A few months ago, we wrote about the concept of insurable interest and the potential challenges that life insurers face when seeking to avoid stranger-originated life insurance (STOLI) transactions. In particular, New York’s highest court late last year refused to categorically invalidate several STOLI transactions after concluding that the then-applicable New York law did not prohibit such arrangements which, in their simplest form, involve an investor who purchases the opportunity to recover the death benefit of a policy insuring the life of a stranger. The case was Kramer v. Phoenix Life Ins. Co., 15 N.Y.3d 539 (2010) and, although the decision doubtlessly was disconcerting to life insurers, the prospective impact of the court’s opinion is limited because the New York legislature has revised the law to prohibit STOLI transactions broadly and to place timing constraints on an insured’s ability to initiate life settlement contracts, by which he or she may legitimately sell rights to the policy proceeds.
In Kramer, the NY Court of Appeals responded to certified questions submitted to it by the U.S. Court of Appeals for the Second Circuit. In twin decisions, the Delaware high court recently had occasion to respond to similar questions from a federal court. In so doing, the Delaware Supreme Court appears to have placed STOLI on the rocks, but with a twist: like the court in Kramer, it concluded that there is no wholesale rule against STOLI transactions under the applicable state law, but … and here’s the twist … it nevertheless mapped out a course for invalidating such arrangements in the typical circumstances, including the cases at issue.
The two Delaware cases are PHL Variable Ins. Co. v. Price Dawe 2006 Ins. Trust, No. 174, 2011, 2011 WL 4360034 (Del. Sep. 20, 2011) and Lincoln Nat’l Life Ins. Co. v. Joseph Schlanger 2006 Ins. Trust, No. 178, 2011, 2011 WL 4360027 (Del. Sep. 20, 2011). Both cases involve the same private investing entity, known as GIII, which purported to have acquired the beneficial interests to trusts that were entitled to recover the death benefits under life insurance policies insuring the lives of the original trust beneficiaries. The insurers in the two cases sought judicial declarations that each of the life insurance policies at issue was void under Delaware law as an illegal contract wagering on human life that, accordingly, lacked an insurable interest. They argued that the individual in each case was merely a straw and the multi-layered trust schemes were intended to conceal wagers on the individuals’ lives.
The Dawe Case
In December 2006, Price Dawe declared the Dawe Trust, designating a family trust as the beneficiary. Price, in turn, was the beneficiary of the family trust. PHL, referred to by the court as “Phoenix,” in early 2007 issued a $9 million policy on Price’s life. Less than two months later, GIII purchased the family trust’s beneficial interest in the Dawe Trust (the owner and beneficiary of the life insurance policy) for around $375,000, without submitting a change of beneficiary or ownership form with Phoenix.
The Schlanger Case
Under a similar arrangement, Joseph Schlanger set up the Schlanger Trust which purchased from Lincoln National a $6 million insurance policy on Joseph’s life. Joseph was the beneficiary of a family trust which, in turn, was the beneficiary of the Schlanger Trust. Immediately upon issuance of the policy, Joseph sold his beneficial interest in the family trust to GIII, which paid all the premiums on the policy.
The Certified Questions
The federal district court sitting in Delaware certified the following three questions to the Delaware Supreme Court:
1. Does Delaware law permit an insurer to challenge the validity of a life insurance policy based on a lack of insurable interest after the expiration of the two-year contestability period?
2. Do the applicable Delaware statutes prohibit an insured from procuring or effecting a policy on his or her own life and immediately transferring the policy, or a beneficial interest in a trust that owns and is the beneficiary of the policy, to a person without an insurable interest in the insured’s life, if the insured did not ever intend to provide insurance protection for a person with an insurable interest in his or her life?
3. Do the applicable Delaware statutes confer upon the trustee of a trust established by an individual with an insurable interest in the life of that individual when, at the time of the application for life insurance, the insured intends that the beneficial interest in the trust would be transferred to a third-party investor with no insurable interest in that individual’s life following the issuance of the life policy?
Insurers May Challenge Existence of Insurable Interest Outside Contestability Period
The Delaware Supreme Court answered “yes” to Question No. 1, concluding that the incontestability provision mandated by state statute did not apply to block a claim by the insurer that the policy was void ab initio which, it recognized, is the case where a life insurance policy lacks an insurable interest. Although it is not the intended focus of this discussion, it is interesting to note that the court construed an ambiguity in the statute as making the incontestability period “directly contingent, and predicated, upon the formation of a valid contract.”
An Insurable Interest Exists if the Insured Procured or Effected the Policy and it is Not a Mask for a Wager
The court answered “no” to Question No. 2: There is no violation of the statutory insurability requirement where the insured procures or effects a life insurance policy with the intent immediately to transfer the benefit to an entity lacking an insurable interest, at least so long as the policy is not a mere cover for a wager. The court refused to engraft an element of intent to the statutory rules and concluded, in any event, that the insured’s subjective intent is not the relevant inquiry. The question, rather, is who procured the policy and whether or not that person meets the insurable interest requirement. The court’s guidance on that point is summarized in further detail below.
If the Insured Declares a Trust, His Intent to Benefit a Third-Party Does Not Inhibit the Trust’s Insurable Interest in His Life
The court’s answer to Question No. 3 was “yes.” As long as the insured established the trust, his intent to transfer the beneficial interest to a third-party without an insurable interest is irrelevant to whether the trust thereby obtains an insurable interest. In the court’s words, “we only inquire whether the owner (either the insured or the trust) has an insurable interest in the insured’s life at the policy’s inception and not whether the beneficiaries of the policy have an insurable interest.” Dawe, supra at *13. Once again, the court emphasized that the trust must not be a mere cover for a wager.
The Way Forward – Follow the Money
Woven throughout the Delaware Supreme Court’s discussion of the historical concept of insurability and the policy reasons against wagering, and its construction and reconciliation of statutory ambiguities and recognition that a highly-regulated market exists to support the legitimate secondary market for life insurance – the so-called life settlement industry – is a guide for life insurers seeking to identify and invalidate fraudulent STOLI transactions.
In Dawe, the court recognized the primacy of determining who “procured or effected” the policy and advised that knowing simply that the insured applied for the policy or provided the consent for its issuance is not enough. The courts’ advice is familiar: follow the money. “To determine who procured the policy, we look at who pays the premiums.” Dawe, supra, at *10. Thus, the fact that the insured pays the premiums provides strong evidence of a bona fide transaction. Yet, it is crucial to determine whether the insured has used his or her own money. If a “third party funds the premium payments by providing the insured the financial means to purchase the policy then the insured does not procure or effect the policy.” Id. In other words- “follow the money.”
The inquiry for determining whether the insured has established a trust for purposes of conferring to it an insurable interest also follows the money trail. Specifically, Delaware law requires the insured to “establish” the trust by both creating and initially funding the trust corpus – in the Dawe and Schlanger cases, the corpus is the policy and the funding consists of the premiums. Nominal funding by the insured is insufficient. Likewise, if funding comes from a third-party (directly or indirectly) as part of a pre-negotiated arrangement, no insurable interest transfers to the trust.
In thus responding to the certified questions, the Delaware court provided the federal court with a plan for invalidating the Dawe and Schlenger STOLI schemes. Careful observers recognize that the court also framed the arguments that insurers should make when they seek to avoid obligations in STOLI transactions, while preserving legitimate life settlement arrangements. Of course, the Dawe and Schlanger decisions, written from the perspective of an appellate court considering pure issues of law, do not attempt to tackle the complex issues of evidentiary sufficiency in such cases. Therefore, it will be interesting to follow the progress of the cases in the US District Court, and we will report back with anything noteworthy.