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New York Insurance Department Invalidates SOLI Scheme (CC 06-04)

It has been a widely accepted principle 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. The insurable interest requirement has been stretched and expanded in various ways of late (see Section 50.7 of this Service), but it is still possible for regulators to find an investment scheme involving life policies (so-called stranger-owned life insurance, or SOLI) to be invalid for lack of insurable interest.

Perhaps because New York has a particularly explicit insurable interest statute (N.Y. Ins. L. § 3205), the New York Insurance Department is notably stringent in requiring an insurable interest for life policies. In 2003, it invalidated a SOLI scheme geared toward nonprofit and charitable institutions (see CC 04-11, "New York Insurance Department Disapproves Securitization Scheme for Lack of Insurable Interest"). And at the end of 2005 it issued an opinion invalidating an arrangement in which individuals assign policies they have purchased with borrowed money to third parties. Life Insurance Transactions (New York State Insurance Department, December 19, 2005).

Description of the Scheme

As described by the Insurance Department, the scheme is not really very complicated at bottom. A third party bank loans money to a high net worth individual to purchase an insurance policy and pay premiums due. The policy is subject to an option agreement—a "Put Option"—under which the client can sell the policy to a third party—usually a hedge fund—on a predetermined "Exercise Date," at least two years after the date of the loan. The loan, which is secured by the policy and the insured's rights under the Put Option, comes due on or after the Exercise Date. If the insured exercises the Put Option, the hedge fund buys the policy at a price predetermined to cover the loan plus interest. If the insured declines to exercise the Put Option, he or she remains the owner of the policy and is liable for future premiums, as well as repayment of the loan with interest. Finally, the hedge fund's obligations under the Put Option are guaranteed, for a fee, by a licensed bank.

From the insured's point of view, the result is two years of free insurance until the Exercise Date. At that time the insured either exercises the Put Option, selling the policy to the hedge fund and paying off the loan with the proceeds, or declines to exercise the Put Option and keeps the policy with all its obligations.

The other critical party to the scheme, the hedge fund, gets nothing if the Put Option isn't exercised. But if it is exercised, the hedge fund gets a policy insuring the life of someone in whom it has no insurable interest. That is why the Insurance Department rejects the scheme.

The Insurance Department's Analysis

The Insurance Department grants that, under New York Insurance Law §3205(b)(1),

"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."

Nonetheless, it states, "based on our review of the transaction it appears that the arrangement is intended to facilitate the procurement of policies solely for resale." That is incompatible with the definition of "insurable interest" for one not bound to the insured by ties of blood or affection, at §3205(a)(1)(B): "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." (The Insurance Department also notes that "arguably" the insureds are not procuring the policies "on their own initiative.") And it does seem true that under the facts as described, the hedge funds or any transferee would only stand to gain—by collecting on the policies—upon the "death, disablement or injury of the insured." Thus, the Department concludes that "the transaction presented involves the procurement of insurance solely as a speculative investment for the ultimate benefit of a disinterested third party . . . and is contrary to the long established public policy against "gaming" through life insurance purchases."

An Additional Objection: Rebating Problem

The Insurance Department also notes that

"Upon the sale of the Policy by a Client [i.e. the insured] (following the exercise of the Put Option) it is conceivable that the policy premiums would be effectively rebated since the Client may well recoup from the proceeds of the Policy sale the amounts it borrowed and paid as policy premiums. Such a Client would thus receive cost free coverage for the two-year incontestability period, arguably an inducement to enter into the transaction."

Such a rebate would be a violation of §2324(a) of the Insurance Law. See Rebates (New York State Insurance Department, August 30, 2004).

Conclusion

The bottom line is that transactions of the sort described in the Insurance Department's opinion are invalid in New York. More broadly, it is clear that New York's insurance regulators are continuing to keep a close eye on SOLI schemes. To the extent the New York Insurance Department sets the pace for other state regulators, this is something to bear in mind.