By Barry Zalma, Attorney and Consultant
By Barry Zalma, Attorney and Consultant
It is the essence of insurance that for insurance to exist the person insured must have an insurable interest in the property or life insured.
Life insurance insurable interest can be defined as an interest based upon a reasonable expectation of pecuniary advantage through the continued life, health, or bodily safety of another person and consequent loss by reason of that person's death or disability or a substantial interest engendered by love and affection in the case of individuals closely related by blood or law. An individual may have an unlimited insurable interest in his or her own life, health, and bodily safety and may lawfully take out a policy of insurance on his or her own life, health, or bodily safety and have the policy made payable to whomsoever he or she pleases, regardless of whether the beneficiary designated has an insurable interest. It is the life of the person taking out the insurance who must have an insurable interest.
Insurance is also, by definition, the taking of a risk of a contingent or unknown event. It is not a gamble. Gambling on life has been illegal for more than 300 years because the life insured by the gambler would be at risk of murder to collect the funds.
The United States District Court, faced with making a decision concerning claims on a life insurance policy that was alleged to have been purchased as a wager on a life rather than a true insurance policy sought direction from the Delaware Supreme Court. In PHL Variable Insurance Company v. Price Dawe 2006 Insurance Trust, By and Through Its Trustee, No. 174, 2011 (Del. 09/20/2011) the Delaware Supreme Court, before STEELE, Chief Justice, HOLLAND, BERGER, JACOBS and RIDGELY, Justices constituting the Court en banc, answered the District Court's questions.
Factual and Procedural Background
The Price Dawe 2006 Insurance Trust is a Delaware statutory trust that Price Dawe formed in December 2006 with a family trust as the beneficiary. Dawe was the beneficiary of the family trust. PHL Variable Insurance Co. (Phoenix) issued a $9 million Delaware life insurance policy on Dawe's life with an issue date of March 8, 2007. The Dawe Trust was the owner and beneficiary of the policy.
The policy contains an incontestability provision stating that "[t]his policy shall be Incontestable after it has been in force for two years from the Issue Date, except for fraud, or any provision for reinstatement or policy change requiring evidence of insurability." Dawe died on March 3, 2010. On June 9, 2010, the Dawe Trust made a claim to Phoenix for the death benefit. Phoenix first contested the policy by filing this lawsuit on November 10, 2010, approximately 3 1/2 years after the policy issue date. These facts are undisputed and constitute the official record for our purposes.
Stranger Originated Life Insurance ("STOLI") Scheme Improper
In its original complaint, Phoenix contended that Dawe did not qualify, and had no legitimate need, for a $9 million life insurance policy. The insurance company claims Dawe misrepresented his income and assets in his application and that he was financially induced into participating in the transaction as part of a stranger originated life insurance ("STOLI") scheme. Phoenix more specifically contends that on or about May 14, 2007, less than two months after the policy went into force, GIII formally purchased the beneficial interest of the Dawe Trust from the Family Trust for $376,111, and did not file a change of ownership or change of beneficiary form with the company. After Dawe died, Phoenix received two competing claims for the death benefit, leading to an investigation that allegedly revealed the true nature of Dawe's life insurance transaction. Phoenix then filed suit in the United States District Court for the District of Delaware in order to obtain a declaration that the policy is void. After denying the defendant Trust's motion to dismiss, the district court certified three questions of Delaware law to Supreme Court, which the court accepted.
The Questions Asked
1) Does 18 Del. C. § 2704(a) and (c)(5) prohibit an insured from procuring or effecting a policy on his or her own life and immediately transferring the policy, or a beneficial interest in a trust that owns and is the beneficiary of the policy, to a person without an insurable interest in the insured's life, if the insured did not ever intend to provide insurance protection for a person with an insurable interest in his or her life?
2) Does 18 Del. C. § 2704(a) and (c)(5) confer upon the trustee of a Delaware trust established by an individual insured an insurable interest in the life of that individual when, at the time of the application for life insurance, the insured intends that the beneficial interest in the Delaware trust would be transferred to a third-party investor with no insurable interest in that individual's life following the issuance of the life insurance policy?
3) Does Delaware law permit an insurer to challenge the validity of a life insurance policy based on a lack of insurable interest after the expiration of the two-year contestability period required by 18 Del. C. § 2908?
Certified Question One: Contestability
The first certified question, shared by both Dawe and Schlanger, concerns whether an insurer may claim that a life insurance policy never came into existence, on the basis of a lack of insurable interest, where the challenge occurs after the insurance contract's mandatory contestability period expires. As certified by the district court in Dawe: "Does Delaware law permit an insurer to challenge the validity of a life insurance policy based on a lack of insurable interest after the expiration of the two-year contestability period required by 18 Del. C. § 2908?"
The Supreme Court answered question one: "YES."
An incontestability clause is a contractual provision wherein the insurer agrees that, after a policy has been in force for a given period of time, that it will not contest the policy based on misrepresentations in the insurance application. The insurance industry has used incontestability clauses for more than 100 years to encourage customers to purchase insurance.
Incontestability clauses provide security in financial planning for the insured, while also providing an insurer a reasonable opportunity to investigate any misrepresentations in the application. These provisions essentially serve the same function as statutes of limitation and repose. By the early twentieth century, life insurance policies included incontestability clauses as a matter of industry practice.
Certain agreements, however, are so egregiously flawed that they are void at the outset.
As with all contracts, fraud in the inducement renders a life insurance policy voidable at the election of the innocent party. Certain agreements, however, are so egregiously flawed that they are void at the outset. These arrangements are often referred to as void ab initio, Latin for "from the beginning." A court may never enforce agreements void ab initio, no matter what the intentions of the parties. Under the common law of contracts, there is a distinction between fraud in the inducement and fraud in the execution. Fraud in the execution occurs when a party makes a misrepresentation that is regarded as going to the very character of the proposed contract itself, as when one party induces the other to sign a document by falsely stating that it has no legal effect. If the misrepresentation is of this type, then there is no contract at all, or what is sometimes anomalously described as a void, as opposed to voidable, contract.
If the fraud relates to the inducement to enter the contract, then the agreement is "voidable" at the option of the innocent party. The distinction is that if there is fraud in the inducement, the contract is enforceable against at least one party, while fraud in the factum means that at no time was there a contractual obligation between the parties. [New England Mut. Life Ins. Co. v. Caruso, 535 N.E. 2d 270 (N.Y. 1989)]
Under Delaware common law, contracts that offend public policy or harm the public are deemed void as opposed to voidable. A life insurance contract that lacks an insurable interest at inception is void ab initio.
Therefore, an insurer can challenge the enforceability of a life insurance contract after the incontestability period where a lack of insurable interest voids the contract. For this reason the Supreme Court answered Question one affirmatively.
Certified Question Two: Intent to Transfer
The second certified question concerns whether the statutory insurable interest requirement is violated where the insured procures a life insurance policy with the intent to immediately transfer the benefit to an individual or entity lacking an insurable interest.
The Supreme Court answered: "NO" but only so long as the insured procured or effected the policy and the policy is not a mere cover for a wager. Therefore, if the fraud alleged is proved and the policy purchase was a mere cover for a wager, there is no cover.
In England, dead pools and the use of insurance to wager on strangers' lives actually became a popular pastime. In response, Parliament enacted the Life Assurance Act of 1774 which prohibited the use of insurance as a wagering contract unlinked to a demonstrated economic risk.
More than a century ago, the United States Supreme Court concisely articulated the public policy behind the insurable interest requirement:
[T]here must be a reasonable ground, founded upon the relations of the parties to each other, either pecuniary or of blood or affinity, to expect some benefit or advantage from the continuance of the life of the assured. Otherwise the contract is a mere wage, by which the party taking the policy is directly interested in the early death of the assured. Such policies have a tendency to create a desire for the event. They are, therefore, independently of any statute on the subject, condemned, as being against public policy. [Warnock v. Davis, 104 U.S. 775, 779 (1881). See also Grigsby v. Russell, 222 U.S. 149, 154 (1911) ("A contract of insurance upon a life in which the insured has no interest is a pure wager that gives the insured a sinister counter interest in having the life come to an end.").]
Over the last two decades, however, an active secondary market for life insurance, sometimes referred to as the life settlement industry, has emerged. This secondary market allows policy holders who no longer need life insurance to receive necessary cash during their lifetimes. The market provides a favorable alternative to allowing a policy to lapse, or receiving only the cash surrender value. The secondary market for life insurance is perfectly legal. Indeed, today it is highly regulated. In fact, most states have enacted statutes governing secondary market transactions, and all jurisdictions permit the transfer or sale of legitimately procured life insurance policies.
Virtually all jurisdictions, nevertheless, still prohibit third parties from creating life insurance policies for the benefit of those who have no relationship to the insured. These policies, commonly known as "stranger originated life insurance," or STOLI, lack an insurable interest and are thus an illegal wager on human life.
In approximately 2004, securitization emerged in the life settlement industry. Under this investment method, policies are pooled into an entity whose shares are then securitized and sold to investors. Securitization substantially increased the demand for life settlements, but did not affect the supply side, which remained constrained by a limited number of seniors who had unwanted policies of sufficiently high value. As a result, STOLI promoters sought to solve the supply problem by generating new, high value policies.
The Delaware Constitution prohibits all forms of gambling unless it falls within one of the enumerated exceptions. A life insurance policy procured or effected without an insurable interest is a wager on the life of the insured the Delaware Constitution prohibits. For nearly one hundred years, Delaware law has required an insurable interest as a way to distinguish between insurance and wagering contracts.
One of the tests as to the validity of the contract is to determine by whom the premiums are to be paid. If the one taking the insurance pays the premiums, the transaction is generally upheld. But there is a strong, though not universal, tendency to condemn contracts in which the premiums are paid by the beneficiary who holds no insurable interest.
Delaware allows an insured to take out an insurance policy on his own life, but the law prohibits persons other than the insured from procuring or causing to be procured insurance, unless the benefits are payable to one holding an insurable interest in the insured's life.
Insurable Interest Requirement Prevents Speculation on Human Life
The insurable interest requirement serves the substantive goal of preventing speculation on human life. At issue is whether a third party having no insurable interest can use the insured as a means to procure a life insurance policy that the statute would otherwise prohibit. The Supreme Court answered no because if that third party uses the insured as an instrumentality to procure the policy.
If a third party financially induces the insured to procure a life insurance contract with the intent to immediately transfer the policy to a third party, the contract lacks an insurable interest. Stated differently, if an insured procures a policy as a mere cover for a wager, then the insurable interest requirement is not satisfied.
Payment of the premiums by the insured, as opposed to someone with no insurable interest in the insured's life, provides strong evidence that the transaction is bona fide. Life insurance policies, however, do not come into effect without premiums, so an insured cannot "procure or effect" a policy without actually paying the premiums. Procuring or effecting a policy has to be something more than simply applying for a policy or providing written consent to the policy's issuance. Therefore, if a third party funds the premium payments by providing the insured the financial means to purchase the policy then the insured does not procure or effect the policy. Third parties are prohibited from procuring or causing to be procured insurance contracts on the life of the insured unless the policy benefits are payable to someone with an insurable interest.
In summary, the insured's subjective intent for procuring a life insurance policy is not the relevant inquiry. The relevant inquiry is who procured the policy and whether or not that person meets the insurable interest requirements.
Certified Question Three: The Trust's Interest
The third certified question concerns whether the relevant statutory provisions confer upon a trustee an insurable interest in the life of the individual insured who established the trust if the insured intends to transfer the beneficial interest in the trust to a third-party investor with no insurable interest. As certified by the district court: "Does 18 Del. C. § 2704(a) and (c)(5) confer upon the trustee of a Delaware trust established by an individual insured an insurable interest in the life of that individual when, at the time of the application for life insurance, the insured intends that the beneficial interest in the Delaware trust would be transferred to a third-party investor with no insurable interest in that individual's life following the issuance of the life insurance policy?"
The Supreme Court answered question number three: "YES," but only so long as the individual insured actually established the trust. If, however, the insured does not create and fund the trust then the relationship contemplated by the statute is not satisfied.
The Supreme Court answer is limited to life insurance procured for a legal purpose and not as a cover for an illegal wager contract. In cases where a third party either directly or indirectly funds the premium payments as part of a pre-negotiated arrangement with the insured to immediately transfer ownership, the policy fails at its inception for lack of an insurable interest.
Gambling on a person's life is wrong and gives the owner of the gambling contract a perverse incentive to kill the person whose life is insured. It is not unusual for a person to insure the life of a stranger and then kill the stranger for the life insurance proceeds. In that regard consider the black widows in California who were recently convicted ["Black Widows" Get Life In Prison reporting on their life sentences.] If the policies were purchased, and the insurer knew how they were purchased, in Delaware the policies would have been void and the crime would have failed.
Delaware made no decisions on the facts of the purchase of the insurance policy so it will be up to the Federal District Court to determine who actually effected the policy. If it was the deceased then Delaware allows the sale of a policy but does not allow a person to purchase a policy on the life of another. If the beneficiary made all of the premium payments its actions were a violation of the law of Delaware and that of almost every state. If the insured effected the policy and paid the premiums until he decided to sell the contract was valid and the insurer will need to pay.
Reprinted with Permission from Zalma on Insurance, (c) 2011, Barry Zalma.
Barry Zalma, Esq., CFE, is a California attorney, insurance consultant and expert witness specializing in insurance coverage, insurance claims handling, insurance bad faith and insurance fraud. Mr. Zalma serves as a consultant and expert, almost equally, for insurers and policyholders. He founded Zalma Insurance Consultants in 2001 and serves as its senior consultant. He recently published the e-books, "Heads I Win, Tails You Lose - 2011," "Zalma on Rescission in California," "Zalma on Diminution in Value Damages," "Arson for Profit" and "Zalma on California Claims Regulations," "Murder and Insurance Fraud Don't Mix" and others that are available at Zalma Books.
Mr. Zalma can be contacted at Barry Zalma, firstname.lastname@example.org and you can access his free "Zalma on Insurance Fraud" newsletter at Zalma's Insurance Fraud Letter.
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