As fraudulent schemes beset the financial market, the Insurance Advocate has learned of yet another "hot deal" simply too good to be true. The result: insurance buyers are left holding the proverbial bag and a big tax bill and conspiring parties are profiting.  
 
What we'll call stealth rebates, harm many elderly people who bought life insurance using premium financing; many face burdensome tax liabilities in their retirement years when they can least afford it. In most cases, the life insurance agents who sold them the deal were not aware of the implications of the mess to which they were a party. Often, the elderly were lured into the scheme by cash payments and the promise of future profits by selling their policy on the settlement market if they were 70 or older. They were told they had no personal expense or liability because the policy premiums were 100% financed and the lender looked only to the policy as collateral for repayment of the loan.    

What the elderly buyer did not know was that the lender was taking part of the insurance commission on the policy as a stealth rebate. New York and nearly every other state prohibits the kick-back or rebating of life insurance commissions or other forms of payment to the buyer of a policy as an inducement to purchase the policy. (New York Insurance Law section 4224(c).) Benefits specified in the policy are exempt from this prohibition.    

The state anti-rebate laws prohibit not only the direct kick-back of commissions to the policy buyer, such as where the life insurance agent receiving the commission writes a check back directly to the buyer, but also indirect payments, such as where the commission is used to provide something of value to the buyer like a below market loan. If the lender was receiving part of the commission which it in turn used to sweeten the loan with a lower interest rate, for example, the arrangement would constitute an illegal indirect rebate and could subject the lender, the agent, the insurance company and possibly even the borrower to penalties under the state insurance law. To avoid detection, a lender engaging in this illicit practice would take care to conceal the indirect rebate so that it was not evident in the policy application to the insurance company or the loan documents signed by the borrower. Through these stealth rebates, the lender was able to run off competing lenders by making cheaper loans and profit from the extra revenues generated by the commissions it received. Let's take a closer look at how this works.   
 
In a normal premium financing arrangement, the lender loans the insured or policy owner money to the pay the policy premiums and takes the policy or other security as collateral for the loan. Generally, the lender took the policy as sole collateral based on the policy's expected resale value in the settlement market. The lender would next charge interest on the loan at a rate that is higher than its costs so that it can make a profit.    

In a stealth rebate loan arrangement, the lender sets up a life insurance agency to receive part of the commission from the insurance company and then uses this money to make a more favorable loan to the policy buyer. For example, the lender may charge a lower interest rate or may loan a greater amount against the policy collateral. In some cases, the extra loan is given to the buyer as a reward for entering into the transaction. In other cases, the lender pockets the commission money to reduce the interest rate or to justify making a loan collateralized by a policy that had a value below the loan amount.    

In each case, the commission money is used to benefit the policy buyer by either lowering the loan interest rate, or giving the buyer a cash payment in the form of a loan, or financing a policy that otherwise has insufficient value to secure the loan. In each case, the lender took the commission and laundered or concealed the illegal rebate to induce purchase of the policy through the premium finance loan. In each case, the elderly borrower unwittingly received an item of taxable income equal to the amount of the stealth rebate as explained later.  
 
It is easy to see why the policy buyer is eager to enter into the arrangement. The buyer gets a bargain loan and not only pays nothing for the policy but in many cases gets cash up front. Further, because the policy is the sole collateral for the loan, the buyer can walk away without repaying the loan and simply give up the policy to the lender. In many cases, the elderly buyer expected that he or she would be able to sell the policy on the settlement market to pay off the loan and pocket a profit on the sale. Of course, the life agent is motivated to promote the transaction because he earns part of the commission.
   
The lender profits in two ways. First, the lender keeps that part of the insurance commission which it did not rebate back to the buyer through the loan. Second, the lender positions itself to take the policy if the buyer defaults on repayment. The lender can then foreclose on the policy and may later sell it on the settlement market for a profit. Although the policy owner may have expected to sell the policy on the settlement market for a profit, there are several factors that might interfere with achieving that objective and might cause the borrower policy owner to relinquish the policy to the lender in discharge of the loan.    
First, the policy owner may find that the policy is not as marketable as expected and the market bids are below the loan amount due. This is often the case if the stealth rebate was used by the lender to make a loan for a policy that did not otherwise meet the lender's policy value requirements for loan collateral. (Of course, the policy may have lost value for other reasons as well, such as due to general market conditions.) The lender, after taking the policy in foreclosure, may be able to resell the policy for a profit nonetheless by bundling it as part of a group of policies for securitization (i.e. an investment pool similar to that used for home mortgages) which is an option not available to an individual policy owner. Second, the policy owner may not be able to find a buyer in time to sell the policy before the loan due date.
   
Many loans impose onerous terms if the loan is not repaid on time. For example, the elderly insured becomes personally liable for the loan, or the loan interest jumps up, causing the policy owner to relinquish the policy rather than face personal liability or confront a ballooning loan balance due. Third, in some cases the lender might offer the policy owner a small payment to relinquish the policy and avoid the complications of finding a third party buyer.  
 
Up until 2006, many of the premium finance loans did not require any down payment by the borrower and were entirely non-recourse, so the policy owner enjoyed life insurance coverage for the term of the loan without any requirement to pay premiums, interest or repay the loan. These loans generally were for 2 years to bridge the contestability period for misrepresentation and suicide. At the end of the loan term, many of the policies were sold or relinquished to the lender. To meet insurance company objections that the loans were merely pre-arranged policy settlement sales to investors, the more recent loans have been designed as so-called hybrid loans which require the borrower to make some down payment or personal guarantee of the loan. But the stealth rebate element of the loans has quietly persisted and this time bomb continues to tick.    
The stealth rebate bomb is a financial disaster for the unwary elderly borrower who in many cases no longer owns the life insurance policy he purchased with the premium finance loan. The elderly borrower may have already received an IRS Form 1099 reporting taxable income on the loan amount discharged by relinquishing the policy to the lender because the market bids offered for the policy were below the loan amount due. Since the borrower was not aware of the stealth rebate used by the lender to support the loan, the borrower entered into the premium finance loan assuming that his or her policy had sufficient value to justify the loan and might reasonably be expected to increase in value over the term of the loan. When the loan comes due, the elderly borrower then discovers that the policy is less valuable if he or she attempts to sell the policy or to refinance the loan. Like the sub-prime mortgage homeowner, the elderly borrower in many cases is forced to default and not only lose the life insurance policy but also owes income taxes on the defaulted loan. Moreover, a former regulator pointed out that the recipient of a rebate or inducement may also be guilty of violating the law.  
 
The stealth rebate victim faces an additional income tax liability on the value of the reduced borrowing costs passed though by the lender. For example, if the lender would normally charge $10,000 interest to cover its cost of funds and profit margin, but on the premium finance loan charged only $3000 because it received a stealth rebate, then the borrower received the amount of reduced interest ($7000) as an item of imputed taxable income. Economically, it is the same as the borrower receiving $7000 of the insurance commission which is taxable income and paying it over to the lender as a nondeductible interest payment. The borrower's net cost is $3000 and the lender receives $10,000. A similar result applies if the stealth rebate was used to make a loan for a policy with insufficient collateral value. For example, if the policy used as loan collateral has a value of $93,000 and the requested loan is $100,000, the lender would make the loan if it received a stealth rebate of at least $7000 to close the gap. The borrower receives a benefit because the lender would not have made the loan without receiving the payment of $7000. For tax purposes, the borrower may be treated as receiving the $7000 as taxable income and then paying it to the lender as a nondeductible loan origination fee. Thus, the borrower receives a loan of $100,000 and the lender tendered a net $93,000 after receiving cash of $7000.   
 
Stealth rebates have been an element in thousands of loans for many years, including loans made by many financial intermediaries, domestic and foreign banks operating in the U.S. But because they are illegal under state insurance law and were not disclosed to the borrowers, it is unlikely that any lender will voluntarily report them as income to the borrowers. Nonetheless, the undisclosed tax liability to the insured could be huge. Because in many cases the insureds paid little or nothing for the financed policy, the elderly insureds were convinced to take out large policies that could generate for the lender stealth rebates running into the hundreds of thousands of dollars per policy. In one case now in litigation, a New York City butcher was paid cash by finance a $10 million policy. In another case, an 80 year old lawyer bought $56 million of insurance which was 100% financed. More of these cases are coming to light as insurance companies as well as victimized insureds and their families start to bring law suits over premium financed policies that turned out to primarily benefit the lender or the investors bankrolling the deal behind the scenes. However, the millions of dollars in stealth rebates that fueled many of these transactions so far have remained concealed. No one yet knows the precise magnitude of the dollars and tax liabilities involved, but the numbers could be staggering even in an era when we have grown accustomed to huge sums in Wall Street bonuses and financial schemes.   
 
With the growing awareness of victimized insureds and more active probing by regulators and government, it can be expected that the covers will soon be pulled off the stealth rebate scandal. Already the U.S. Congress and state regulators have begun hearings and investigations into premium finance lending practices. In addition, the U.S. Treasury Department has been reviewing the premium finance market as an area of unreported income. In a time of public outcry over lax regulation and illicit financial practices, it is easy to predict that stealth rebates may be the next financial scandal to make news.

"Ripe for Abuse"  
When the New York State Insurance Department proposed legislation addressing the business of life settlements, they sought to set up a framework for regulating the transactions, not currently regulated in New York. Superintendent, Eric Dinallo, stated: "Life settlements can be ripe for abuse. In these times of economic uncertainty, there is strong pressure on people pressed for cash to sell valuable assets, such as life insurance policies. This bill protects consumers by establishing a transparent marketplace with specific licensing, registration and disclosure requirements. That means consumers will be given the critical information they need to make a decision in a life settlement transaction, including the value of offers and counter-offers, the fees paid to life settlement brokers and the contractual arrangements among the parties involved in a transaction."    

The proposed legislation calls for licensing requirements for life settlement providers and life settlement brokers, as well as registration requirements for life settlement intermediaries. It also proposes establishing privacy protections and other safeguards for insured individuals and policyowners.
    
The law currently regulates viatical settlements, transactions involving the sale of life insurance policies by insured individuals who have a catastrophic or life-threatening illness or condition. A life settlement involves the sale of a life insurance policy without regard to the insured person's health. Under the proposed legislation, the Insurance Department would have the authority to issue, revoke, suspend or nonrenew life settlement provider and life settlement broker licenses. It would require the registration of life settlement intermediaries who maintain electronic or other systems that facilitate life settlement transactions. Additionally, it would give the Department prior-approval authority for contract forms used in transactions. The legislation would establish numerous safeguards for insured individuals and policyowners. These would include protection against unlawful release of all information concerning the identity of an insured individual or policy owner, without the consent of the insured. The legislation would also require:    
• The disclosure of significant life settlement contract provisions. • The disclosure of affiliations or contractual arrangements among parties involved in a transaction. • A complete and accurate description of all offers and counter-offers relating to the sale of the life insurance policy. • A reconciliation for the policy owner showing the difference between the gross offer for the purchase of the life insurance policy and the net amount to be paid to the owner, including a listing of all fees and compensation to the life settlement broker and others. • Advising the policyowner that selling a life insurance policy could result in tax consequences and could limit the insured individual's ability to buy life insurance in the future.
   
The proposed legislation also specifically prohibits life settlement providers and brokers from engaging in stranger-owned life insurance (STOLI), a practice in which a life insurance policy is purchased for the benefit of someone, who at the time of policy issuance, has no insurable interest in the life of the insured individual. The Insurance Department drafted the proposed legislation following a series of four public hearings last year to gather consumer input. The Department also solicited the views of life settlement providers, life settlement brokers, life insurers, life insurance agents, investors and trade associations.