A recent court decision highlights a potential
problem with irrevocable life insurance trusts.

Although it is a concept with solid policy underpinnings and a long pedigree, the notion of "insurable interest" has, until recently, been given little thought by wealth transfer planners. That changed dramatically with the 2005 ruling of the U.S. District Court for the Eastern District of Virginia in Chawla v. Transamerica Occidental Life Insurance Company. In that case, the court determined that a trust established by the decedent insured did not have an insurable interest in the decedent's life, and therefore the policy issued by the insurer (Transamerica) was void. While this aspect of the court's ruling was overturned on appeal, the case nevertheless served to bring to light a problem lurking in the laws of many states: that a common planning device, namely the irrevocable life insurance trust, or ILIT, may lack an insurable interest in the life of its settlor and therefore the policy issued to the trust may be void.
Let's examine some of the implications for planners of the Chawla decision and the issues it raises, as well as some of the policy concerns supporting the insurable interest rule. Additionally, let's examines the facts of the case and its implications for planners who advise, draft and set up ILITs. We'll conclude with a recommendation to planners who advise clients to consider ILITs as part of their estate planning.

Insurable Interest Considerations
"Insurable interest" is an ambiguous term that is often misunderstood by the public. It is important to the placement and ongoing validity of an insurance contract. The term has been often glossed over as an irrelevant formality, leading over time to inconsistencies among states' interpretations and invalid schemes that prey on its vulnerability. To understand insurable interest laws more fully, one must consider their origin.
In the early 18th century, life insurance planning resembled more a Vegas casino run by the Sopranos than the established industry it is today. This was especially true in England. The purchase of life insurance was like roulette. The market was open, allowing anyone to buy insurance on the life of another in the form of a wager.
One could purchase a policy on another's life without the owner knowing the insured, or vice versa. If the insured happened to die within the time period prescribed in the policy, there would be a payoff. There was no requirement that the owner of the policy have any interest whatsoever in the life of the insured beyond the policy (which even today remains, in a sense, a bet that the insured will not live to his or her full life expectancy).
This lack of structure caused devastation and corruption in the marketplace, which drove England to make changes. In 1774 it issued The Life Assurance Act, which sought to establish an insurable interest in the form of a potential pecuniary loss stemming from a legal obligation that is suffered on the death of the insured. Put another way, the applicant for a policy on the life of another had to have a monetary interest in the continued life of the person who was insured, and not just in his or her death. If there was no such interest, the policy was voidable-that is, the insurer was under no obligation to honor the contract and pay the death benefit.
Over time, most states in the U.S. have codified the insurable interest rules to include a broader set of standards than those set forth in the 1774 Act. In addition to the presence of a pecuniary interest, most contemporary insurable interest statutes provide that an insurable interest can also be established by people who are related by blood. Although most states have codified the insurable interest rules, there remains a lack of uniformity in their interpretation and application. There are many cases in which identical, or nearly identical, statutes in different states have produced completely different results. For example, a court in one state may hold that a familial relationship alone is enough to support an insurable interest, while another state court may determine that there is not a strong enough pecuniary interest between parties to establish such an interest.
It is important to keep in mind that the insurable interest rules normally do not apply to policies that are assigned. An assignee does not necessarily have to have an insurable interest. Historically, assignments have been used to cover debts and other obligations where a pecuniary interest exists. In recent years, there have been policies put in place with the premeditated plan of assigning and selling them to a third party in the settlement market. In the view of many, this practice has reintroduced an element of gambling, which runs counter to spirit of the insurable interest rule. However, case law supports the validity of assigning the policy or the death benefit after a policy has been issued.

The Chawla Case
The Chawla case itself, apart from its unusual facts, is unremarkable. The plaintiff, Vera Chawla, applied to the defendant, Transamerica Occidental Life Insurance Company, for a $1,000,000 policy on the life of the decedent, Harald Geisinger. Transamerica rejected the application on the grounds that Chawla did not have an insurable interest in Geisinger's life. The plaintiff reapplied for the same coverage, this time in her capacity as Co-Trustee (along with Geisinger) of a trust established by Geisinger. This time, the policy was issued. Coverage was subsequently increased to $2,450,000.
When Geisinger died, Transamerica rescinded the policy, denied the claim and returned the premiums to the plaintiff, on the grounds that the decedent had not disclosed material medical information on the application. The plaintiff then sued Transamerica, which answered by asserting not only that material misrepresentations had been made on the application, but also that the plaintiff had no insurable interest in the life of the decedent. In finding for Transamerica, the court based its opinion primarily on its finding that the decedent had made numerous material misrepresentations and omissions on the insurance application. The decedent failed to disclose, among other things, that he had undergone surgery for a brain tumor; that a shunt had been inserted after that surgery to relieve an accumulation of fluid; and that he had a history of alcohol abuse. The court concluded on the evidence that, had the decedent disclosed these facts to Transamerica, the company would not have issued the policy, at least not on the same terms.
However, the court went further in its analysis. In addition to the material misrepresentation issue-which itself was enough to decide the case in Transamerica's favor-the court also ruled on the insurable interest question, again finding in favor of the defendant. The court concluded that the plaintiff's case failed as a matter of law because the trust did not have an insurable interest in the decedent's life, a necessary precursor for the issuance of a valid policy.
In reaching this conclusion, the court applied the Maryland insurable interest statute, which provided that, for anyone other than a close legal or blood relative, an insurable interest consisted of "a lawful and substantial economic interest in the continuation of the life, health, or bodily safety" of the insured. However, "an interest that arises only by, or would be enhanced in value by, the death . . . of the individual" was not an insurable interest. The court noted that "upon the death of the decedent, the Trust assets were distributed to Plaintiff, who sold them for an amount in excess of the mortgage. Consequently, the Trust promised to gain more assets upon the decedent's death, i.e., death benefits under the policy, than it would have in the event the decedent lived." Therefore, the trust had no insurable interest in Geisinger's life.
This reasoning raised more than a few eyebrows in the planning community. Admittedly, the Chawla case itself involved relatively unusual (and, in the sense of the legal aphorism, "bad") facts. However, the case called into question whether the insurable interest rule (whether in statutory or common-law form) might be applied more broadly, and particularly to one of the most common planning devices: the irrevocable life insurance trust.

The Irrevocable Life Insurance Trust
The irrevocable life insurance trust (ILIT) has long been a staple of effective wealth transfer tax planning, and its basic concepts are well known and widely accepted. Under Section 2042 of the Internal Revenue Code, a decedent's estate includes the value of the proceeds of any policy of insurance on the decedent's life payable to the decedent's estate, or with regard to which the decedent at the time of his or her death possessed any "incidents of ownership." While an insured can divest himself or herself of the "incidents of ownership" over a policy by transferring it to another, such a transfer is subject to the "three-year rule" of Code Section 2035. In other words, if an insured transfers a policy and dies within three years of the transfer, the proceeds are "brought back" into his or her estate and taxed at their full value.
In response to these difficulties, practitioners developed the irrevocable life insurance trust. In brief, the ILIT is a trust that is designed to purchase and hold a policy of insurance on the life of an insured grantor. At the insured's death, the proceeds of the policy are receivable by the Trustee, who holds them for the benefit of the beneficiaries under the terms of the trust agreement. At no time does the insured possess or exercise any ownership over the policy. Likewise, the trust may purchase insurance on the life of the grantor and pay premiums thereon, but it is not required to do so. The trust typically is unfunded or only minimally funded, with the grantor making periodic gifts to the trust that the trustee uses to pay insurance premiums (again, at the trustee's discretion). Assuming that the trust is properly structured and administered, the insurance proceeds are not included in the decedent's estate.
Although it is primarily a transfer tax strategy, the ILIT offers additional advantages over outright ownership by the beneficiaries-for example, the insured's children. The trust can provide a source of liquidity for an otherwise illiquid estate if the trustee is authorized to make loans to the estate or to purchase estate assets. It can provide management and protection for beneficiaries who are minors or otherwise incapable of managing substantial sums on their own.
Perhaps most importantly, it affords flexibility. The interests of multiple beneficiaries can be structured to suit the circumstances. Thus, to take perhaps the simplest example, the proceeds can be held in trust for the insured's spouse for life, with the remainder to be divided among the insured's children, whether outright or in further trust. This is particularly appealing (and common) in the case of a second marriage.
In the context of the insurable interest rule, all of the advantages of the ILIT may in fact turn out to be problems. It is the trust's very "separation" from the insured grantor that calls into question whether, under statutes like Maryland's, the trust does indeed have an insurable interest in the life of its grantor.

The ILIT And Insurable Interest
The Maryland statute contained language that, if applied broadly, likely would invalidate most insurance contracts other than those specifically addressed by other parts of the statute. Recall that, for "third party" policies, the Maryland statute specifically disqualified a monetary interest in the life of the insured that "arises only by, or would be enhanced in value by, the death . . . of the individual." It is difficult, if not impossible, to imagine an ILIT that does not meet this description.
During the life of the insured, the typical insurance trust does not hold more than the policy and serves primarily as a "conduit" for premium payments. In such circumstances, the trust qua trust cannot help but have a monetary interest in the life of the insured that is "enhanced in value" by the death of the insured. Indeed, the whole purpose of the arrangement is to capture the value that arises under the insurance contract by reason of the death of the insured.
Part of the conceptual difficulty in applying this analysis to an ILIT as the Chawla court did is that a trust is not an "entity" with a separate legal existence. Perhaps it might be more accurate to say that it is not just an entity; it also is a form of split ownership wherein the legal and equitable interests in the trust property are divided between the trustee and the beneficiaries, respectively. Therefore, to regard the trust as only an entity is insufficient to determine its true nature.
A sensible approach to applying the insurable interest rules to trusts, and one taken by several states, is to "look through" a trust to the underlying interests, and to provide both that the Trustee has an insurable interest in the life of the individual settlor of the trust, and that the trust has an insurable interest in the life of any other person in the same proportion as the beneficiaries of the trust. In other words, if all of the beneficiaries (for example, the insured's spouse and descendants) have an insurable interest in the life of the insured, the trust has the same insurable interest. 
In those states that take this approach, the insurable interest problem for most ILITs simply disappears. If the individual insured (or insureds) are the settlors of the trust, the trustee by statute has an insurable interest in their lives and no further difficulty exists. In those rare cases in which a trust owns a policy on the life of someone other than the settlor of the trust, as long as the beneficiaries have an insurable interest in the life of that insured again there is no difficulty with the trust's procurement of the policy-which also seems a sensible approach from a policy perspective. However, not all states take this approach. Advisors need to be aware of this lack of uniformity and address it when it is most effectively addressed, that is, during the planning and implementation stages.

Recommendation For Advisors
The most important advice for planners advising their clients on establishing an ILIT also is, probably, the simplest: know what state law is likely to apply to the trust, and make sure that the applicable law expressly provides that a trust established by an individual insured has an insurable interest in that individual. Delaware, for example, offers such assurance, as well as an overall very flexible trust code and favorable tax laws. In 2006, specifically in response to Chawla, Georgia revised its insurable interest statute along the lines of Delaware's provision.
How would an advisor in, say, South Carolina, ensure that Georgia (or Delaware) law applied to a trust set up by a South Carolina client-with a South Carolina Trustee? For better or worse, choice of law is one of the least predictable areas of law. Would a South Carolina court respect a trust provision selecting Delaware law as the law to apply to the trust, especially with no other connection to Delaware? The answer depends at least as much on questions of public policy as it does on concrete "legal" rules. Therefore, unless the individual insured has a demonstrable connection to the state whose laws are to apply to the trust, the best course of action is to name a Co-Trustee-such as a bank or trust company-in that state.
Along the same lines, it might be advisable to build into the trust document some mechanism for changing the law that is to apply to the trust. This might be done, for example, by allowing for the appointment of a new trustee and a change in law to the residence or place of business of that trustee. Unless and until some uniformity is achieved in this area-and it should be emphasized that insurable interest is only one of the many factors that enter into a choice of law-the planner should seek to build in flexibility in order best to achieve the client's goals.

Jim Robinson is an associate of the in the Private Wealth Practice Group of Arnall Golden Gregory LLP in Atlanta. His practice focuses on wealth transfer taxation, business succession planning, estate planning and administration, and charitable planning and exempt organizations. Stephen B. "Bo" Wilkins is a chartered life underwriter (CLU), chartered financial consultant (ChFC) and a chartered advisor in philanthropy (CAP). He is a registered representative of M Holdings Securities Inc., a member firm of Nease, Lagana, Eden & Culley Inc. in Atlanta.