Financial Arbitrage Opportunities

What is Arbitrage? Simply put, simultaneous purchase and sale of an asset in order to profit from the difference in price. That definition can be extended to a number of areas with several scenarios.

Arbitrage transactions have been and are happening round the clock around the world. Knowledgeable ones end up on the positive end of the deals of all kinds.

If you pick up the phone and talk to 5 people at, IRS, Govt. agencies, commercial banks, big wire houses, institutions, politicians, economists and others you will get 5 different opinions and answers every time!! All the five agreeing even once would be nothing short of a miracle. This is Arbitrage of opinions at functioning on all cylinders.

In the financial world the classic example would be how the banks operate as they are masters of Arbitrage technology (manipulations?). Let us look at a simple example. Two consumers walk into a local bank. Two officers at the bank are sitting next to each other, one a CD specialist and the other a loan officer. One consumer hands over $100,000 to the CD specialist for deposit. In turn the consumer receives a CD, certificate of deposit (certificate of disappointment?) guaranteeing 2.5% annual interest. Big deal right?

The other consumer meets the loan officer trying to raise a loan for $100,000. The officer takes the $100,000 just received at the next desk and passes on the customer a bank check for $100,000 and charges an interest of 9%. The bank locked in a gain of 6.5% on $100,000 in just a few minutes. That is a positive arbitrage of 6.5%. Banks do this the whole day, the whole week, and the whole year. If the credit of the customer is less than perfect they are going to charge him a lot higher interest widening their gains. You see why the banks own multi storey buildings?

The gains do not stop there as the banks will leverage that $100,000 multiple times. Their credit card operations are mind boggling and stunning from the standpoint of consumer fairness. That is a different subject and we are not going there. What most investors do not know is they can be their own bankers and play the same game for gains for themselves if they paid attention and learnt the tricks of the trade.

The focus of this article is, how arbitrage works in enhancing, GUARANTEED INCOME and the ESTATE in a tax advantaged way for a senior. Here is a hypothetical example:

John Doe 75, a diabetic with cardiac issues.
Has a million dollars to invest. He needs $45,000 income year. Could use more if possible.
He meets with two financial advisors.

ADVISOR 1: Recommends investing in high quality bonds offering 4.5% ie $45,000 pre tax. John is satisfied. John will receive income for life and his $1m principal will be part of his estate subject to estate taxes when he passes away (could be 50% in taxes). Heirs may net $500,000. This depends on John's gross estate.

ADVISOR 2 (Arbitrage specialist):
From her past experience this advisor knows looking at John's medical history, she can do much better than Advisor 1. Advisor 2 conveys that to him and asks for three weeks time to offer a plan. John agrees.
Following is the two parts recommendation from Advisor 2 after three weeks:

1. John will give to the investment company $1m in exchange for pretax $120,000 in tax advantaged guaranteed income per year for life.
2. John will use $60,000 for him as income and invest $60,000 in a wealth replacement contract which will deliver $1m to John's heirs, income and estate tax free if properly structured, thus replacing the asset for the beneficiaries.

Enormous good as well as bad have come out of the individual differences and opinions between human beings. Kingdoms have been gained and lost on this opinions and differences battle. Positive or negative arbitrage for better or worse is created when opinions differ amongst two or more decision making people in power in the financial world.

The underlying investment used here to generate substantially enhanced in come is MEDICALLY UNDERWRITTEN SINGLE PREMIUM IMMEDIATE ANNUITY (SPIA). This SPIA contract is generally issued by financially sound life insurance companies. Though there are over 10,000 life insurance companies in the US, under 25 specialize in SPIAs. Advisor 2 knows that. She shopped around with 10 of the top rated, financially sound life insurance companies, provided them John's medical records to get the best guaranteed income offer for life. As is the case most of the times, she got 10 different offers. That is because 10 underwriters from 10 insurance companies looked at John's medical records through difference lenses and came to different conclusions. They have different opinions.

The life time guaranteed income range offered by these 10 companies was $60,000 per year from company 10 to all the way to $120,000 per year from company 1. It was no brainer for Advisor 2 to choose the best offer. The underwriter from company 10 who came up with an offer of $60,000 evaluated that John's health condition was not bad and with proper medical treatment has a better than normal life expectancy, may be 17 years. In this case the company has to pay guaranteed income for longer periods and hence the income offer was low.

The underwriter from company 1 who offered $120,000 income concluded that John's condition is bad and he has much less life expectancy than normal and may have 8 years or less of life left. In his opinion John's age for this purpose is 83 and not 75. The company has to pay the income for a much shorter duration and hence $120,000 per year is fair.

The other 8 underwiters had evaluations and offers in between $60,000 to $120,000. In fairness to John's heirs, Advisor 2 had the challenge on her hand to replace the $1m lost asset at a reasonable cost. Advisor 2 being a pro in her field goes to the underwriter of company 10 who felt John's health is good and gets the $1m wealth replacement contract for a cost of $60,000 per year. Company 1 was not a choice as the underwriter wanted $150,000 per year for the wealth replacement contract.

Do you see how all these works out. It is all a play of opinions. If you know how to take advantage of it you will do well for yourself.

Why Tax Advantaged income and death proceeds?
If you compare the two offers from the two advisors, you will notice, bond offer from Advisor 1 was pre tax $45,000. Assuming the client is in a 30% bracket, he would net $31,500 after tax.

Offer from Advisor 2 is $120,000 pre tax income. Under current tax laws, SPIA has certain special tax treatment called EXCLUSION RATIO. What that means is $120,000 income is treated as return of the principal for most part. Generally, depending on a number of factors 75% to 95% of the income could be tax exempt. This 75 years old client is likely to be taxed on may be 15% of the $120,000. That would be a taxable income of $18,000. At 30% tax rate, the tax liablity could be $5,400.

Client keeps $114,500 after tax income. If he committed $60,000 per year as long as he is alive to the wealth replacement contract he gets to keep $54,500 spendable income. That is $20,000 more than the spendable income of $31,500 from Advisor 1. John would love this. Wont't he?

When John passes away his heirs will receive $1m income and estate tax free if properly structured.
Results could widely vary depending on a number of crucial factors. But wonderful opportunities do exist to be tapped into and consumers use it all the time.

Long long ago, very long ago, once upon a time GOD ALMIGHTY (GA) appeared before Adam and Eve. This is what happened:

GA: Each of you have 30 seconds to ask me three wishes. Go ahead and ask me, quick- come on 10 seconds gone, hurry up!

One Spouse: Wine, Women and War!
Oher Spouse: Arbitrage, Leverage, Compound Interest
GA: Granted.

Which spouse asked what? You guessed it right. I agree.

There you have it, the 1st, 2nd, 3rd or the 9th, 10th, 11th wonders of the world.

Good luck with your Arbitrage investing.


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