New York Insurance Department Disapproves Securitization Scheme for Lack of Insurable Interest (CC 04-11)

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.  Recently, however, this axiomatic concept has been challenged by a variety of situations in which the party seeking a life policy does not have a traditional insurable interest, yet arguably is not engaging in a wagering transaction of the kind the Life Assurance Act and its progeny sought to forbid. In cases such as viatical settlements, same-sex domestic partnerships, charitable contributions, and even, to an extent, corporate-owned life insurance (COLI) on non-key employees connected with cost recovery of employee benefits, legislators and judges have been receptive to finding an insurable interest.

This Current Comment examines a new scheme that stretches the bounds of the concept of insurable interest and that was, for that reason, disapproved by the New York Insurance Department in a recent opinion. 

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 20, Subdivision B 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. 

But social and business institutions change, and the law, including the doctrine of insurable interest, develops to accommodate them.  Thus, although there is manifestly no insurable interest, in the traditional Warnock sense, in the following cases, courts and legislatures have found that the life policies in question are valid:

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 legally 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 corporation secures an obligation to its non-key employees, such as retirement benefits, by taking out insurance policies on their lives to the extent of the obligation.

(Note that the last situation is to be distinguished from that of so-called leveraged COLI (derided as "Janitor`s Insurance"), in which a large corporation takes out policies on hundreds or thousands of its non-key employees to secure tax advantages. Those tax advantages have been legislatively abolished and the IRS has sued a number of the companies involved.  See Section 19.1, Subdivision G of this Service, “Further Limitation On Deductibility Of Policy Loan Interest— Plan Of Purchase Rule,” for details.)

It is not surprising that there would be a tendency to find an insurable interest in these cases.  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.   And in the case of non-leveraged COLI policies, it is legitimate and reasonable to secure an obligation to non-key employees by taking out policies on their lives to the extent of the obligation, especially if this is the arrangement that enables the employer to offer the benefit in the first place. (Of course conventional arrangements insuring key-employees raise no insurable interest issues.)

A New Development Goes Too Far

However, the newest wrinkle, a variation on the charitable giving concept, goes so far toward eliminating insurable interest altogether and converting life policies into wagering transactions that industry associations—AALU and NAIFA —whose constituents have a vested interest in selling life policies, have announced their opposition to legislation intended to legitimate it. Moreover, the New York Insurance Department, perhaps the only body to have considered the scheme, has disapproved it.  Insurable Interest Requirement (Life Insurance), State of New York Insurance Department, July 7, 2003 (hereafter Insurable Interest).

The schemes being marketed are complex and apparently vary in details.  However, the arrangement addressed in Insurable Interest, the New York Insurance Department opinion, contains the essence of the concept, and the New York statute permitting charities to be the beneficiaries of life policies, N.Y. Ins. L. §3205(b)(3) (McKinney Supp. 2003), is typical of such statutes.  For those reasons, this Current Comment will focus on the New York opinion and the scheme set forth therein.

The New York Insurance Department Opinion: The Skeleton of the Scheme

In the scheme discussed by the Insurance Department, the charity (“Sponsor”) (qualifying under §170(c) and §50(c)(3) of the Internal Revenue Code) establishes a trust (the “Issuer Trust”) to issue collateralized endowment bonds )the “Bonds”).  The Sponsor owns the beneficial interest of the Issuer Trust.  The heart of the scheme is a pool of about 100 “Associates,” i.e. charitable donors, who consent to Sponsor to acquire life insurance policies and single premium immediate annuities (the “Policies” and “Annuities”) and be their owner and beneficiary.  They also consent to the use of the Policies and Annuities to collateralize the Issuer Trust indenture.  The Policies and Annuities are purchased out of the proceeds of the Bond offering. Their benefits are then assigned to the Issuer Trust, which uses the benefits to collateralize the Bonds.  The Sponsor retains ownership and beneficiary status of the Policies and Annuities, and once the Bonds are paid, these instruments are returned to the Sponsor.

The Annuities provide periodic payments for the life of the Sponsor and the Policies provide death benefits. These are paid to or for the benefit of the Issuer Trust and the bondholders, and are applied to transaction costs, premiums, and amounts due the bondholders.

As the Insurance Department says,

The transaction described herein appears to be a method of facilitating the use of life insurance and annuities as charitable donation vehicles on a large scale. The proposed method for this is by providing a mechanism that both facilitates the transfer of the insurable interest of the potential donors (the "Associates" herein), to the charitable donees (the "Sponsors" herein) as well as providing a method for financing the acquisition of Policies and Annuities once those interests are transferred.

Where Does the Money Go?

The transaction is complicated, so it is worth stepping back and seeing exactly how it is supposed to work.  Life insurance is an attractive vehicle for charitable donations and, in spite of historical insurable interest concerns, has been permitted by statute in virtually every jurisdiction.  The insurable interest of potential donors in their own lives constitutes a capital pool on which charities can therefore draw.  To raise the funds to purchase the policies, the charities issue bonds. The bonds are collateralized by the policies and annuities, so when benefits are paid under the policies and annuities they go to pay expenses, premiums, and the bonds. 

So the money goes (a) to the bondholders for the life of the bonds; (b) to the charities once the bonds are retired.  Thus, though the charities will ultimately reap whatever is left of the insurance interests after expenses, premiums, and the bonds (with interest) are paid, they have to wait for the life of the bonds; meanwhile all payments go to the bondholders.  The problem is that the bondholders are complete strangers to the insureds and the charities.  From their point of view, the arrangement is a wagering transaction; in the words of Warnock, they are “directly interested in the early death of the assured,”  or at least have no interest in the insured’s continued life, and their role in the transaction does not create such an interest. 

In general, New York Insurance law §3205(b)(2) prohibits a person from procuring a policy of life insurance upon another without having an insurable interest at the time the policy is acquired.  The exception for charities is §3205(b)(3):

Notwithstanding the provisions of paragraphs one and two of this  subsection, a Type B charitable, educational or religious corporation formed pursuant to  paragraph (b) of section two hundred one of the not- for-profit corporation law, or its  agent, may procure or cause to be procured, directly or by assignment or otherwise, a  contract of life insurance upon the person of another and may designate itself or cause to  have itself designated as the beneficiary of such contract.

(It may be worth noting that “Type B organization” is a significantly narrower concept than “§501(c)(3) organization:”)  The transaction does not come under this exception.  The statute was intended, according to the Insurance Department, merely to allow donors to effect charitable contributions of life insurance policies directly, rather than having the donor take out the policy on his or her own life and then assign it to the charity.  The present case is more radical than that:

In the proposed arrangement, although the Sponsor is the only named beneficiary and owner of the Policies, the economic reality is that a significant portion of the proceeds of the Policies and Annuities must be diverted to provide the bondholders with a return on their investment. In addition, while the Sponsor ostensibly retains sole ownership of the Policies and Annuities, this ownership interest is compromised by the fact that the Sponsor must assign its rights under the Policies and Annuities to the Issuer Trust, which in turn must pledge them as collateral.

Under the proposed transaction, the Sponsors receive only a small portion of the economic benefit of the Annuities and Policies, and have, as a practical matter, a clouded ownership interest in the Annuities and Policies. Thus, the proposed arrangement is not consistent with the purpose of the Section 3205(b)(3). Accordingly, the arrangement is not acceptable under the New York Insurance Law.

Insurable interest matters here because the bondholders are enjoying income derived from policies they could not have procured themselves because they lack an insurable interest in the lives of the Associates.

Scheme and Variations

Certainly there is no traditional Warnock insurable interest to ground the bondholders’ enjoyment of their income, and this situation differs from the four mentioned above in that there is no interest of the Associates served by the scheme.  The Associates want to donate to the Sponsor charity: very well.  But they could just as well do so by taking policies out on their own lives and assigning them to the sponsor, or as New York law permits, letting the Sponsor take them out directly, without the fundraising apparatus of the bondholders.  The only purpose the bondholders serve is to capitalize the Associates’ insurable interest, and this is surely contrary to the whole doctrine.  If insurable interest means anything, it means that interests in people’s lives cannot be bought and sold—traded—like securities.  Yet securitization is exactly what’s happening here.  There is no intent to insure the Associates here, just to leverage their insurable interest for investment purposes. 

So far, law and wise policy seem to be against the transaction. However, anecdotal reports indicate that these arrangements are even worse in practice.  Reportedly, these schemes are being aggressively marketed to charities and universities, who in turn solicit contributors to serve as Associates. Further, the preferred candidate Associates are the wealthy elderly—precisely the target audience for life settlements, whose pitfalls have been explored in this Service. See Viatical Settlements, Life Settlements, and the Secondary Insurance Market, Parts I and II (CC 04-02 and 04-04). The third parties who buy the bonds are not clear, but may include institutional investors, increasing the concern about securitization. Finally, it is said that lobbying pressure is being brought to bear on the legislatures of several states to ensure that their insurable interest law permits these transactions.

Conclusion

With serious controversy within the industry about the very propriety of these arrangements, we are far from hearing the last about this issue.

(April 2004 Current Comment)

Copyright 2004, Advanced Planning Press, LLC. All Rights Reserved.