Stranger-Owned Life Insurance (STOLI)

What Is Stranger-Owned Life Insurance?

Stranger-owned life insurance (STOLI) is an arrangement in which an investor holds a life insurance policy without an insurable interest. Without an insurable interest, the investor would ordinarily be prohibited from purchasing the original policy.

Understanding Stranger-Owned Life Insurance (STOLI)

Stranger-owned life insurance (STOLI), or stranger-originated life insurance, is a way to bypass the insurable-interest requirement of purchasing life insurance. To legally purchase life insurance, the purchaser must have an insurable interest in the insured. That means the insured’s death would adversely affect the policy owner's finances. Some definitions of insurable interest require that the purchaser and the insured have a loving relationship, such as one that exists between spouses or parents and children.

STOLI arrangements are broadly illegal, and many schemes include fraudulent financial reporting. For example, a senior citizen uses falsely exaggerated financial numbers to purchase an inordinately large life insurance policy. In exchange, a third party agrees to finance the premiums. Eventually, the original purchaser puts the policy into a trust before selling it to the third-party lender for a cash payment. The insured gets “free” money. The third-party lender gets a large life insurance policy that pays a tax-free benefit when the insured dies.

Criticism of Stranger-Owned Life Insurance

The lack of insurable interest makes STOLI highly unethical. If the policyholder has an insurable interest, it is reasonable to assume that they hope for a long life for the insured rather than an accelerated death just to collect the death benefit. Without the insurable interest, the policyholder has more interest in the insured's death, an event that completes the agreement and benefits the third-party.

Having an insurable interest keeps corporate-owned life insurance (COLI) legal and, to some, ethical. While a COLI policy collects premiums from the employer\beneficiary, the financial value of the employee\insured to the company gives the employer interest in the insured’s continued health and well-being.

Even a company-owned policy, broadly legal and widely used, may give employees uneasy feelings. H. H. Holmes, a nineteenth-century businessman and the first noted US serial killer, famously purchased life-insurance policies on his employees before murdering them. That’s why the issuance of life insurance is subject to several requirements, including the consent of the insured.

Special Considerations

A common workaround of the insurable-interest requirement is to manufacture it, as in the hypothetical situation above. An investor seeking to take out a life insurance policy on a stranger may manufacture insurable interest instantly by granting that stranger a loan. The stranger’s death would leave the loan unrepaid, fulfilling the most skeletal definition of insurable interest.

Despite the Internal Revenue Service and state governments having a distaste for STOLI, as well as insurance companies’ increasing vigilance, the practice persists.