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.
In the case discussed, an irrevocable life insurance trust (ILIT) established by the husband sold the survivorship policy to an ILIT set up by the spouse to provide for the special needs of a severely disabled daughter, one of several children designated trust beneficiaries under the husband’s ILIT. Concurrent with second ILIT (like the first, a grantor trust), the couple implemented a partnership to execute the transaction.
The value of the policy sale to the second ILIT from the first was based on (1) the contract’s gift tax value (2) interpolated terminal reserve (approximately a life insurance policy’s cash value); and (3) unearned premiums.
In its PLR, the IRS ruled the policy sale was exempt from transfer for value rules under Internal Revenue Code (IRC) “safe harbor” provisions that permit the transfer of a policy to either an insured (in this instance, the wife) or to a bona fide partner of the insured. Leimberg said a safe harbor will also apply in instances where the insured is shareholder of corporation and when the transfer is in part a gift. In all cases, said Leimberg, advisors should check on the legitimately of such transactions if they believe they may involve an income-taxable transfer for value. “You should always be [concerned] about transfers of an interest in a policy if there is any kind of valuable consideration in money,” he said.
Yet another minefield for life insurance professionals, the panelists said, are cases involving product sales to a mentally impaired senior. In a now famous case, the producer Glenn Neasham was convicted by a lower California court of criminal theft for having sold an annuity to an 83-year-old woman who may have not have been competent at the time of sale due to the onset of dementia. An appellate court later overturned the lower court’s ruling, observing that Neasham did not intend to cheat his client. But the litigation nonetheless proved devastating emotionally and financially for Neasham.
The take-away for producers?
“Be sure when selling to older clients to document why a product was suggested to the client, particularly if there is any indication of an mental impairment or inability to engage in a sophisticated financial transaction,” said Brody. “Be certain also that your office has procedures to deal with these kinds of clients. “In addition, consider involving family members or other financial advisors so you have a record of what you did, plus statements from other witnesses who can verify that the client was able to understand what he or she was doing,” he added. “The bottom line: Watch for any signs of mental or emotional frailty in the prospect — and act accordingly.”
The panelists also called attention to a common occurrence in situations involving a marriage break-up: the failure of the parting couples, and their advisors, to change the beneficiary designation on a life insurance to be consistent with the divorce decree. Generally, such designations override other documents, such as a will or estate plan, in which a party other than the contract beneficiary is named the recipient of the policy proceeds.
But in a Nebraska state court case broached by the session panelists, the presiding judge ruled that a divorce decree — one in which each of the spouses agreed to forgo all rights to the other’s life insurance and employee benefits — overrode beneficiary designations listed in their respective policies. (In this case, a surviving ex-spouse, the designated beneficiary of her former husband’s life insurance policy, tried to secure the proceeds upon his passing.)
Linus Sudzias, an attorney and owner of ICS Law Group, said that many state legislatures have enacted laws consistent with the Nebraska state court ruling, the statutes treating a divorced spouse as having pre-deceased the insured for purposes of a beneficiary designation.
“It’s essential for agents and brokers to stay in touch not only with divorce attorneys, but also clients to make sure their policy beneficiary designations and other financial documents are up-to-date,” said Sudzias. “We as advisors can help them not only after the divorce, as in this case, but also during the divorce process.”