Insurance arbitrage takes advantages of differences in pricing between annuities and life insurance. An annuity issued by an insurance company promises to pay you a set amount each year so long as you live. A life insurance policy promises to pay a set amount if you die. You ordinarily pay a lump sum for the annuity up front and you pay monthly premiums for the life insurance. If you die early the annuity company wins and the life insurance company loses.

All life insurance companies have their own way of pricing products. One company may have a much better deal on an annuity, while another company may have a much better deal on life insurance. For instance the annuity company may expect you to die at 75 while the life insurance company expects you to live to 80. Insurance arbitrage is the process of finding out about these discrepancies and taking advantage of them.

When you find a better price on an annuity you buy the annuity and use part of the annuity property to premiums on the life insurance. You keep the rest of the annuity payments or use them to buy more life insurance.

To illustrate, assume both an annuity and life insurance policy are priced the same way. Both issuers have the same costs and both expect you to live to the same age. If you buy both products then the net proceeds of both should be the same, if you live to the projected age. This means that the total annuity payments less the amount paid for the annuity would equal the total insurance proceeds less the premiums paid, with adjustments for the time value of money. When the annuity is priced more favorably to the customer then the monthly annuity payments will go up relative to the life insurance premiums. The increase can be kept or used to buy more life insurance. As a result you could get more life insurance than you could have gotten by buying the life insurance directly without also buying the annuity.

Part of each annuity payment is a tax free return of capital. Because of this insurance arbitrage is sold to older persons as a way to earn a tax free rate of return higher than what they could get on a tax free bond.

Some people may not be insurable so they are not candidates for this device. Also this scheme is illiquid. You usually cannot get out of an annuity without a penalty and it is hard to sell a life insurance policy.

Annuity payments include a return of principal so it is natural that they would be higher than insurance premiums for the same amount of term life insurance. Therefore, it is easy to show a rate of return on this arrangement. But why would you do it? At age 75 do you want or need life insurance? You will be paying high commission costs for the annuity and insurance policy. Will the return make up for it? Is the illiquidity suitable?

Some insurance people say they can find enough difference in pricing between annuities and life insurance to make this scheme work. Life insurance in these schemes can be used with other devices to keep the insurance out of the taxable estate. This can be done with little or no gift tax cost (of course this can be done with a life insurance policy itself without an associated annuity.) Remember that the annuity disappears at death and is not in the taxable estate.

Donald M. Thompson * 55 W. Monroe #3950; Chicago, IL 60603
Ph: 312-782-0844 * Fax: 312-201-1436 * Email: donthompsonlaw@sbcglobal.net