Some life insurance policies are starting to haunt the living. Three years ago, I said "premium financed" policies were "not exactly a scam, but dangerous." Today that warning seems like an understatement.

More than $20 billion of these so-called "spin life" insurance policies have been sold and now they're starting to implode. Many policy holders don't realize the trouble they face.

The concept seemed straightforward when sales were rampant several years ago. Agents promised clients that investors would lend them money to pay the premiums for the first two years, until the policy was past the "contestability period." Then the policy would be sold to an investor, who would continue to pay the premiums, hoping to collect on this "bet" on the senior's longevity.

Agents were encouraging elderly people to buy huge life insurance policies on themselves, even though they didn't need the insurance, and couldn't afford the premiums.

Why would any person let a stranger become the owner of a policy on his life? The answer is simple: money.

Pre-death bonus: Seniors were tempted by upfront "bonuses" that ranged from thousands of dollars to expensive cruises just for letting the investor bet against the insurance industry's mortality tables, and eventually collect the policy proceeds. And they were promised more money when the policy was sold.

At first, there was no risk to seniors. The loans to pay the premiums were "non-recourse." However, three years ago, insurance companies decided that customers needed to guarantee at least 25% of the premium. The insurers potentially sensed problems brewing, but still wanted to sell policies.

Sales agents collected fat commissions by convincing seniors there was no risk. Household names in financial services were raising money to buy these policies, betting they would pay premiums for a few years and then collect on death. Among them were LaSalle Bank (now part of Bank of America ( BAC)), Credit Suisse Group ( CS) and funds managed by Berkshire Hathaway ( BRK.A) and Goldman Sachs ( GS).

Death bet gone wrong: Then came the credit crunch. Demand for the policies dropped as investors struggled to borrow. When the two-year premium period expired, the insured expected brokers to sell the policies, allowing them to collect their bonuses. But there was no money to complete deals.

Suddenly, seniors faced premiums on insurance they didn't need and couldn't afford. It wasn't unusual for a senior to take out a $5 million policy, citing estate tax purposes. The premium on that policy could be $200,000 a year.

Sure, they could stop paying premiums and drop the policies, but most had signed documents agreeing to repay at least 25% of the first two years of premiums, plus interest. At the end of two years, the senior would owe $100,000 plus interest, adding another $6,000 to the tab.

Forgiven loans taxed: If the senior manages to pay off the guaranteed amount, plus interest, the lender will "forgive" the balance and additional interest. However, the policy holders will owe taxes on the forgiven debt.

If $300,000 plus $18,000 in interest was forgiven, a senior in the 35% tax bracket would owe an additional $100,000 in taxes on this phantom income.

Marc Sheridan and Don Tolep of Sheridan Wealth Advisors in Bay Harbor, Fla., say they're seeing more seniors facing financial ruin with these loans. They say the Internal Revenue service might be collecting as much as $1 billion in taxes on this income.

It's estimated that more than 10,000 of these "spin life" policies were sold in recent years. It looked like easy money for those willing to "share" their insurable capacity. Now they're learning an expensive lesson. And that's the Savage Truth.
Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column in the Chicago Sun-Times is nationally syndicated. She was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures. Savage currently serves as a director of the Chicago Mercantile Exchange Corp.

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