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.