Warning: If you sell a life insurance policy to an individual whom a court later determinates has no insurable interest in the insured, be prepared to return the sales commission — all of it.
This cautionary note, among others, was the focus of a wide-ranging panel discussion at the 2014 annual meeting of Association for Advanced Life Underwriting, held in Washington, D.C., May 4-6. The conference "super session" brought together three attorneys to examine the implications for insurers and advisors of recent court cases and IRS private letter rulings.
Prominent among several of the court cases examined were contracts in which a third-party funded the purchase of a life insurance policy. Often referred as investor-initiated or stranger-owned life insurance (IOLI or STOLI), the transactions can raise red flags among state regulators and judges when the policy owner subsequently sells the insurance product to a third-party financier (e.g., life settlement company) that designates itself the policy beneficiary.
What warning signs might distinguish the legitimate from the illegitimate transaction?
"The real question is, was someone other than the insured pulling the strings?" asked Steve Leimberg, president of Leimberg Associates Inc. "Was the insured merely a straw man, someone engaged on behalf of a third-party to disguise the real purpose of the policy purchase?
"If so, he added, the courts will void the policy because the buyer never had an insurable interest in the insured."
When determining whether a policyholder does indeed have an insurable interest, said Leimberg, the courts will consider several factors, including whether:
(1) the insured can afford to pay the premiums;
(2) the insured wanted or needed the policy coverage;
(3) the policy was transferred the day after it was issued or the day the policy contestability period ended; and
(4) a third-party funded or procured funding for the policy.
If a policy is declared void "ab initio" (from the beginning), the courts have ruled that insurers can keep some or all of the paid premiums to reimburse them for the cost of coverage. If, however, the insurer was "unjustly enriched" by the payments, then it must forgo the premiums and the agent or broker who sold the policy will be required to return the commission. "One very important lesson we should take away from this year's STOLI cases is this: Insurers will be the losers if they don't tighten up their underwriting processes," said Leimberg. "The courts are fed up with sloppy underwriting on every level. Time is running out on shoddy cases."
And potentially on agents and brokers engaged in fraudulent activity. Larry Brody, a partner at Bryan Cave LLP, cited a case, Lloyd's of London vs. AXA Equitable, in which a producer who pled guilty to defrauding an insurer for falsifying information was denied coverage under his errors and omissions (E&O) professional liability insurance.
The lessons for producers: Those who engage in such fraud have "no protection," and therefore can expect to pay out of pocket any court-imposed punitive damages. They must carefully review their E&O policy to uncover scenarios not covered by the contract (e.g., life settlements deemed to be securities); and, when feasible, purchase supplemental coverage to reduce their liability exposure.
Turning to estate planning, the panel explored an IRS-issued private letter ruling (PLR) involving the sale of a survivorship life insurance policy covering a husband and wife. The issue: Whether the transaction constituted a "transfer for value," thus making the policy proceeds income-taxable.
