Ruling clouds status of insurance trusts

By Rick Miller

March 28, 2005


CHICAGO - A controversial court ruling last month that cast doubt on the use of life insurance trusts is already having a chilling effect on the widely used estate planning strategy.

Worries over the decision effectively quashed a trust deal for John K. Bacci, a certified financial planner with Foundation Financial Advisors Inc. in Linthicum, Md. He was in midst of arranging to have a client's $2 million life insurance policy placed inside a trust when the lawyer involved demanded a letter from the insurer to "cover his backside."

Big impact feared

"The minute the attorney gets cold feet, it's done, it's over," Mr. Bacci said. "Attorneys are freaked from what I can see."

In the case of Vera Chawla vs. Transamerica Occidental Life Insurance Co., a federal court judge ruled that a multimillion-dollar life insurance policy was void because a trust was the owner and beneficiary of the policy.

Under Maryland law, which was applied in the case, a trust does does not have an "insurable interest" in the life of its grantor, because it receives the death benefit, the judge said.

Potential impact 'enormous'

"The potential impact is enormous," said Mr. Bacci, who has about a dozen clients with irrevocable life insurance trusts, or ILITs.

"If it's upheld under appeal, then we have reinvented estate planning."

While the case has roiled advisers and estate-planning lawyers in Maryland, there are concerns that states with similar laws could be subject to the ruling.

William Crispin, who represented the trustee, Ms. Chawla, said the judge's holding, if sustained, could be adopted by courts in Alabama, Arkansas, Illinois, Kentucky, Louisiana, Michigan, Missouri and possibly South Carolina.

"For financial planners, just think of the situation they are in," said Mr. Crispin of Crispin & Associates PLLC in Washington.

If an adviser, particularly in Maryland, recommended an ILIT and the life insurance claim is denied, "you will be sued, you have engaged in malpractice."

But the American Council of Life Insurers in Washington and the Association for Advanced Life Underwriting in Falls, Church, Va., believe the judge's decision was specific to the unique facts of the case and doesn't have broad implications.

"We think it is unlikely that a position that an insurance trust lacks an insurable interest will be upheld on appeal," said Tom Korb, AALU director of government affairs.

Other lawyers and advisers share that belief.

As Michael Kitces, a financial planner in Maryland, puts it: "I don't view this by any means as the death of irrevocable life insurance trusts."

"The classic line that most lawyers use is, bad facts make for bad law," added Mr. Kitces, director of financial planning at Pinnacle Advisory Group Inc. of Columbia, Md. "This case is kind of a mess for lots of different reasons."

The Chawla case involves Harald Giesinger, a single man in his 70s who tried to take out a $1 million life-insurance policy with the beneficiary being Ms. Chawla, a friend in her 50s who was the wife of Mr. Giesinger's physician.

The insurance company, Los Angeles' Transamerica, wouldn't issue the policy because Ms. Chawla was not a relative and had no insurable interest in Mr. Giesinger.

Insurable interest is typically associated with family members or business associates who stand to lose financially because of a person's death.

Mr. Crispin said Mr. Giesinger and Ms. Chawla had a "business relationship" and did some real estate investments together.

"But there was a personal side to the relationship," Mr. Crispin said. "He is a single guy and has no family and he became the godfather of the Chawlas' children. He lived at the house a good part of the time. They took care of him."

Mr. Giesinger took out a policy - later increased to $2.45 million - in which the owner and beneficiary was a trust, meaning Mr. Giesinger and Ms. Chawla were co-trustees.

But when he died in 2001, Transamerica denied the claim, saying that Mr. Giesinger had misrepresented his medical history on his application, including failing to mention he had undergone surgery to remove a brain tumor.

In the subsequent lawsuit, U.S. District Court Judge Claude M. Hilton in Alexandria, Va., ruled in favor of Transamerica. Applying Maryland law, where Ms. Chawla lives, he agreed that there had been medical misrepresentations.

But some say the judge took his ruling a step further than he had to, deciding that life-insurance trusts in Maryland cannot have an insurable interest regardless of who the beneficiary is, according to Mr. Crispin.

"If a family in Maryland has been paying their life insurance premiums for the last 20 years with the notion that, if the husband died, the wife would be able to pay off the mortgage with the insurance proceeds, maybe put the kids through school, guess what? Under this holding, as fought for by Transamerica, there is no insurance for the wife if it is held in a trust," he said.

Mr. Crispin is also baffled as to why Transamerica would raise the insurable-interest issue.

"Is there a business reason, apart from winning this case, that any insurance company would shoot itself in the head like this and fight for a rule that would hurt its own business?"

Mr. Crispin asked. He is appealing before the 4th U.S. Circuit Court of Appeals.

In a prepared statement, Bill Tate, Transamerica's senior vice president and chief marketing officer, said the company does not view the ruling as "having any application to trusts generally, including those set up for estate planning purposes."

"We believe that because this particular decision was based on facts unique to this case, it does not call into question the insurable interest in policies owned by trusts," he said.

'Unintended consequence'

Still, William H. Van Pelt IV, president of the Mid-Continent Companies Ltd. in Houston, a national financial planning firm catering to the wealthy, also questions why Transamerica would raise the issue.

"An unintended consequence is that sophisticated clients and their advisers are going to ask the question: Do we have to worry about a carrier just fighting the claim based upon a fact pattern that may be complicated?"

Steven Oshins, a lawyer with Oshins & Associates LLC in Las Vegas, said it's not time to panic. That time would only come if other courts rule in similar fashion.

"I have probably set up a thousand life insurance trusts and I can't have the thousand people terminate their insurance and buy new insurance because of one case that probably is wrong," he said.

"I am not nervous," he added, "but I am sweating just a little bit."