Annuity Arbitrage - using an annuity to pay for the premiums of a life insurance policy:
Annuity arbitrage is the wedding of a rated single pay immediate annuity (a "SPIA") and a life insurance product on the same person. The annuity pays a steady stream of cash flow to the insured until death, while the life policy obviously pays a death benefit upon the same event. In this structure, an annuity paying a desirable amount of cash flow per year above the annual cost of insurance is desired. If structured properly, the annuity should: (a) pay the cost of insurance per year and (b) have enough cash flow left over per year to give a desirable yield, or investment return, to the insured. The excess return is the arbitrage spread enjoyed by the individual funding the structure.
Here's a real life case example: The insured party, "Ms. K", is a 78 yr old female with modest health impairments. She was rated table two or lower by most every life carrier that was approached for an offer. Lincoln Benefit Life was the only carrier willing to make a competitive offer on a UL product based on a Table II, non-smoker rating. Based on her impairments, it became clear that there was an opportunity to shop for a rated SPIA that might pay for her UL policy while also providing enough remaining yield to create an attractive investment.
A rated SPIA quoted from Lincoln Financial rated Ms. K at age 86 based on her current health and impairments. The annuity yielded an annual cash flow stream of $696,000 per year, or 17.40% of face value ($4.0mm). The annual cost of insurance based on premiums to the insured was $330,000/yr, or 6.6% of the face value ($5.0mm). The net yield or "arb-spread" between the annual annuity payout and the annual life premiums was 10.80% (simple interest) for the insured, all from an "A rated" annuity company; obviously a very attractive yield when considering the underlying credit. Upon death of the insured, the SPIA will stop paying, however, the life policy will pay out its death benefit ($5.0mm) to the beneficiaries (or estate) of the insured.
Why does this work? Why would there be such a discrepancy between insurance companies?
As odd as it may seem, different insurance carriers, both on the life and annuity side will often see different mortality of the same person. These differences exist because the annuity company is betting on when the insured is going to die, and the life carrier is betting on how long they are going to live. These differences in expectations on both sides of this "trade" is what creates the arbitrage.
Why is this attractive as an investment for a senior? There are several reasons: 1.) The SPIA product is a guaranteed cash flow to you for your entire life, and will not vary from year to year, no matter what happens to interest rates; 2.) Your beneficiaries are guaranteed full death benefit payout upon death from your life policy; 3.) Your only risk is the credit risk of the life carrier and the annuity carrier, hence, only investment grade carriers should be used; 4.) You are only fully taxed on a portion of the annuity income (Exclusion Ratio)