A—The Insurable Interest Requirement for Life Insurance: Recent Developments

It has been axiomatic since the British Life Assurance Act of 1774,14 Geo. 3, c. 48, that a policy of life insurance can only be procured by a party that has an insurable interest in the life of the insured. Recently, however, a variety of situations has arisen in which the party seeking a life policy does not have an insurable interest, yet is not engaging in a wagering transaction of the kind the Life Assurance Act and its progeny sought to forbid. This special report examines four such situations and explains why legislators and judges seem receptive to finding an insurable interest in three of the cases but not necessarily the fourth.

Insurable interest is a matter of state law. This special report will frequently refer to New York law because the statute (N.Y. Ins. Law §3205) is comprehensive and representative, and because the New York Insurance Department has issued many useful advisory opinions on insurable interest. Of course, planners should consult the applicable law in each particular case.

Background on Insurable Interest

A “wagering transaction” in this context is just that—a life insurance policy taken out purely as a gamble on the life of someone with no relation to the gambler. An Act of Parliament was necessary to ban the practice because life insurance contracts were, in fact, used in this way. One example is the quasi-life insurance arrangement known as the tontine. Subscribers to a tontine would pay into a capital pool that was invested and paid dividends. When a participant died, his share was allocated among the survivors. The last man standing took the jackpot. The incentive for killing off one’s fellow subscribers is obvious, which is why the tontine is remembered today primarily because of Robert Louis Stevenson’s novel The Wrong Box and its film treatment from the 1960s.The Life Assurance Act required that persons contracting for life insurance must have a definite interest in the life of the insured or the insurance would be void.

To take a policy out of the class of wagering contracts, the person seeking to procure the policy must have an interest in the continued life of the proposed insured, so that that person’s death would cause him a loss, not a gain. The classic American statement of the doctrine appears in Warnock v.

Davis, 104 U.S. 775, 779 (1881):

It is not easy to define with precision what will in all cases constitute an insurable interest, so as to take the contract out of the class of wager policies. It may be stated generally ,however, to be such an interest, arising from the relations of the party obtaining the insurance, either as creditor of or surety for the assured, or from the ties of blood or marriage to him, as will justify a reasonable expectation of advantage or benefit from the continuance of his life. It is not necessary that the expectation of advantage or benefit should be always capable of pecuniary estimation; for a parent has an insurable interest in the life of his child, and a child in the life of his parent, a husband in the life of his wife, and a wife in the life of her husband. The natural affection in cases of this kind is considered as more powerful – as operating more efficaciously – to protect the life of the insured than any other consideration. But in all cases there 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 wager, 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.

(Emphasis added.) Since Warnock this common law principle has found statutory expression throughout the states. California’s newly enacted statute, effective January 1, 2004, is typical:

An insurable interest, with reference to life and disability insurance, is 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.

Cal. Ins. Code §10110.1.New York puts it similarly:

In the case of other persons, [an insurable interest is] a lawful and substantial economic interest in the continued life, health, or bodily safety of the person insured, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the insured.

N.Y. Ins. Law §3205(a)(1)(B).

It follows from the California definition, and is fundamental, that an individual has an insurable interest in his or her own life. From this core interest others branch off. As stated in Warnock, Spouses have an insurable interest in each others’ lives, which survives divorce. See Divorce and Insurable Interest, New York State Insurance Department (November 6, 2000).“Love and affection” can create an insurable interest between blood relatives, though whether such an interest exists in a particular case is always a matter of fact. See Section 20B of this Service for a discussion of the differing results reached under different state laws and fact patterns. Other insurable interests arise out of pecuniary relations. A creditor has an insurable interest in a debtor’s life to the extent of the debt plus the cost of the insurance. And a corporation has an insurable interest in the life of any key executive or employee, i.e. one whose death would cause it tangible economic loss.

However, there is manifestly no insurable interest, in the traditional Warnock sense, in the following cases, all of which reflect new social and business institutions:

1.      Viatical settlement: An investor or intermediary procures a life insurance policy on the life of a terminally ill person, paying the insured a percentage of the face amount. On its face, this is the very model of a modern wagering contract.

2.      Same-sex domestic partnership: Same-sex partners may have bonds of love and affection as strong as any spouses, but they are not spouses.

3.      Charities: The leverage and tax advantages of life insurance make it an alluring vehicle for charitable donations, but how can a charitable institution procure a life policy on anybody other than its key personnel?

4.      Corporate Owned Life Insurance (COLI): A large corporation takes advantage of deductions allowed under former law by procuring life policies on thousands, even tens of thousands, of its non-key employees.

The doctrine of insurable interest is developing in different directions to accommodate these new situations. Essentially, the tendency is to find insurable interests, through legislation if necessary, in the first three situations (in the case of (2), in those jurisdictions that give legal recognition to same-sex domestic partnerships), but to deny an insurable interest in large-corporation leveraged COLI arrangements; particularly those used for tax reasons. Most recently, in Mayo v. Wal-Mart Stores, Inc., No. 02-21059 (5th Cir. January 5, 2004), the Fifth Circuit held that Wal-Mart did not have an insurable interest in employees on whom it had taken out COLI policies. (Note that as explained below, some COLI programs are designed to secure a company’s obligations, such as retirement benefits, to the insured employee, and that many states have enacted statutes providing for an insurable interest to the extent of the obligation in this case.)

It is not hard to understand the difference. With viatical settlements, domestic partnerships, and charitable giving, the parties are in some sort of relation, whether commercial or interpersonal, in which each, specifically the insured, intends to derive some pecuniary benefit from life insurance. Other things being equal, it’s to be expected that the law will bend in the direction of permitting parties to engage in arm’s-length contractual relations freely. In the case of leveraged COLI, by contrast, the company takes out the insurance to gain tax benefits for itself; the insured derives no benefit from the policy and, indeed, may not even know it exists.

Viatical Settlements

Viatical settlements were devised in the late 1980s in response to the AIDS crisis, which found a large number of relatively young insured men faced with death considerably before their actuarial life expectancies. As the court in SEC v. Life Partners, Inc., 87 F.3d 536 (D.C. Cir. 1996), explained:

[a] viatical settlement is an investment contract pursuant to which an investor acquires an interest in the life insurance policy of a terminally ill person--typically an AIDS victim--at a discount of 20 to 40 percent, depending upon the insured`s life expectancy. When the insured dies, the investor receives the benefit of the insurance. The investor`s profit is the difference between the discounted purchase price paid to the insured and the death benefit collected from the insurer, less transaction costs, premiums paid, and other administrative expenses.

87 F.3d at 537.The viatical settlement industry expanded rapidly, and now even encompasses so-called life or senior settlements, marketed as a planning tool for healthy seniors with incontestable policies and large death benefits. (For a detailed account of viatical and life settlements, see Section 22.1D of this Service or Current Comment, Viatical Settlements, Life Settlements and the Secondary Insurance Market, Parts 1 and 2.)

The viatical settlement industry has been dogged by controversy since its inception, thanks to initial lack of regulation, viatical settlement providers’ failure to disclose the risks involved, and notorious instances of outright fraud. In addition to these problems, it would appear that the investor in the viatical settlement is a complete stranger to the insured and has no insurable interest in him or her. On the contrary, since the longer the insured lives, the smaller is the investor’s profit margin, some commentators have actually speculated that viatical settlements cold provide a motive for homicide. E.g. Joseph Belth, Viatical Transactions: the Frightening Secondary Market for Life Insurance Policies (2000).

Whether or not the potential for homicide is overstated, lack of insurable interest is not an insuperable obstacle to viatical settlements. In general, the requirement is that the person procuring a life policy have an insurable interest at the time the policy is acquired. The later cessation of the relation that gives rise to the insurable interest does not invalidate the policy. This principle is familiar from cases such as divorcing spouses, as discussed above, and key executives who cease to be affiliated with the corporation that purchased the key executive policy. See Insurable Interest—Key Man Insurance, New York State Insurance Department (July 17, 2003) (“[A]lthough an insurable interest in another’s life must exist at the inception of the policy in order to create a valid contract, that interest need not continue unless the policy so provides.”) Since the insured who seeks to enter into a viatical settlement is typically viaticating a policy he has procured on himself or herself, an insurable interest will typically exist at inception, and the insured can alienate the policy to one who has no insurable interest (e.g. by assignment in exchange for a percentage of the death benefit), assuming applicable state law does not directly prohibit this.

Furthermore, abuses and perceived abuses have generated pressure for regulation of the viatical settlement industry: as of November 2003 35 states had enacted statutes regulating viatical settlements and 21 states regulated life settlements. Where such statutes exist, viatical or life settlements are valid regardless of whether there is an insurable interest.

The development of New York law is instructive. New York Insurance Law §3205(b)(2) provided (and still provides):

No person shall procure or cause to be procured, directly or by assignment or otherwise any contract of insurance upon the person of another unless the benefits under such contract are payable to the person insured or his personal representatives, or to a person having, at the time when such contract is made, an insurable interest in the person insured.

In February 1990, the Insurance Department opined in its Opinion 90-1 that §3205(b)(2) prohibited a corporation from offering to purchase life insurance policies from individuals in exchange for an assignment of all interest in the policies—i.e. from offering viatical settlements. Its May 1991 Opinion 91-56 stated the same prohibition for individuals. However, in 1993 Article 78 of the Insurance Law was enacted specifically to authorize viatical settlements (without stipulating that the purchaser of the contract had an insurable interest), and the Insurance Department acknowledged this by withdrawing its earlier opinions (Re: Office of General Counsel Opinions 90-1 and 91-56, New York State Insurance Department, October 30, 2001).

In two other opinions issued at about the same time, the Insurance Department explained and elaborated its new position. The Department’s Opinion 99-37 had interpreted the Insurance Law’s definition of “viator” as a “person who has a catastrophic or life threatening illness or condition” as prohibiting viatical settlements by persons who do not have such a condition. It drew the conclusion that only persons suffering from such conditions could engage in viatical settlements. On reconsideration, the Insurance Department looked at §3205(b)(2), quoted above, and §3205(b)(1), which provides:

Any person of lawful age may on his own initiative procure or effect a contract of insurance upon his own person for the benefit of any person, firm, association or corporation. Nothing herein shall be deemed to prohibit the immediate transfer or assignment of a contract so procured or effectuated.

Subsection (b)(1) says, consistently with the general doctrine of insurable interest, that any individual, having an insurable interest in his or her own life, may procure a policy on that life and then assign the policy immediately. And subsection (b)(2) says that so long as a life policy is originally payable to a person with an insurable interest in the insured, it can be procured by anybody, whether or not they have an insurable interest. Thus, viatical settlement companies can contract with anyone, not just viators as defined by statute. Re: Office of General Counsel Opinion 99-37, New York State Insurance Department, November 14, 2001.Finally, a very similar opinion had already explicitly drawn the conclusion, from the same body of law, that life settlements are legal in New York (reversing a position the Insurance Department had taken in 1999).Re: Life Settlement Contracts in New York, New York State Insurance Department, August 29, 2001.

Conclusion

In states that regulate viatical and life settlements, such contracts will plainly be valid even though the viatical settlement company lacks a traditional insurable interest in the insured, as reflected in the New York Insurance Department’s opinions.States that have not yet chosen to regulate viatical or life settlements will almost certainly contain a provision like New York’s §3205(b)(2): the core of the concept of insurable interest is the prohibition on a party’s procuring a policy payable to someone who does not have an insurable interest in the insured’s life. However, by negative implication, if the proposed beneficiary does have an insurable interest in the insured, anyone can procure a policy on the insured’s life.Whether or not a state has a provision like §3205(b)(1), expressly allowing the insured to procure a policy on himself or herself and immediately assign it (compare, e.g., Neb. Rev. Stat. §44-704(1) (explicit provision) with Del. Code Ann. tit. 18, §2704 (no explicit provision)), there should be no problem from the point of view of insurable interest. As long as an insurable interest existed when the policy was procured, it will be valid, at least on that ground.

Same-Sex Domestic Partnerships

Same-sex domestic partnerships are, of course, a matter of intense social and political controversy in the United States at this time. But they exist, and therefore raise the question of what financial planning options are open to the partners. At first glance, it would appear that one option open to heterosexual couples is not open to them. Where same-sex partnerships are not recognized by state law, the partners do not have an insurable interest in one another based on their relationship, however committed it may be, and therefore cannot take out life policies on each other as heterosexual spouses can. (The same is true, of course, of opposite-sex unmarried domestic partners.)

At this writing, the Ohio legislature has just passed a statute denying recognition to same-sex domestic partnerships, making it the 38th state (along with the federal government) that has such a law. At this writing no state recognizes same-sex marriages, though Massachusetts has been instructed to do so by that state’s Supreme Judicial Court, in a November 2003 decision (Goodridge v. Dep’t of Public Health, SJC-08860 (November 18, 2003) and a February 2004 advisory opinion (Goodridge v. Dep’t of Public Health, SJC-08860 (February 4, 2004).Meanwhile, the only state that grants civil recognition to same-sex unions is Vermont; the only other states that grant some of the same benefits to same-sex couples as to married couples are California, Hawaii, and as of January 2004, New Jersey.

Three of these states permit same-sex domestic partners to procure policies on each other’s lives.

Vermont: Vermont’s civil union statute provides that “[p]arties to a civil union shall have all the same benefits, protections and responsibilities under law, whether they derive from statute, administrative or court rule, policy, common law or any other source of civil law, as are granted to spouses in a marriage. ”Vt. Stat. Ann. tit. 15, §1204(a).By implementing regulation, the Vermont Department of Banking, Insurance, Securities, and Healthcare Administration has expressly stated that “[t]he existence of a civil union shall automatically create for each party to a civil union an insurable interest in the other party,” definitively settling the question. Reg. 2000-01-1H, §6(e).

Hawaii: Hawaii recognizes a relation between “reciprocal beneficiaries” (who can be people who could not marry, such as grandparent and grandchild), under which reciprocal beneficiaries may, among other things, take out life insurance policies on one another. Haw. Rev. Stat. §431:10-234(b).

New Jersey: the New Jersey Domestic Partnership Act, P.L. 2003, ch. 246, approved by the legislature on January 12, 2004, does not address the subject of insurable interest. In fact, it approaches the question the other way around. Domestic partnership requires “joint financial arrangements or joint ownership of real or personal property” that show the proposed domestic partners are “jointly responsible for each other’s common welfare,” §4(b)(1), and one such arrangement is “designation of one of the persons as primary beneficiary in the other person’s life insurance policy,” §4(b)(1)(d). In order to be domestic partners, then, two people would have to have a strong enough pecuniary interest in one another to satisfy the definition of insurable interest at N.J. Stat. Ann § 17B:24-1.1(1)(a)(2)  (“An individual has an insurable interest in the life, health and bodily safety of another individual if he has an expectation of pecuniary advantage through the continued life, health and bodily safety of that individual and consequent loss by reason of his death or disability.”).

California’s domestic partnership law allows both domestic partners to share in group insurance policies offered by the employer of one partner, but does not address insurable interest issues.

Thus, same-sex couples who live in Vermont, Hawaii, or New Jersey need not concern themselves with insurable interest issues. Those issues may be more problematic in other states, particularly the majority that have enacted statutes affirmatively denying the validity of same-sex domestic unions (and failing to extend recognition to those effected under the laws of states that do recognize them). In these states, planners and their clients may have to be content with indirect measures, such as one partner’s procuring a policy on himself or herself and assigning it to the other.

Charitable Organizations

The application of the insurable interest doctrine to charitable giving is another case study in the accommodation of the law to practical needs. An outright gift of a life insurance policy to charity is highly desirable both for the donor and for the recipient charity. In particular, such a gift will result in an income tax deduction for the donor to the extent of his or her basis in the policy (or the policy value if less). No income tax deduction is available if the donor merely designates the charity as policy beneficiary, whether revocable or irrevocable, for failure to satisfy the partial interest rule. (For details, see Section 8E of this Service.) However, a charity will not generally have an insurable interest in a donor’s life. Thus, the gift could be made, but is potentially voidable under a traditional concept of insurable interest. The unwelcome tax consequence is that because the charity’s interest is voidable under the state’s insurable-interest law, and a challenge to such interest would likely cause ownership of the policy to revert to the donor or his heirs, the gift is only a partial interest which does not qualify for the income tax or gift tax charitable contribution deductions.

The IRS in fact took this position in at least one private letter ruling, holding that if an insurance policy is acquired by a taxpayer with the intention of donating it to a charity in a state with an insurable interest statute, the property donated is deemed only a non-deductible partial interest in the policy. PLR 9110016 (November 30, 1990).The ruling denied the donor an income tax or gift tax deduction on the ground that she was trying to “circumvent the law” by obtaining an insurance policy with the intent of transferring it to an organization without an insurable interest. ”Worse, it went on to hold that when the donor dies, even if the insurance proceeds are received by the charity, they will be includable in the donor’s gross estate, with no offsetting estate tax charitable contribution deduction—under the three-year rule of I.R.C. §2035 if she dies within three years after the gift, under I.R.C. §2033 if she dies more than three years after the gift (if her executor can recover the proceeds for the benefit of her estate). 

PLR 9110016 interpreted New York’s §3205.Soon afterward, the New York legislature amended §3205 specifically to allow an insured to transfer a newly purchased policy immediately. Apparently the purpose was to negate the IRS ruling, and so the IRS revoked it in PLR 9147040 (August 20, 1991).

Virtually every state has enacted provisions allowing charities to own life insurance policies where the insured is a donor in whose life the charity does not otherwise have an insurable interest. They typically require the consent of the insured. Some define “charitable organization” with reference to I.R.C. §501(c)(3) (e.g. Fla. Stat. Ch. 27.404); others refer to their own law (e.g. N.Y. Ins. Law §3205(b)(3).These variations means that although insurable interest should not present a real problem to charitable giving of life insurance policies, the planner should (as always) be sure to consult applicable state law.

Corporate-Owned Life Insurance (COLI)

The last area of development in insurable interest doctrine stands apart from the others. Corporate-owned life insurance (COLI) evolved from key executive insurance. The original idea was to use life insurance as a funding device for nonqualified deferred compensation plans, postretirement medical coverage, and the like. Simply put, a company purchases a life policy on an employee with a death benefit sufficient to defray the anticipated cost of the employee benefit.

This form of COLI—using life insurance on an employee to secure a financial obligation to that employee—is a rational business arrangement for a legitimate business purpose. (See Section 15.1C of this Service for further discussion.) For non-key employees, it turns the traditional concept of insurable interest on its head. Traditionally, a creditor has an insurable interest in a debtor to the extent of the debt; since it’s the company that owes the employee rather than the other way around, one would think it is the employee who has the insurable interest (in a corporate entity, which of course doesn’t have a life that can be insured). Nonetheless, numerous states have enacted statutes specifically authorizing it. For example, Ga. Code Ann. §33-24-3(c) provides in relevant part:

A corporation, foreign or domestic, has an insurable interest in the life or physical or mental ability of any of its directors, officers, or employees . . . pursuant to any contract obligating the corporation as part of compensation arrangements. . . . The trustee of a trust established by a corporation providing life, health, disability, retirement, or similar benefits to employees of the corporation or its affiliates and acting in a fiduciary capacity with respect to such employees, retired employees, or their dependents or beneficiaries has an insurable interest in the lives of employees for whom such benefits are to be provided.

And New York Insurance Law §3205(d) authorizes COLI arrangements as follows:

(d) In addition to any other basis under which either an employer, or an irrevocable trust established by one or more employers or one or more employers and one or more labor unions, have an insurable interest in the lives of any of its employees or retirees or those of its subsidiaries or affiliated companies, an employer or such a trust shall have an insurable interest in the lives of any such employees or retirees who are participants or who are eligible to participate, upon the satisfaction of age, service or similar eligibility criteria, in an employee benefit plan, established or maintained by an employer as defined by the federal Employee Retirement Income Security Act of 1974, 29 U.S.C. S 1001 et seq. . . . .

The detailed regulatory provisions that follow will be discussed somewhat later in this special report. Finally, it is notable that California’s new insurable interest law, specifically designed to eliminate large-scale tax-abusive COLI arrangements (see Tax News, California Restrictions on COLI Policies Take Effect January 1, 2004, December 16, 2003), preserves COLI arrangements for retirement and similar benefits. Cal. Ins. Code §10110.1(c).

Past Abuse of the Concept: Large-Scale Leveraged COLI

If this were the only use to which COLI had been put, it probably would have achieved general acceptance. (Indeed, given recent prominent media reports about large corporate employers cutting back on retirement benefits, health insurance for retirees and the like, limited COLI plans might well be marketed as funding devices that could preserve such benefits.) However, tax rules in effect before the passage of the Health Insurance Portability and Accountability Act (HIPAA) in 1996 made abuse of the concept by large corporations almost inevitable. Under those rules, interest on policy loans was deductible. Because it was usual to pay annual premiums with a policy loan, this meant the possibility of a positive cash flow from the policy (when deductible interest plus tax-free inside build-up exceeded premium expense). At some point along the way, aggressive corporate CFOs and their advisors realized that if the company can generate positive cash flow through leveraging the policies it held for otherwise legitimate business reasons (such as key executive protection or policies funding non-qualified plans), why not insure the lives of as many employees as possible?  Large corporations could potentially save millions in taxes through leveraged coverage of hundreds of employees. Winn-Dixie Stores, Inc., a large public corporation, took such a course in 1993, insuring more than 30,000 employees!  CM Holdings (a holding company for Camelot Music, Inc., a national music store chain) insured 1,430 of its employees. American Electric Power (AEP), a major Midwestern public utility, insured 20,000 employees. Through situations such as these, leveraged COLI programs were sometimes derided as “janitor insurance.”

Leveraged COLI and Insurable Interest

These large-scale leveraged COLI programs had no legitimate business purpose: they existed solely for the purpose of tax arbitrage, and they were for the most part closed down after HIPAA eliminated their rationale. Since then, the IRS has aggressively sought to recoup the tax deductions claimed by corporations such as Winn-Dixie, AEP, CM Holdings, and Dow Chemical Corp., an effort very fully reported in this Service (see Section 19.1G and numerous Current Comments and Tax News).

The IRS has not, for the most part, been concerned with the issue of insurable interest. One case in which it raised the issue and lost is of special interest. In Dow Chemical Corp. v IRS, 250 F. Supp.2d 248 (E.D. Mich. 2003), in an early phase of its COLI program Dow reduced its proposed insureds from 20,000 to 4,000 on legal advice that its coverage should be commensurate with its benefit liabilities. The 4,000 “were all management personnel earning over $50,000 annually” and under an internal evaluation scale “were present and future leaders, became eligible for certain executive level benefits (such as stock options), and held positions of responsibility in various locations throughout the company.” “Moreover,” the court continued, “all of the employees consented to coverage, which further vindicates the public policy designed to prevent wagering contracts on which the insurable interest rule is grounded. ”Id.Given all this, the district court concluded that Dow had met Michigan’s insurable interest standard, which requires only that “that the beneficiary has a reasonable expectation of some benefit or advantage from the continuance of the life of the assured,” Indemnity Ins. Co. of North America v. Dow, 174 F.2d 168, 170 (6th Cir. 1949).It does not seem unreasonable for the court to have done so—but that is because Dow essentially converted a janitor insurance program into a key person program.

Programs less carefully fashioned have come under attack from families of deceased employees who had been insured under COLI policies without their knowledge. Since the company is the beneficiary as well as the owner of a COLI policy, it of course collects the death benefit. It is hardly surprising that when family members learn of payments, sometimes running into six figures, made on life policies that employers took out on their loved ones without telling them, lawsuits would follow, and that the insurable interest question would take center stage.

A “janitor insurance” policy, one in which numbers of non-key employees are insured with no attempt to relate the coverage to a legitimate business purpose, is not a wagering contract. There is no element of wager or uncertainty involved: as long as the applicable law doesn’t change and the premiums are paid, the company will get its payoff when the employee dies. Nonetheless, it is hard to imagine a clearer case of a violation of the insurable interest principle, a case in which life insurance is procured by a party with no insurable interest in the insured. Two recent decisions that happen to involve Wal-Mart Stores, Inc.’s COLI program sustain this position, one explicitly and one by implication.

Rice v. Wal-Mart and Mayo v. Wal-Mart

Wal-Mart’s national presence makes it susceptible to suit in every state, as these cases from the federal courts in New Hampshire and Texas show. Rice v. Wal-Mart Stores, Inc., No CV-02-390-B (D.N.H. September 30, 2003) involved two Wal-Mart employees, a local store manager and a maintenance worker, who were insured under COLI policies that paid Wal-Mart some $170,000 and $380,000, respectively, on their deaths. Their widows sued Wal-Mart on a number of theories including lack of insurable interest. Although the district court denied the plaintiffs’ request for a declaratory judgment that the policies were void for lack of insurable interest, it did so on the ground that only the insurer has standing to raise the insurable interest issue.  Significantly, it did not dismiss plaintiffs’ claim that Wal-Mart and the insurer, Hartford Life, were unjustly enriched by insuring employees in whom they had no insurable interest. In fact, in denying Hartford Life’s motion to dismiss the court observed that “determining whether Wal-Mart had an insurable interest in the lives of the insured employees involves a fact-sensitive inquiry which is not proper at this stage of the proceedings,” but is clearly a legitimate inquiry at the proper time. If the facts are right, the Rice court is saying, it will hold that Wal-Mart was unjustly enriched because the COLI policies are void for lack of insurable interest.

The Texas case, Mayo v. Wal-Mart Stores, Inc., raises the question more directly. The issue was litigated in the district court and appealed by Wal-Mart on an interlocutory basis to the Fifth Circuit. That court affirmed the district court, analyzing Texas law as requiring an insurable interest and recognizing such an interest in traditional groups: relatives, creditors, and “those having an expectation of financial gain from the insured`s continued life. ”The court’s response to Wal-Mart’s argument that it does have an insurable interest in its rank-and-file employees is worth noting:

Wal-Mart argues that it has a reasonable expectation of pecuniary benefit in the continued lives of its employees sufficient to bring it within the last of the three categories described [above]. Texas courts have held, however, that the state of employment alone does not give an employer an insurable interest. . . . Wal-Mart contends that, in addition to the bare employer/employee relationship, it possesses an expectation of financial gain from the continued lives of its employees by virtue of the costs associated with the death of an employee, such as productivity losses, hiring and training a replacement, and payment of death benefits. These are costs that are associated with the loss of any employee, however, and, as Texas precedent clearly indicates, employers lack an insurable interest in ordinary employees. . . . Indeed, Texas courts have recently rejected similar arguments based on the costs flowing from an employee`s death.And, as Sims [one of the plaintiffs] ripostes, Wal-Mart does not claim that Sims was of any special importance to the company, much less that Wal-Mart`s “success or failure was dependent upon [the insured employee].”

(Footnotes and citations omitted)

The court went on to analyze the further development of Texas law on insurable interest, and determined that changes in that law were not broad enough to take in Wal-Mart’s COLI policies.Mayo is, therefore, the first case that explicitly holds COLI policies void under the law of any state for lack of insurable interest.

Future COLI Litigation on Insurable Interest: Likely Trends

The Rice and Mayo cases indicate likely strategies for future COLI plaintiffs who want to raise the insurable interest issue (to the extent that they can get in under applicable limitations periods, given that many leveraged COLI programs have been discontinued). Rice shows that even where a direct claim of lack of insurable interest fails because it was not raised by the insurer, a claim such as unjust enrichment that essentially involves insurable interest can be pleaded. Mayo shows that a case brought in a state such as Texas that has not adopted a statute expressly authorizing COLI policies is likely to prevail on its insurable interest claims.

That leaves cases brought in states (and in federal district courts applying the law of states) that have COLI statutes. Such statutes can differ greatly in breadth. For example, Georgia’s statute, quoted above, provides that “A corporation, foreign or domestic, has an insurable interest in the life or physical or mental ability of any of its directors, officers, or employees . . . pursuant to any contract obligating the corporation as part of compensation arrangements. . . .”There is no requirement that the employee be informed of the existence of the policy or that there be any kind of proportionality between the death benefit and the company’s economic loss upon the employee’s death. (No doubt because of this breadth, Wal-Mart’s COLI policy in Mayo actually contained a choice of law clause favoring Georgia law; the court’s decision to deny effect to this clause and apply Texas law instead was, therefore, a crucial preliminary.) New York’s law, on the other hand, contains detailed provisions such as Insurance Law §3205(d)(1)-(5):

       (1) The employer providing for insurance coverage or causing such coverage to be issued under this subsection: 

            (A) prior to or at the commencement of any such coverage notifies prospective insureds in writing that coverage is being obtained on their lives, requires that prospective insureds consent in writing to such coverage, provides each consenting insured the right to have any coverage on his/her life issued under the authority of this subsection discontinued at any time and describes in the notice the method the insured may use to terminate coverage; 

            (B) at the time any insured employee’s employment terminates, notifies the employee of the right to discontinue such coverage, provided, however, that no such notification shall be required if the insured employee possesses a present or prospective right to receive any of the benefits under an employee benefit plan being financed, in whole or in part, by such life insurance coverage; and 

            (C) at any time after the termination of an insured employee’s employment and upon the termination of an employee benefit plan being financed, in whole or in part, by such life insurance coverage or a reduction of the benefits provided thereunder, notifies the employee of the right to discontinue such coverage.

        (2) At the time coverage is issued, the total amount of insurance coverage issued to date to the employer or trust under authority of this subsection shall not exceed the costs of employee and/or retiree benefits already incurred in connection with such employee benefit plan since the earliest date coverage on an employee or retiree was issued under this subsection, plus the projected future cost of such benefits as established by the employer. 

        (3) The amount of coverage insuring the life of each such employee or retiree and the selection of the employees or retirees to be insured is based purely on nondiscriminatory factors such as age, premium amount or some other nondiscriminatory factor, and not on conditions or terms of employment other than participation in an employee benefit plan described herein. 

        (4) If subsequent to issuance of the policy or policies providing life insurance coverage pursuant to this subsection, the insurer providing the coverage is replaced by another insurer, the employer shall notify each insured employee or retiree of such replacement. 

        (5) During the first five years subsequent to issuance of the policy or policies providing life insurance pursuant to this subsection, the policyholder does not undertake a pattern of borrowing likely to require all or a substantial part of the cash values of the policies to be pledged as security against repayment of such loans, unless such borrowing was incurred because of an unforeseen substantial loss of income or unforeseen increase in financial obligations.

These provisions—notice, right to discontinuance, proportionality of death benefit to employer liability—plainly attempt to curb the potential for COLI policies to become janitor insurance. (Subsection (d)(5), of course, addresses the tax abuse potential of these policies, not the insurable interest issue.) A COLI program that conforms to New York law will look more like the program approved in Dow than like Wal-Mart’s. The abuse of leveraged COLI must be weighed against the fact that nonleveraged, carefully tailored COLI programs retain their business validity, making safeguards like New York’s all the more important. The blatant tax abuses of the 1990s may have been curbed, but COLI will persist, and the question whether a particular COLI program goes beyond the bounds of insurable interest will remain pertinent.

Even under a broad statute like Georgia’s, it is arguable that a COLI program without proportionate liability fails for lack of insurable interest.A statute that does not define “insurable interest” is open to judicial interpretation, and a court could well hold that a company’s insurable interest in its non-key employees extends only as far as its potential benefits liability to them, just as a creditor’s insurable interest in his debtor extends only as far as the debt. How the laws will develop remains to be seen.

Conclusion

Betting on the lives of strangers can be a harmless, albeit perhaps morbid, pastime. Witness the popularity of the so-called Dead Pools on the Internet, where participants submit a list of celebrities they predict will die during the coming year; the player who gets the most hits wins. A life insurance policy on a stranger is a very different kind of bet, and for more than two centuries public policy has rightly required an insurable interest. The recent developments surveyed above testify to the resilience of the insurable interest doctrine and to the manner in which it has adapted to legitimate social and business needs, while continuing to protect against potential abuses.

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