RI Lawyer Solicits Terminally Ill To Sell Annuities

(MoneyWatch)  And now, another strange story from the biggest little state in union, Rhode Island. Yesterday, the Wall Street Journal reported that a RI estate attorney had solicited terminally ill patients to "serve as paid fronts" for purchases of variable annuities. The article caught my eye because I used to live in RI; the case involves a well-known charitable local attorney; and I've been an outspoken critic of variable annuities for some time.

For a primer on variable annuities, check out this short video:


Now back to our story. Attorney Joseph Caramadre, considered an "insurance expert" beat the insurance companies at their own game. For years, insurers have been hawking variable annuities (VAs) as a perfect mix of tax-deferred investing and insurance. While the investments inside VAs look a lot like mutual funds, they have a feature that allows heirs of annuity owners the ability to receive the initial investment back as a death benefit, should the owner of the contract die.

Many investors exhaust the money inside of the annuity well-before they die, so to some extent, they pay for a benefit that they don't need. The extra death benefit is part of the reason that variable annuities are so expensive and it's also why the government confers special tax-deferred treatment on the products.

For years, variable annuities have been oversold to consumers, which is why the SEC has a special section on its web site detailing the dangers of these contracts:

Caution!
Other investment vehicles, such as IRAs and employer-sponsored 401(k) plans, also may provide you with tax-deferred growth and other tax advantages. For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity.

In addition, if you are investing in a variable annuity through a tax-advantaged retirement plan (such as a 401(k) plan or IRA), you will get no additional tax advantage from the variable annuity. Under these circumstances, consider buying a variable annuity only if it makes sense because of the annuity's other features, such as lifetime income payments and death benefit protection. The tax rules that apply to variable annuities can be complicated - before investing, you may want to consult a tax adviser about the tax consequences to you of investing in a variable annuity.

Wow--the SEC might as well have outlawed these products inside of retirement plans, but I guess the insurance lobby is still going strong, even after the AIG melt-down.

Our RI attorney exploited the death benefit feature by realizing that unlike a traditional life insurance policy, the variable annuity death benefit comes with no medical exam. That means that you can be terminally ill, invest in the contract and essentially get a no-lose way to play the market and collect a big commission check. No word on who collected those fat commissions, but there had to be plenty of licensed agents lining up to get a piece of the action.

From the WSJ:

If stocks rose while the person was still alive, the investor did well. If they fell, the investor got a full refund, leaving the insurer on the hook for the loss. Meanwhile, a broker-in some cases a partner in Mr. Caramadre's firm-would collect a share of a commission of as much as 7.5% of the invested amount, paid by the insurer.

Now all Caramadre needed was sick people who would allow their names to be used to purchase the contracts. Channeling his desire to "genuinely...help the terminally ill," he placed ads in the Rhode Island Catholic, the official newspaper of the local diocese, offering $2,000 in "CASH, Immediately Available." Then the attorney played matchmaker, connecting the terminally ill, financially-strapped prospect with investors who would benefit from the patient's death.

The plan worked, according to Caramadre's lawyer, who claimed that "everyone who was touched by Mr. Caramadre made money." But now insurance companies are getting hip to the scheme. Federal lawsuits have been filed, claiming that the ploy violates the concept of "insurable interest," which means that the beneficiary of the policy has to suffer a financial loss as a result of the insured's death.

The insurance companies may have been too cute by half. If insurable interest is a requirement on annuities, then why no medical exams? These companies have often exploited the gray area they occupy between the investment and insurance worlds. Maybe it's time for them to figure out where they want to make money in the future.

That said, it's hard to feel good about Mr. Caramadre's scheme. In the end, there don't seem to be any protagonists in this story.