By Stephan Leimberg and Howard Zaritsky
The STAT is an intriguing use of annuities to avoid risk of loss in aggressive investments. It is available only because some annuity issuers attempt to tempt older annuitants by offering a full return of their premiums if the annuitant dies prematurely. It seems unlikely that annuity issuers will cease to offer this appealing feature, so that if they wish to avoid the use of annuity contracts in STATs, they will need now to change their policy applications significantly to inquire into whether the policy owner has a relationship with the annuitant akin to that required with respect to life insurance contracts.
Probably the most important part of this opinion is its refusal to apply the Rhode Island insurable interest rule to annuity contracts. This was based substantially on the existence of discrete rules under Rhode Island law for annuity contracts. Perhaps insurers who issue annuity agreements will find other states whose laws do not draw such fine distinctions and apply the law of those states, in an effort to avoid a repeat of this analysis.
If the insurers in this case are able to establish that the sponsors, agents and brokers committed fraud or breached their contracts, which is still highly uncertain, persons putting together future STATs will need to be more scrupulous in describing their arrangements and answering accurately the policy application questions. The burden may be on the issuers, however, to change their applications to ask the questions needed to obtain this information, if they want to avoid having annuity contracts used in this manner."
As members well know, LISI was one of the first organizations out in front of the STOLI issue. We're now able to report that members have a new acronym to digest: STAT, aka "Stranger Initiated Annuity Transactions."
Over the past year or so, STATs have made headlines in such national publications as the Wall Street Journal and the New York Times. Now,Howard Zaritsky provides members with his analysis of what appears 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) The court's opinion was issued just five days ago, and it's a doozy, so members are cautioned to put on their seatbelts before they read Howard's commentary.
Now, here is Howard's commentary:
In W. Reserve Life Assur. Co. v. Conreal LLC, 2010 U.S. Dist. LEXIS 56340 (D.R.I. June 2, 2010), a U.S. district court 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 (Rhode Island) does not require an insurable interest to buy an annuity contract on the life of another person, even though the policy has a significant death benefit.
The key to the scheme was recruiting terminally-ill people as annuitants. The investors bought annuity policies that allowed them to invest the premiums in stocks and bonds.
When the annuitants died, the policies' contained a death benefit that guaranteed, at minimum, the full return of their premiums, effectively protecting the investors from any risk of loss on the securities. Apparently, it worked, apart from possible liability on the part of the sponsors, brokers and agents for fraud and related contractual liabilities.
Joseph Caramadre was an attorney specializing in "reading the fine print of insurance and annuity products and finding 'loopholes.'" He conceived the idea of using variable annuity contracts, in which premiums could be invested in securities on behalf of the owner with an election of a death benefit that guaranteed the return of premiums upon the death of the annuitant, no matter what the market value of the policy was at that time. Caramadre figured out that, if one did not have to wait too long for the annuitant to die, such a policy offered the opportunity for riskless securities speculation. Investors could make aggressive short-term trades without worrying about losses.
Finding Just the Right Annuitants
The key to this strategy was finding terminally ill individuals, with a correspondingly short life expectancy, willing to be annuitants. Caramadre and an associate, as sponsors of this arrangement, circulated flyers among hospice patients and workers, stating that they had a "Program for the Terminally Ill."
Once they identified both a terminally-ill annuitant candidate and an investor, they arranged for a licensed agent of an annuities broker to provide an annuity application. They then paid the sick patient to sign the application as the annuitant, designating the investor as the owner and beneficiary. The investor paid the premiums. It was alleged that, in some cases, Caramadre, his associate or the sales agent actually forged the annuitant's signature.
Insurers Reject the STATs Quo
Western Reserve Life Assurance Co. of Ohio and Transamerica Life Insurance Company argued that the annuity contracts that they had sold were invalid and that they should not be required to pay the promised death benefits. They sought the following relief:
1) Rescission of the policies in which the annuitants are still living, or a declaratory judgment that the annuities are void, because they were procured on the basis of fraud, because the owners lack an insurable interest;
2) Damages for common law fraud, because the agents and some of the owners submitted applications without identifying that the arrangements were STATs;
3) Civil liability pursuant for criminal insurance fraud against the sponsors, brokers, agents, and some of the owners;
4) Civil conspiracy against the sponsors, brokers, agents, and some of the owners;
5) Breach of contract against the brokers, for violating the brokerage service agreements between Plaintiffs and the brokers;
6) Breach of the implied covenant of good faith and fair dealing against the brokers;
7) Unjust enrichment against the brokers and agents, for taking commissions from Plaintiffs in connection with the annuities; and
8) Negligence against the brokers and agents, for allowing the submission of annuity applications pursuant to the STAT.
Defendants Raise Three Defenses
The defendants moved to dismiss for failure of the insurers to state a claim upon which relief could be granted. They asserted "dozens of grounds for dismissal," which the court condensed into three principle defenses:
1) State law does not require that one buying an annuity contract have an insurable interest in the life of the annuitant, even if there is a death benefit;
2) The two-year incontestability period had expired, barring the insurers from litigating any claims related to the annuity applications; and
3) The defendants made no material misrepresentations or omissions in connection with the annuity applications.
Policy Owners and Beneficiaries Defeat the Insurers - Policies Not Rescinded
The court held for the sponsors, brokers and agents and against the insurers on all but one of the claims in the complaint.
No Insurable Interest Required to Buy an Annuity Contract
The insurers argued that the annuities were void or voidable because the owners had no insurable interest in the annuitants, which they argued violated applicable state law (Rhode Island). The district court disagreed, and held that an annuity contract does not, in Rhode Island, require an insurable interest.
Rhode Island law requires an insurable interest whenever someone "shall procure or cause to be procured any insurance contract upon the life or body of another individual. . . ." An insurable interest means that the policy owner must have either "a substantial interest engendered by love and affection" in the insured or a "lawful and substantial economic interest in having the life, health, or bodily safety of the individual . . . continue. . . ." The court noted that the insurable interest rule guards against creating incentives to shorten human life.
The defendants that annuity contracts are not "insurance contract[s] upon the life or body of another" and the court agreed, noting that state law placed life insurance and annuity policies in two separate categories. State law defined "annuities" as:
all agreements to make periodic payments for a certain period or where the making or continuance of all or some of a series of the payments, or the amount of any payment, depends on the continuance of human life, except payments made in connection with a life insurance policy. (Emphasis in the opinion).
State law defined "life insurance" as:
every insurance upon the lives of human beings and every insurance appertaining to that life, including the granting of endowment benefits, additional benefits in the event of death by accident, additional benefits to safeguard the contract from lapse, accelerated payments of part or all of the death benefit....
The state law also reinforced the statutory distinction between annuities and life insurance by enacting the Life Settlements Act (LSA), which takes effect in July, 2010. The LSA prohibits "stranger originated life insurance" (STOLI) transactions, in which one person initiates "a life insurance policy for the benefit of a third-party investor who, at the time of policy origination, has no insurable interest in the insured." (Emphasis in the opinion.) This was, the court stated, exactly what occurred in this case, except that the policies in this case were annuity policies, rather than life insurance.
The court noted that:
"the word 'annuity,' . . . is not used once in the LSA. . . . Had the General Assembly intended to extend the ban on stranger-owned products to annuities, it could easily have said so in the new law." This, the court stated, "helps to smother Plaintiffs' contention that the words 'any insurance contract' in [the insurable interest statute]. . . should refer to annuities."
The insurers contended that annuities may be "hybrid products" that have some of the characteristics of insurance products and some of the characteristics of investment securities, and that the court should look address them as insurance products where that is a significant purpose. They relied on a 1928 Rhode Island case, Sisson, which treated multi-year pre-paid burial contracts offered by an undertaker as insurance. If death occurred before a series of annual payments was completed, the undertaker agreed that he would not levy any additional charge against the decedent's heirs, and would provide the services.
The district court rejected the analogy to Sisson, noting that the contract in that case was a straightforward agreement to provide a service, with a provision waiving further costs on the death of the purchaser. This, the court stated, was similar to mortgage or credit life insurance, but the STATs were financial instruments that, "while they also happen to involve monetary exchange connected to the duration of a life, they are not life insurance."
In this regard, the court noted that the Rhode Island Supreme Court had long recognized "a fundamental difference between life insurance, which requires an insurable interest in order to prevent gambling on human life because it is against public policy, and annuities, which embrace the gamble as a core component of the contract:" An annuity could be a hybrid type of policy only if it had insurance at its core, but in this case, the annuities were an exchange of premiums for a future income stream, with death benefits as an incidental feature.
The court also noted that the annuity applications included no questions about the relationship between the annuitant and either the policy owner or the beneficiary. Thus, the court stated, they appear not to have themselves treated the annuity contracts as life insurance policies that require an insurable interest.
Immediate Incontestability Clause Protects Policy Owners and Beneficiaries from Fraud Charges
The insurers argued that the policies were void or voidable because they had been procured by fraud. The district court disagreed, finding that the incontestability clauses preclude a claim of fraud and, in this case, the annuity contracts stated that the: "policy shall be incontestable from the Policy Date," rendering them incontestable from their issuance. Therefore, claims of fraud were not sufficient to render the policies invalid or unenforceable.
The insurers, recognizing that the incontestability clauses posed a problem, also asked the court to construe them as inapplicable on the grounds that immediate incontestability would violate public policy as a temptation to fraud. The insurers noted that the courts in Massachusetts and Iowa had so held.
The district court noted that the Rhode Island Supreme Court had not yet ruled on this point, but that "no reasonable reading of that court's decisions, or Rhode Island statutory law, supports Plaintiffs' contention." The court noted that Rhode Island law treats incontestability provisions as being included for the benefit of the insured, rather than the insurer, and that all insurance policies subject to Rhode Island law must contain a two-year contestability period or terms that are more favorable to the policyholders. Thus, in Rhode Island, immediate incontestability appears to be encouraged, rather than discouraged.
The incontestability clauses also effectively struck out the insurers' claims for fraud, conspiracy, and civil liability for crimes and offenses against the policy owners, who are the beneficiaries of the policies, because such causes of action are barred by the same bar that applies to the claims against the various agents. The claims against the policy owners and beneficiaries rely on the same underlying allegations, and permitting them to continue would "essentially permit an end-run around the incontestability clauses."
The court even went so far as to reject an argument that the insurers had not actually made, that incontestability clauses are special to insurance contracts, and should not be extended to the owners of annuities where the owners participate in a fraud. The court noted that the insurers likely did not raise this argument because it undercut their claim that annuity contracts should be treated like insurance, but even if they had made this argument, the court stated, it would fail because the incontestability clauses appear in the contracts and make no exception for fraud. Annuities are not life insurance, but they are related types of contracts, and the relationship between makes the insurance cases persuasive, and those cases reject this argument.
Incontestability Clauses Don't Protect Sponsors, Agents and Brokers, However
The court, however, rejected the defendants argument that the incontestability clauses protect not only the policy owners and beneficiaries, but also the sponsors, agents and brokers. The court stated:
unlike Harry Potter's "Invisibility Cloak," which could conceal not only Harry, but anyone who wore it, . . . "[t]he benefits of an incontestable clause can be availed of only by an insured or his or her beneficiary, and cannot be invoked by a stranger to the contract." [citation omitted] The clauses thus have no effect on the fraud claims against the sponsors, agents, and brokers. . . .
Defendants, in the alternative, assert various other grounds on which the fraud claims should be dismissed; all of these argument fail to carry the day.
The court noted that the insurers' complaints, read in full, alleged facts sufficient to support a charge of fraud against the sponsors, agents and brokers, if the facts are proven at trial. The defendants argued that the alleged omissions and misrepresentations of the sponsors, brokers and agents were not material, but the court here also disagreed.
The defendants' noted that the insurers never questioned the owner's relationship to the annuitant, or the annuitant's health status, and that misrepresentations as to these facts could not, therefore, be material, because the insured "has no duty [to disclose information] where the application makes no specific inquiries." That lack of duty, however, is premised on the applicant's or insured's lack of actual knowledge that the material is important, and many state courts have allowed claims for "[f]raudulent concealment ... even without inquiry concerning the concealed material facts by the insurer."
The Rhode Island Supreme Court has not addressed the issue directly, but the court noted that it had recognized fraud claims based on concealment which suggest that fraud can arise from nondisclosure, where the defendant has a duty to speak. Whether or not the duty arises is a question of fact that must be left to the jury.
The duty to speak generally obligates a party to divulge facts that, if withheld, render other affirmative representations misleading. In this regard, the court noted that the plaintiffs had alleged that the defendants concealed:
1) the recruitment of annuitants who faced imminent death;
2) in some cases, the annuitants' ignorance of the terms of the policies;
3) the payments to some annuitants to sign the applications;
4) in some cases, the forgery or possible forgery of annuitants' signatures; and
5) with respect to the agents, the fact that they were not the agents who sold the policies, in contradiction of representations on the applications that they brokered the annuity sales and deemed them appropriate.
These points, the court stated, could sustain a charge of fraud.
The sponsors, agents and brokers also argued that the insurers could not establish the scienter element of fraud: that the defendants actually intended to deceive the insurers. The court disagreed.
The sponsors' claimed that none of their alleged omissions was material, even if they knowingly withheld facts, and that it was appropriate for them to stay silent about those facts. The materiality of these facts, however, is a matter for a jury, and so the sponsors' motion to dismiss could not be sustained on this ground.
The agents and brokers argued that the insurers never alleged that they had knowingly concealed information or lied. The agents noted that the insurers insisted that the named agents had no "substantive involvement" in selling the policies and that, in some cases, the annuitants "had never met" the agents before signing the applications.
The court noted, however, that the insurers declared that the agents "knew the . . . omissions in the applications" were misleading and that it was the sponsors, not the agents, who identified the buyers, and who solicited the annuitants to sign the applications. The court stated that these facts, if proven, would make it unlikely that the agents had actually brokered the sales, which would provide a "basis for inferring" that each agent knew it was misleading to proclaim on the application that he had made the annuity recommendation and found the investment appropriate.
The court also refused to dismiss the insurers' claims for conspiracy and unjust enrichment against the sponsors, agents, and brokers. The sponsors, agents and brokers argued that the claims for conspiracy and unjust enrichment claims cannot prevail, because each is based on the fraud claims, which they claimed were invalid. The court noted that it had permitted the fraud claims to go forward, so that they might be reasonably accompanied by the claims for conspiracy and unjust enrichment.
On the other hand, the court did dismiss the insurers claims for civil liability for crimes and offenses, holding that they ran into a problem based on the differences between life insurance and annuity contracts. The court noted that the Rhode Island insurance fraud statute on which the claims depend only criminalizes deceit in connection with "any application for the issuance of an insurance policy." The court stated that phrase "insurance policy" in the statute was "even less susceptible to the interpretation that they include annuities than the words 'insurance contract'" and that the defendants might have committed a crime, but not this one.
Breach of Contract Claims Proceed Against the Brokers
The court refused to dismiss the breach of contract claims against the brokers because they were related to the fraud claims, which would also go to trial. The court noted that the insurers entered agreements with each of the brokers setting conditions for the sale of insurance and annuity products and a fraud on the part of the broker, if proven, could create liability under at least two contract provisions.
1) A Western Reserve agreement clause that obligated the brokers to indemnify Western Reserve for "fraudulent ... acts" of the brokers' "employees ... or agents" related to the sale of Western Reserve products; and
2) A clause in both insurers' contracts that requires the brokers to "supervise" their agents in selling their products. Fraudulent acts of the agents could be evidence of a failure to supervise.
Breach of Implied Covenant of Good Faith and Fair Dealing
The court held for one insurer and against the other on claims against the brokers for violation of an implied covenant of good faith and fair dealing. The disparate results stemmed from the different choice-of-law clauses in the two contracts.
The Transamerica contracts also included an express choice-of-law clause designating New York law as governing the terms of the agreement. New York law "does not recognize a separate cause of action for breach of the implied covenant of good faith and fair dealing when a breach of contract claim, based upon the same facts, is also pled." Thus, Transamerica could only rely on its contract claims.
The Western Reserve contracts selected Florida as the applicable law, and Florida law requires claims based on the implied duty of good faith and fair dealing to accompany a violation of a specific contractual provision. As the court had permitted Western Reserve to go forward with its claim for breach of contract, the claim for violation of the implied covenant of good faith could also proceed.
Negligence Claims Struck Down
The court struck down the insurers' claims for negligence, because Rhode Island law allows only negligence that assert physical or emotional damages. The economic loss doctrine in Rhode Island prohibits parties who " have contracted to protect against potential economic liability" from recovering " purely economic damages" in tort claims.
If the insurers in Western Reserve Life Ass. Co. of Ohio v. Conreal, LLC are able to establish that the sponsors, agents and brokers committed fraud or breached their contracts, which is still highly uncertain, persons putting together future STATs will need to be more scrupulous in describing their arrangements and answering accurately the policy application questions. The burden may be on the issuers, however, to change their applications to ask the questions needed to obtain this information, if they want to avoid having annuity contracts used in this manner.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
CITE AS: LISI Estate Planning Newsletter #1655 (June 14, 2010) at http://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
Obtain a Free Download of Western Reserve Life Ass. Co. of Ohio v. Conreal.
W. Reserve Life Assur. Co. v. Conreal LLC, 2010 U.S. Dist. LEXIS 56340 (D.R.I. June 2, 2010); Clark v. Allen, 11 R.I. 439 (R.I. 1877); Cronin v. Vt. Life Ins. Co., 40 A. 497, 497 (R.I. 1898); Welch v. Union Cent. Life Ins. Co., 78 N.W. 853, 854-55 (Iowa 1899); Murray v. State Mut. Life Ins. Co., 48 A. 800, 800 (R.I.1901); Reagan v. Union Mut. Life Ins. Co., 76 N.E. 217, 218 (Mass.1905); Sisson ex rel Nardolillo v. Prata Undertaking Co., 141 A. 76 (R.I.1928); Maslin v. Columbian Nat'l Life Ins. Co., 3 F.Supp. 368, 369 (S.D.N.Y.1932); Prudential Ins. Co. of Am. v. Tanenbaum, 167 A. 147, 150 (R.I.1933); Harrison State Bank v. U.S. Fid. & Guar. Co., 22 P.2d 1061, 1064 (Mont.1933); Columbian Nat'l Life Ins. Co. v. Indus. Trust Co., 166 A. 809, 812 (R.I.1933); Newton v. N.Y. Life Ins. Co., 325 F.2d 498 (9th Cir.1963); Home Loan & Inv. Ass'n. v. Paterra, 255 A.2d 165, 168 (R.I.1969); Lighton v. Madison-Onondaga Mut. Fire Ins. Co., 106 A.D.2d 892, 892-93 (N.Y.App.Div.1984); Putnam Res. v. Pateman, 757 F.Supp. 157, 162 n. 1 (D.R.I.1991); Sun Ins. Co. of N.Y. v. Hercules Sec. Unlimited, Inc., 195 A.D.2d 24, 30 (N.Y.App.Div.1993); First Interstate Bank of Billings v. United States, 61 F.3d 876, 877-78 (Fed.Cir.1995); Nisenzon v. Sadowski, 689 A.2d 1037, 1046 (R.I.1997); Nautica Int'l, Inc. v. Intermarine USA, L.P., 5 F.Supp.2d 1333, 1340-41 (S.D.Fla.1998); Burger King Corp. v. Weaver, 169 F.3d 1310, 1318 (11th Cir.1999); Guilbeault v. R.J. Reynolds Tobacco Co., 84 F.Supp.2d 263, 269 (D.R.I.2000); Lander v. Hartford Life & Annuity Ins. Co., 251 F.3d 101, 105 (2d Cir. 2001); Harris v. Provident Life & Accident Ins. Co ., 310 F.3d 73, 81 (2d Cir.2002); Zaino v. Zaino, 818 A.2d 630, 638 (R.I.2003); Am. United Life Ins. Co. v. Martinez, 480 F.3d 1043, 1048 (11th Cir.2007); Franklin Grove Corp. v. Drexel, 936 A.2d 1272, 1275 (R. I.2007); R.I. Gen. Laws § 9-1-2 (civil liability for crimes); R.I. Gen. Laws § 11-41-29 (insurance fraud); R.I. Gen. Laws 1956 § 27-4-27 (2010) (insurable interest); R.I. Gen. Laws § 27-72-2(9)(i)(A)(X) (defining STOLIs as "fraudulent life settlement act[s]"); R.I. Gen. Laws § 27-72-14 (prohibiting "fraudulent life settlement acts"); R.I. Gen. Laws § 27-4-6.2(a) (incontestability clauses); 17 Lee R. Russ and Thomas F. Segalla, Couch on Insurance § 240:65 (3d ed.2009); S. Leimberg & H. Zaritsky, TAX PLANNING WITH LIFE INSURANCE (Thomson-Reuters/WG&L, 2d ed.).