Insurable Interest Rules
for Charities—What’s it all about?

New techniques resurrect problems from the past


"Charity Oversight and Reform: Keeping Bad Things from Happening to Good Charities" was the topic at a Senate Finance Committee hearing on June 22nd. Topics included involvement of charities in tax shelters, valuation of tangible and intangible property, and governance and best practices.1 The message was clear: charities had better behave.

This article is adapted from one that originally appeared in the July/August 2004 edition of Giving Counsel, a newsletter serving professional advisors in the giving community published by the Arizona Community Foundation.

May 12, 2004
Insurable Interest Under Siege
by Mike Nelson

May 20, 2004
Charities and Insurance:
‘The Next Big Thing?

by Larry Bell

May 2004
Death-Pool Donations
by Wendy Davis
Trusts & Estates magazine

One area of concern for federal lawmakers is efforts to loosen the state insurable interest laws for charities. These rules are important because they determine when a charity can purchase life insurance on an individual.

In a letter dated May 26, 2004, to Frank Keating, President of the American Council of Life Insurers, a prominent trade association, Sen. Gordon H. Smith (R-OR) and Senator Kent Conrad (D-ND), both members of the Senate Finance Committee, outlined their concerns: promoters of complex insurance transactions seeking modification to state insurable interest laws to allow unrelated financial investors, indirectly through charitable organizations, to buy life insurance on large numbers of the charity’s donors.2

Their concern is that this runs counter to the long standing public policy of limiting those who can rightfully buy an insurance policy on the lives of a specific person. Further, these transactions, to which the charity’s involvement is key, likely create attractive opportunities for third party investors but leave little, if anything, for the charity.3

Insurable Interest Laws – A Quick History
“Insurable interest”—even among professional advisors—is not exactly a household phrase. However, the public policy underlying the insurable interest rules gets right to the heart of why life insurance is not considered just another financial instrument, and why it is given special treatment under the tax code. So what’s the big deal if the insurable interest rules are relaxed for charities? The answer warrants a quick history lesson.

In the 1700s, life insurance in England was sport. Policies could be, and were, applied for on the lives of strangers.4 Often, the insureds did not even know the policy owners, or even that insurance had been placed on their lives.5 At the time, policies were even purchased on public figures as wagers that the insured would not live for the period of coverage, which in some cases was just a few days.”6 To put an end to such “a mischievous kind of gaming.” Parliament enacted England’s first insurable interest law in 1774, which provided:

[N]o insurance shall be made by any person or persons … wherein the person or persons for whose use, benefit, or on whose account such policy or policies shall be made, shall have no interest, or by way of gaming or wagering; and that every assurance contrary to the true intent and meaning hereof shall be null and void to all intents and purposes whatsoever.7

In the United States, the rationale is best described in Warnock vs. Davis, 104 U.S. 775 (1882):

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 relation of the party obtaining the insurance, either as creditor of or surety for the assured, or from ties of blood or marriage to him, as will justify a reasonable expectation of the advantage or benefit of the continuance of his life. It is not necessary that the expectation of advantage or benefit always be capable of pecuniary estimation.… [I]n all cases, there must be a reasonable ground, founded upon the relations of the parties to each other … to expect some benefit or advantage from the continuance of the life of the insured. 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, … against public policy.8

Arizona’s Insurable Interest Laws
A.R.S. 20-1104. Insurable interest with respect to personal insurance; definition

A. Any individual of competent legal capacity may procure or affect an insurance contract upon his own life or body for the benefit of any person. But no person shall procure or cause to be procured any insurance contract upon the life or body of another individual unless the benefits under such contract are payable to the individual insured or his personal representatives, or to a person having, at the time when the contract was made, an insurable interest in the individual insured.

B. If the beneficiary, assignee or other payee under any contract made in violation of this section received from the insuree any benefits thereunder accruing upon the death…of the individual insured, the individual insured…may maintain an action to recover such benefits from the person so receiving them.

C. “Insurable interest”…includes only interests as follows:

1.   In the case of individuals related closely by blood or by law, a substantial interest engendered by love and affection.

2.   In the case of other persons, a lawful and substantial economic interest in having the life, health or bodily safety of the individual insured continue, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death…of the individual insured.

3.   An individual party to a contract or option for the purchase or sale of an interest in a business…has an insurable interest in the life of each individual party to the contract....

4.   A charitable organization…has an insurable interest in the life of each proposed insured that joins with the charitable organization in applying for a life insurance policy naming the charitable organization as owner and irrevocable beneficiary.

...LILACS clearly conflict with the longstanding public policy that policy owners should be more interested in the continuation of the insured’s life than his or her death.

Arizona’s insurable interest laws are based on the same principles outlined in Warnock. However, like many states, Arizona makes special provision for charities (Subsection C.4.). This provision was enacted—legitimately—to enable charities to directly solicit and obtain life insurance on the lives of their donors for fundraising purposes.

One way to understand the benefit that charities already enjoy in Arizona is to contrast Subsection C.4 (the “Charity Rule”) with Subsection C.2 (the “General Rule”). The Charity Rule says that charities have an insurable interest in someone so long as that individual signs the application and the charity is named owner and irrevocable beneficiary. This makes the Charity Rule straight forward and simple to apply—If the insured signs the application and the charity is owner and irrevocable beneficiary, the charity has an insurable interest.

The General Rule, on the other hand, isn’t as easy. The proposed policy owner must have a lawful and substantial economic interest in the continuation of the insured’s life as distinguished from an economic interest that is created or enhanced by the death of the insured. This is a much more subjective test. Furthermore, the risk of failing this test is that the policy owner may lose the economic benefits under the policy (See subsection B, above).

The Charity Rule allows charities to operate with certainty. Thus, they know they have an insurable interest at the time the policy is purchased. However, when applying the General Rule, charities might legitimately wonder if they pass.

Does a charity have a substantial economic interest in the continuation of life of its donors? All of them or just the “regulars?” What if the proposed insured hasn’t made a gift in quite some time? While the likely answer is yes to these questions, it may not be as clear to the charities they would like. Therefore, it is worthwhile to note that special rules already exist for charities.

LILACS—The Scandal De Jour
The current insurable interest debate is largely focused on complex financial instruments known as Life Insurance and Life Annuity-based Certificates (LILACS). Lilacs generally involve the following structure:

  • A charity forms a special purpose trust, of which the charity is the beneficial owner.
  • The trust sells bonds to investors.
  • Bond sales proceeds are used to purchase (either directly or through the charity) life insurance and annuities on a pool of the charity’s donors (typically 100 or more).
  • The life insurance and annuities are pledged as collateral for the benefit of the bond holders. Typically, the annuities pay the life insurance premiums so the collateral is quite secure.
  • After the bond holders are paid in full, the remaining life insurance and annuities are distributed to the charity.9

The promise to the charity is a significant payout without any up front cost or capital risk. The concern, however, is that the charity will end up with little or no benefit while the bond holders reap the benefits.10 Furthermore, secondary markets have already developed for the bonds.11 Thus, the charity’s donors will most certainly have no connection—past or future—to the investors who will benefit from their deaths.

At present, LILACS and similar structures are only allowed in a handful of states, such as Texas, Virginia, Nebraska, and Tennessee.12 Private interest groups have been lobbying in other states to expand their marketing for these products, but with mixed results.13 Interestingly, the major life insurance trade associations have come out in opposition to these techniques.14

The associations fear that further relaxation of insurable interest rules for charities to allow LILACS will run contrary to sound public policy by permitting the purchase—albeit indirect—of life insurance on strangers. It is feared that this type of legislation could undermine the integrity of life insurance and the legitimate benefits it provides.15

What’s wrong with this picture?
While maybe not to the extreme of wager policies, LILACS clearly conflict with the longstanding public policy that policy owners should be more interested in the continuation of the insured’s life than his or her death.

LILAC promoters are going to great lengths to sanction through charities something they can’t do directly—raise vast pools of money to buy hundreds of life insurance policies whose benefits are then used to repay investors. Furthermore, as one commentator puts it, “In these transactions, the only fixed number is the commission.”16 If lucky, the charities get the leftovers.

To add tremendous insult to injury, charities that do participate in LILACS or similar structures could find themselves in a world of hurt for other reasons as well. These transactions may create unpleasant and sometimes life threatening side effects with respect to unrelated business taxable income, debt-financed income, securities laws, and the private benefit rules.17

Where do we go from here?
If your charity or its donors solicits you for a LILAC, run for the hills. Used properly, life insurance is a viable planning tool for charities, whereby the charity can receive 100% of the benefit. Besides, in all likelihood, the federal government and the insurance trade associations will eventually succeed in shutting down these potentially abusive transactions. In the meantime, if you are looking for guidance on insurable interest rules, look no further than the past.

1 See “Grassley Plans Hearing on Charitable Giving Problems, Best Practices,” United States Senate Finance Committee Press Release June 1, 2004; “Grassley Works to Protect Charities from Misuse, Exploitation,” United States Senate Finance Committee Press Release June 22, 2004.

2 The letter was distributed as an attachment to the Association for Advanced Life Underwriting (AALU) Washington Report Bulletin No. 04-78.

3 See the article by Mike Nelson, Insurable Interest Under Siege, May 12, 2004.

4 Janice E. Greider and William T. Beadles, Law and the Life Insurance Contract, Fourth Edition, Richard D. Irwin, Inc., Homewood, IL, 1979, p. 134.

5 Ibid.

6 Ibid.

7 Ibid., citing 14 Geo. III, Chap. 48.

8 Ibid., p. 135.

9 See Stephanie Strom, “Charities Look to Benefit from a New Twist on Life Insurance,” New York Times, June 5, 2004; see also State of New York Insurance Department opinion letter dated July 7, 2003.

10 See Stephanie Strom, “Charities Look to Benefit from a New Twist on Life Insurance”; Nelson, Insurable Interest Under Siege: See also Wendy Davis, “Death-Pool Donations,” Trusts & Estates, May 2004, p. 55.

11 See Stephanie Strom, “Charities Look to Benefit from a New Twist on Life Insurance.”

12 See AALU Bulletin No. 04-78.

13 See Stephanie Strom, “Charities Look to Benefit from a New Twist on Life Insurance”; State of New York Insurance Department Opinion letter dated July 7, 2003 .

14 AALU Bulletin No. 04-78.

15 Ibid.

16 Donald Jay Korn, “Giving Your All,” Financial Planning, November 2003, p. 70.