their clients. Respondents were asked to complete the sentence: "I don't feel comfortable talking with my clients about life settlements because..."

* 59% said: "I don't feel qualified to discuss life settlements."

* 28% said: "It's not part of my job responsibilities."

* 13% said: "I've heard stories that make me feel uncomfortable about life settlements."

Why do the majority of CPAs feel unqualified to discuss life settlements? There are no special qualifications to discuss life settlements, as long as the CPA does not receive any money from the policy's sale proceeds or from any outside sources. The CPA does not need to be licensed to sell life insurance or be registered as a life settlement broker to discuss life settlements with clients. Rules covering life settlements substantiate what practitioners already know to be true for attorneys, CPAs, or financial advisers who act in a fiduciary capacity to protect their client's best interest and take a fee for services.

A model act adopted by the National Conference of Insurance Legislators (NCOIL) clearly states that CPAs, attorneys, and financial planners that commonly represent clients in a purely advisory capacity are not considered to be life settlement brokers and therefore cannot be compensated by a life settlement provider or any other person, except their client (the policy owner). (4) Even though CPAs can provide advice about life settlements that is in their clients' best interest, they do not have a fiduciary duty in the life settlement process under the NCOIL model act.

Who has a fiduciary duty to the client in the life settlement process?

Choosing the best life settlement resource to work with to represent a client who may benefit from a life settlement can be confusing. It is easy to be misled about who represents whom and how value is created for the client. In the life settlement industry, there is a buy-side and a sell-side similar to other investments. It is important to understand who sits on the same side of the table with the CPA and the client in the life settlement process.

On the buy-side, a life settlement provider/buyer is the representative for the institutional investors. The life settlement market is regulated in the majority of states and requires special licensing. For this reason, most institutional investors choose to use a life settlement provider who is licensed to handle the life settlement process so that investors do not have to go through the cumbersome task of securing and renewing licenses in multiple states. The provider/buyer is obligated to the individual or entity purchasing the life insurance policy on the secondary market and works to secure the highest internal rate of return for the investor(s).

The provider cannot serve two masters; therefore, a provider/buyer does not have a fiduciary duty to the client even if a CPA is involved as a fiduciary adviser for the client. The provider/buyer can represent one fund, a group of funds, or the provider's personally owned fund(s). In other scenarios, the provider/buyer is not the owner of any of the funds that it represents, and some providers aggregate policies for a portfolio they then sell in the tertiary market.

The chart "Fiduciary Duties in the Life Settlement Process" shows who owes a fiduciary duty to whom in the life settlement process.

On the sell-side, a life settlement broker has a legal fiduciary duty to the policy owner/seller during the life settlement process. A broker, as the seller's representative, facilitates the negotiations that protect the seller's interests in a life settlement auction. NCOIL's model act defines the role of a broker as an individual or entity that represents the policy seller (Owner), owes a fiduciary duty to the Owner, and must act in the best interest of the Owner. (5) The broker sits on the same side of the table with the seller and the seller's advisers and is the only legally appointed representative who carries the fiduciary torch for a client in the life settlement process itself.

A competent broker has the policy owner/seller and the adviser sign an engagement agreement and then skillfully designs a case that will be presented to the secondary market to maximize value to the seller. The broker follows all compliance and Health Insurance Portability and Accountability Act (HIPAA) (6) procedures, protects sensitive client data, and manages the expectations of the policy owner and his or her adviser/advisory team. The broker, as the life settlement fiduciary in the transaction, handles the negotiation process and creates a competitive bidding auction between life settlement buyers.

For a highly desirable policy, it is not uncommon to go through 10 to 15 rounds of bidding to generate 20 to 30 bids and incremental bid increases. The providers/buyers usually pay a substantially higher price to acquire the policy when a broker is involved than they would if the policy owner/seller works directly with a provider. The chart "Bid Transparency: Competitive Auction Process," on p. 456, shows an abbreviated bid matrix that demonstrates why CPAs need a life settlement broker to create competition and to ensure their clients have a licensed fiduciary to protect their best interests in the life settlement process.

Due diligence that protects CPAs and their clients

One of the most confusing aspects of the life settlement market is related to determining who represents whom. The art of omission is a common tactic used by providers/buyers/direct marketers that can easily mislead consumers and advisers. CPAs hear a lot about "fair value," which in reality is discounted fair market value (FMV) that is higher than cash surrender value (CSV). CPAs should demand FMV for their clients and verify the auction process used to achieve it. Here are several due-diligence questions CPAs should ask any life settlement provider/buyer or life settlement broker to choose the right one:

* Do you have a licensed fiduciary duty to represent the best interests of my client in the life settlement process?

* How many years have you been involved in the life settlement industry?

* Can you provide information to validate your good reputation in the industry?

* Do you provide bid transparency?

* How do you handle privacy and protect sensitive client data and medical information?

* Have any of the principals or members of your team been involved in litigation relating to life settlements?

It is now safe to go back into the water

The first survey question showed that 13% of the CPAs said, "I've heard stories that make me feel uncomfortable about life settlements." That is understandable when one considers the early history of the life settlement market, which was controversial at best. Viatical settlements, which are different from life settlements, originally involved sales of life insurance policies by people who were suffering from HIV/AIDS in the 1980s, providing much-needed cash for terminally ill patients.

Viatical settlements were followed by the stranger-originated life insurance (STOLI) debacle, which also left a bad taste in the mouths of the fiduciary community. In a STOLI arrangement, a person purchased life insurance for an unrelated third party solely as an investment, rather than to benefit beneficiaries, and circumvented the life insurance requirement that the owner of the policy have an insurable interest in the person whom the insurance covers. Both NCOIL and the National Association of Insurance Commissioners (NAIC) have introduced model acts to help stop the trafficking of life insurance policies by STOLI programs. (7) Laws that prohibit STOLI have been enacted in 20 states. (8) Prudent investors want to avoid investing in risky STOLI policies, and life settlement providers/buyers that purchase life insurance policies for investors will not touch any policy that has even a hint of STOLI. Life setdement brokers have anti-fraud methods to detect these types of schemes or bad behaviors.

Representative sample of settled policies, by type Universal life...