By Stephan Leimberg and Howard Zaritsky
In LISI Estate Planning Newsletter #1655, Howard Zaritsky provided members with his analysis of what appeared to be the first reported “STAT” decision, W. Reserve Life Assur. Co. v. Conreal LLC, 2010 U.S. Dist. LEXIS 56340 (D.R.I. June 2, 2010).
In Western Reserve, the U.S. district court for Rhode Island sustained the use of “stranger-initiated annuity transactions,” or STATs, a technique in which the use of commercial annuity contracts as an investment vehicle allowed individuals to invest in publicly-traded securities with absolutely no risk of loss. The court held that, among other things, applicable state law in Rhode Island did not require an insurable interest to buy an annuity contract on the life of another.
Now, Howard returns to provide members with his analysis of Nationwide Life Ins. Co. v. Steiner, 2010 U.S. Dist. LEXIS 71163 (D.R.I. July 13, 2010), where the U.S. district court for Rhode Island has once again sustained the validity of a commercial annuity contract issued to someone with no insurable interest in the life of the annuitant.
Here is Howard’s commentary:
The U.S. District Court for Rhode Island has once again sustained the validity of a commercial annuity contract issued to someone with no insurable interest in the life of the annuitant, in an arrangement known as stranger initiated annuity transactions (STATs). These STATs permit an investor to make very speculative and aggressive investments with no risk of loss during the lifetime of the annuitant.
Annuity contracts are often issued by life insurance companies, but they involve a different set of assumptions and relationships from those involved in life insurance policies. The insurer in a life insurance policy has an economic interest in the insured living as long as possible, while the issuer of an annuity desires that the insured live as short a time as possible. Nonetheless, in both instances, there should be the same public policy requiring that the policy owner, if someone other than the insured or annuitant, has a reason to desire that the insured or annuitant live as long as possible.
Investors appear now to be attempting to originate variable annuities for speculation in a manner that resembles the STOLI life insurance arrangement. These STATs involve financing the purchase of variable annuities by individuals who are chronically or terminally ill. The individual buys an annuity policy that guarantees a lifetime annuity payment, but that also guarantees that the annuitant will receive the cash value of the policy, based on its directed internal investments, and that if the annuitant dies within a relatively short time, the premiums will be returned, often with interest. The investors who convince the annuitant to obtain the policy pay the premiums and, in some cases, pay the annuitant to apply for the policy.
The annuitant assigns the policy death benefits to the investors or names them the beneficiaries. If the market value of the investments grows significantly, the investors benefit when the annuitant dies. If the market value of the investments does not grow, the investors recover the premium payments, sometimes with interest. The annuitant receives a cash payment for entering into the transaction.
The validity of this arrangement may turn on whether the insurable interest rules apply to variable annuity contracts. The investors in such cases lack a traditional insurable interest in the life of the annuitant, but it is unclear whether the insurable interest rules apply to annuities.
In Western Reserve Life Assurance Co. of Ohio v. Conreal LLC, the U.S. District Court sustained the use of STATs and enforced the obligation to pay the annuity against the issuer. That same court has reaffirmed its conclusions now in Nationwide Life Ins. Co. v. Steiner, though this time based largely on the specific terms of the annuity contract in question, rather than the broader principles of insurable interest.
STEINER CASE DETAILS
Nationwide Life Insurance Company (Nationwide) brought this action seeking a declaratory judgment that it has validly terminated an annuity it issued to Sheila and Manfred Steiner. The Steiners counterclaimed for breach of contract.
The Steiners applied to buy an annuity from Nationwide, listing on the application form that Manfred would be the owner and Sheila the beneficiary, and naming Sheryl Stroup as the annuitant. The Steiners left blank the question on the application about their relationship to Stroup, and Nationwide still accepted the application. The Steiners made an initial payment of $1 million for the annuity. Stroup died a month later.
Under the annuity policy, Manfred could invest the premiums in securities, and a death benefit provision guaranteed the return of the cost of the policy upon redemption. A year after Stroup died, Manfred sought to recover what he paid in, despite the fact that the value of the underlying investments had dropped significantly.
After receiving the Steiners' request, it investigated the policy and discovered that Stroup’s death certificate indicated that she suffered from metastatic lung cancer at the time of the policy application. Nationwide also discovered that it had also issued a second annuity for which Stroup was the annuitant, with another policy owner.
These alerted Nationwide to the fact that the annuity was part of a STAT arrangement. Nationwide wrote to Manfred that it was rescinding the annuity, and sent him a check for the annuity’s surrender value.
Nationwide brought suit for declaratory judgment to establish its right not to enforce the death benefit clause of the annuity contract. Nationwide asserted that the contract was unenforceable, beyond return of the surrender value.
The Steiners counterclaimed for breach of contract, bad faith refusal to pay under the policy, tortious interference with contractual relations, and intentional infliction of emotional distress.
The Contract Claims
Nationwide argued that it could refuse to pay the death benefit, because of a termination clause in the annuity that stated:
In issuing this Contract, Nationwide intends to offer only annuity and related benefits (including death benefits) to single individuals and their beneficiaries. These benefits result in Nationwide assuming certain risks. This Contract is not intended for use by institutional investors, people trying to cover risks involving multiple lives with a single contract or by someone trying to cover a single life with multiple Nationwide contracts.
If Nationwide discovers that the risk it intended to assume in issuing this Contract has been altered by any of the following, then Nationwide will take any action it feels is necessary to mitigate or eliminate the altered risk including, but not limited to, rescinding the Contract and returning the Surrender Value:
(1) Information provided by the Contract Owner(s) is materially false, misleading, incomplete or otherwise deficient.
(2) The Contract is being used with other contracts issued by Nationwide to cover a single life or risk.
* * * *
Nationwide's failure to detect, mitigate or eliminate altered risk does not act as a waiver of its rights and does not bar Nationwide from asserting its rights at a future date.
Nationwide asserted two grounds for termination under this provision. First, the Steiners' application was “materially ... incomplete or otherwise deficient,” because it did not state the relationship between the annuitant and the beneficiary. Second, the Steiners' annuity was “being used with other contracts issued by Nationwide to cover a single life or risk,” because of the second policy on Stroup's life.
The Holding on the Contract Claim
On cross-motions for judgment on the pleadings, the District Court for Rhode Island (Judge Smith) held for the Steiners, and ordered Nationwide to pay the full amount owed under the death benefit clause. The court held that neither part of the termination clause cited by Nationwide authorized escaping from its liability under the death benefit provisions of the annuity contract.
The Reasoning on the Contract Claim
The court rejected Nationwide’s argument that the “other contracts” language of the termination clause prevented its obligation under the death benefit provisions, because the clause, if ambiguous, must be construed against the insurer who prepared the contract, and because accepting Nationwide’s argument would mean that the contract was illusory.
Nationwide had argued that the “other contracts” provision gives it broad authority to terminate the contract if it discovers that the risk it “intended to assume in issuing [the policy] has been altered” by the sale of “other contracts ... to cover [the] life referenced in the first annuity. . .” The Steiners argued that were the termination clause that sweeping, it would be inconsistent with the rest of the contract. They noted that the introduction to the termination clause explains that the “Contract is not intended for use ... by someone trying to cover a single life with multiple Nationwide contracts,” but that another provision entitled “purchase payments” states:
[T]otal cumulative [p]urchase [p]ayments under the Contract and any other annuity contract issued by Nationwide with the same Annuitant may not exceed $1,000,000 (and will be returned to the Contract Owner), unless Nationwide agrees in writing to accept [payments] exceeding $1,000,000. (emphasis in opinion).
The court agreed with the Steiners that the “other contracts” clause was ambiguous, and that it only prohibits having one owner buy multiple annuity contracts on the life of the same annuitant; different owners could buy separate Nationwide annuity contracts on the life of the same annuitant. The court noted that the “other contracts” language referred to “someone” trying to buy multiple contracts on one life, and that the use of the word “someone” indicates that multiple persons can buy multiple policies on one annuitant’s life.
Nationwide argued that the general rule of contract construction that a specific term controls over a conflicting general term, must prefer Nationwide’s specific right to terminate the contract upon discovering that there are multiple contracts, over the more general rationale for reserving revocation rights stated in the introduction to the termination clause. The court disagreed, because any ambiguity in a contract must be construed against the drafter.
The court also explained that it must reject Nationwide's interpretation of the termination clause because, were Nationwide’s interpretation correct, the entire contract would have been illusory. Nationwide argued that it could terminate the contract upon discovery that there were more than one annuity on a single life, regardless whether Nationwide sold the terminated contract before or after the other contract, and regardless whether it knew or should have known that there was another contract issued on the same annuitant’s life. The court explained that, “if Nationwide can cancel the annuity based on its own subsequent action, then it was never contractually bound to anything.” The termination provision would not provide sufficient “limits and restrictions constituting the necessary legal detriment of consideration and conditions so as not to render the agreement illusory.”
Therefore, the court stated, Nationwide was in the same situation whether it breached the contract and must pay the death benefit (returning the full premiums paid) or its argument were accepted and the contract were held illusory.
Nationwide also argued that the Steiners' failure to state the beneficiary's relationship to Stroup on the annuity application activated Nationwide's termination rights, but the court held that Nationwide waived the right to challenge any omission in the application when it issued the policy. The court, in a footnote, noted that the parties in this case also disputed whether an annuity owner must have an “insurable interest” in the annuitant, but the court explained that it had already held in the negative on this question inWestern Reserve Life Assurance Co. of Ohio v. Conreal LLC.
Nationwide tried to salvage this argument by noting that the contract states that its “failure to detect, mitigate or eliminate altered risk does not act as a waiver of its rights and does not bar Nationwide from asserting its rights at a future date.” Nationwide argued that it did not figure out that the Steiners were unrelated to Stroup until after Stroup died, but the court held that the no waiver clause cannot fix Nationwide's mistake. Nationwide accepted an incomplete application either because it decided that the missing information was unimportant, or it simply failed to review the application fully. In either case, the nonwaiver clause does not reflect a “failure to detect, mitigate or eliminate altered risk.”
The Remedy for Breach of Contract
The court held that, because Nationwide had no authority to terminate the annuity, it was liable for breach of contract to the Steiners. The Steiners, therefore, were entitled to receive the death benefit provided for in the annuity.
The Tort Claims
The court rather summarily rejected the Steiners’ claim that Nationwide was also liable in for tortious interference with contractual relations and intentional infliction of emotional distress. It agreed with Nationwide that it cannot be liable for bad faith when its position was “fairly debatable” and because Nationwide could breach its contract, but it could not tortiously interfere with its own contract.
The STAT is an extension of some of the techniques and issues of STOLI into the area of annuity contracts. Annuity contracts are not, strictly speaking, life insurance contracts, though they are usually issued by life insurance companies.
If the U.S. District Court for Rhode Island was correct in both Western Reserve Life Assurance Co. of Ohio v. Conreal LLC and Nationwide Life Ins. Co. v. Steiner, it will be very difficult for annuity issuers to prevent the use of their products in this fashion. Any annuity contract that both permits extensive flexibility in the selection of the underlying investments and promises to return the premium payments upon the early death of the annuitant will be a very appealing means for investing in highly risky investments. For the investor, it will be a “heads-I-win, tails-you-lose” proposition that will be hard to resist.
Of course, in this country, litigators pay their own costs of contest. Therefore, investors in STATs should recognize that part of the cost of their investment is likely to be a significant legal fee to sustain their right to recover under the death benefit clauses of the annuity contracts. If the contract in question is not issued in Rhode Island, these costs may be quite substantial, and the chance of victory is certainly less than 100%.
Therefore, STATs should be undertaken by those who appreciate risk. They will be investing the annuity cash values in highly risky investments, and if the investments do not perform well, they may have to litigate in order to collect.
CITE AS: LISI Estate Planning Newsletter #1690 (August 22, 2010) athttp://www.leimbergservices.com Copyright 2010 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission Express Permission
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