Who Benefits When an Insured Dies in Investor-Originated Life?

Life insurance offers a financial safeguard, providing a sum of money to designated beneficiaries upon the death of the insured. This provides financial security, helping loved ones manage expenses or replace lost income. While traditional life insurance is typically acquired by an individual or their family for protection, Investor-Originated Life Insurance (IOLI) represents a distinct structure. IOLI involves parties beyond the insured and their immediate family, introducing a different dynamic to policy ownership and benefit distribution.

Defining Investor-Originated Life Insurance

Investor-Originated Life Insurance (IOLI), often called Stranger-Originated Life Insurance (STOLI), is a financial arrangement where an investor initiates and funds a life insurance policy on an individual with whom they have no traditional insurable interest. The investor’s primary purpose is to profit from the policy’s death benefit. This differs from conventional life insurance, where the policyholder seeks to protect their family or business from financial loss.

IOLI is designed from its inception as an investment vehicle for a third party. The key parties involved typically include the insured individual, the investor or an investment entity, and the life insurance carrier. The insured is the person whose life is covered, while the investor drives the policy’s creation and funding. The life insurance carrier underwrites the policy and pays the death benefit upon the insured’s passing.

In a typical IOLI setup, the investor, or a broker, approaches potential insured individuals, often seniors, offering financial incentives. These might include an upfront payment or an agreement to cover premiums. The investor, rather than the insured or their family, initiates and often funds the policy, with the financial interest centered on the future payout. This structure has raised ethical and legal questions.

The concept of insurable interest is central to traditional life insurance; it requires that the policy owner would suffer a financial loss if the insured died. For instance, spouses have insurable interest in each other, and a business owner has insurable interest in a key employee. In IOLI, the investor generally lacks this traditional insurable interest in the insured’s life, other than the financial interest in the policy itself. This absence of conventional insurable interest at inception leads many states to regulate or prohibit such arrangements.

The Investor’s Role and Policy Ownership

The motivation for an investor to originate an IOLI policy stems from its potential as a financial asset or investment vehicle. Investors view these policies as opportunities to generate returns from the death benefit. The expectation is that the death benefit will exceed the total premiums paid and other costs associated with acquiring and maintaining the policy. This approach treats life insurance as an investment instrument rather than protection.

IOLI arrangements are typically structured so that the investor, or an entity established for their benefit, directly owns the policy. Common arrangements involve direct ownership or the policy being held within a trust. This trust is created on behalf of the investor to manage the policy. This ownership structure ensures the investor maintains control over the policy and its future benefits.

The responsibility for premium payments usually falls to the investor or their associated entity. The investor assumes the ongoing cost of keeping the policy in force by paying the required premiums. This commitment is part of the investor’s overall investment. In some scenarios, the investor might loan money to the insured to cover initial premiums, particularly during the policy’s contestability period, typically the first two years.

As the policy owner, the investor or their designated entity holds the legal right to name the policy’s beneficiary. This ensures that the financial returns from the policy are directed to the investor. While the insured individual may receive an upfront payment, they typically do not retain control over the beneficiary designation.

Distribution of Death Benefits

When the insured individual in an Investor-Originated Life Insurance arrangement passes away, the death benefit distribution reflects the policy’s ownership structure. Since the investor or an entity established by the investor typically owns the policy, the designated beneficiary is the investor or that specific trust or investment entity. This ensures the financial return flows to the party who initiated and maintained the investment.

The process of claiming the death benefit involves the policy owner, acting as the beneficiary, submitting a claim to the life insurance carrier. This requires providing proof of the insured’s death, such as a death certificate, along with policy details. The insurance company, upon verifying the claim, disburses the death benefit according to the beneficiary designation on file.

Upon receipt of the death benefit, the financial outcome for the investor-beneficiary is typically a lump sum payment. This lump sum represents the full face value of the policy. The investor’s profit is the difference between the death benefit received and the total amount invested in the policy, including acquisition costs and all subsequent premium payments.

While death benefits from life insurance policies are generally excluded from income tax for typical beneficiaries, the tax implications for an investor in an IOLI arrangement can differ. Under the “transfer for value” rule, if a life insurance contract is transferred for valuable consideration, the death benefit exclusion for the investor is limited. The investor may recognize ordinary income on the portion of the death benefit that exceeds their adjusted basis in the policy, which includes the amount paid for the policy plus any premiums subsequently paid to keep it in force.