In a scene reminiscent of Arsenic and Old Lace, a couple of little old ladies in California were convicted in 2008 of murdering homeless men after taking out $2.8 million in life insurance on them. While you’d never commit murder, you may have wondered if you could take out life insurance on Mr. Rich, the wealthy octogenarian down the block and wait to collect when he shuffles off his mortal coil. The short, simple answer is no. In most states, you have to prove that you have a legitimate connection to the person whose life you want to insure. It’s called insurable interest in insurance industry terms. So you can legally insure a spouse, child, grandchild, a key employee or partner or even somebody who owes you a ton of money. But you can’t buy life insurance policies on total strangers…unless you’re part of a relatively new investment scheme called Stranger-Owned Life Insurance or Life Settlement.
Aside from the fact that investing in something that only pays off when somebody dies is kind of creepy, Stranger-Owned Life Insurance is a risky investment. Here’s how it works in theory. The Stranger-Owned Life Insurance promoter approaches Mr. Rich and asks him to purchase a multi-million dollar life insurance policy. In return, the promoter will supply Mr. Rich with the money to pay the premiums for the next two years, maybe even sweeten the deal with some upfront money to pay for the medical exam. If Mr. Rich dies during the two-year period, his named beneficiaries get the death benefit less the money loaned for the premiums. If Mr. Rich is still around after two years, he can 1) pay back the loan plus interest and retain the policy, 2) cash out the policy and use any profit to pay back the loan or 3) transfer the policy to the promoter and owe nothing. The promoter is betting Mr. Rich will opt for Door Number 3 and his half-million dollar upfront investment will yield a $9.5 million return when Mr. Rich inevitably dies and, while it could be construed as unethical, it’s all perfectly legal. By current law, after a policy has been owned for two years it can be transferred to a disinterested party. The promoter may even assemble a portfolio of these policies, package them as securities and invite investors like you to buy into this so-called high-yield, no-risk investment. It’s kind of like the may risky mortgages were repackaged and sold as no-risk securities a couple of years ago. We all know how that turned out.
But other than the creepy factor, what’s the risk? For starters, the insurance industry does not like this perversion of a product they have sold for decades as an estate-planning tool. Consequently, the industry has its fraud-antennae up. If you invest in a Life Settlement policy and the insurance company decides to invalidate the policy, you’re out of luck. You have no way of knowing if Mr. Rich told the truth on his policy application. And there’s always the possibility that Mr. Rich come from great genetic stock and will be the actuarial odds. In that case, the additional cost of premiums will erode the potential return. You should also know that death benefits are taxed as ordinary income, which is higher than capital gains on from more traditional investments.