At Last, an Easy Way to Make a 16.36% Average Annual Rate of Return...Without Risk

Earlier this year this column carried an article with a similar title (but the percentage was 16.28%, instead of the 16.36% in this title). Readers buried us in an avalanche of calls, faxes and e-mails. Even got a few letters. All wanted more information.

Here’s my favorite quote from a reader, which arrived by fax: “After reading the article you wrote… about the TIP investment, I would like more information… because it sounds too good to be true.” The most common question (or some variation) was, “How is it possible?”

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?… senior settlements (SS)… 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 investors will receive the $500,000 death benefit when Joe dies.

This transaction (Joe selling the policy and the investors buying it) is called SS. A TIP is a fractional interest in a SS.

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 8 to 11) 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 15) it has been in business. When the first article was written, the average rate of return was 16.28% per year…. Now inched up to 16.36%.

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—always ordinary income—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.

A little background about the life insurance industry before answering the quote and the question at the beginning of this article. There are basically two types of life insurance: permanent [has cash surrender value (CSV)] and term (no CSV). According to 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, SSs to the rescue. However, before the invention of TIPs, SSs 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 SS game for about 15 years and recently announced a $400 million loan to a new wholly owned subsidiary to invest in SSs.

TIPs are the bridge that allows the little guy to get into the SS profit game.

Go back to Joe’s SS/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 SS. Of course, the insurance company is anything but delighted and would like to keep SSs 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 SS 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 life expectancy of each SS policy seller at about 16% plus. Generally, the NASDAQ company only completes SSs where the insured’s life expectancy is five years or less.

The result of how a TIP transaction is structured allows the TIP investor to enjoy—

An average historical rate of return of 16.36%.
Not worrying about market volatility or whether it goes up or down.
The guaranteed return of your principal, as well as your profit.
And best of all, keep 100% of the profit because there are no fees or costs when you buy a TIP.

Now you know how it’s done. You also know because of the strange economics (no death benefit paid about 93% of the time) of the insurance industry and the ingenious way TIPs are structured that an 16.36% average rate of return is indeed, not too good to be true.

If you want to make a killing on your investments, TIPs are not for you. But if a set rate of return, with no market risk is of interest to you TIPs might be the answer.