Worst case scenario: You sell your client a life insurance plan, but the insurer refuses to pay the death benefit claim. This is not out of the realm of possibility, as state regulators and insurance companies become more scrutinizing over “insurable interest.”
How close is close enough for your clients’ to be considered a beneficiary to a life insurance policy? Do they have to be married? A blood relative? It’s often an interesting dance trying to figure out whether a client has insurable interest in someone else’s life.
The definition of insurable interest varies by state. But generally, it means that the owner of a life insurance policy is likely to benefit if the insured continues to live and suffer some loss or damage if the insured dies. As a result, not just anyone can purchase a life insurance on your client’s life and make themselves the beneficiary.
Often, the beneficiary—a parent, child, husband, wife, brother or sister—has a clear insurable interest due to a blood relationship or marriage. An insurable interest can also exist in creditor-debtor or business relationships. But, depending on state laws, engaged couples may not have an insurable interest in each other’s lives.
The issue of whether an insurable interest exists picked up steam in recent years due to Stranger Originated Life Insurance (STOLI). With this type of transaction, an investor seeks to make money off the death of an insured. The investor—with no insurable interest—is named as the beneficiary of the life insurance policy. States increasingly are banning STOLI transactions.
STOLI transactions have triggered a greater awareness of the issue of insurable interest by state regulators and insurance companies. Regulators are re-asserting insurable interest requirements, says Michael Lovendusky, associate general counsel of the American Council of Life Insurers, Washington, D.C.
New York Life weeds out STOLI transactions with questions on life insurance applications that ask the intent of the policy owner and insured, says spokeswoman Theresa Wolcott. The company is on the lookout for red flags, such premium financing and beneficiaries that have no connection with the insured.
This means advisors must be extra diligent in writing life insurance policies.
Know the Rules
Richard Arzaga, founder of Cornerstone Wealth Management in San Ramon, Calif., says he would raise questions if a client requested substantially more insurance than a financial plan determined the client needed.
In one egregious example of a lack of insurable interest, afederal court judge voided a $10 million Prudential Financial insurance policy on the life of a Delray Beach, Fla. retiree. In December 2011, the judge ruled that Prudential also could keep the $620,000 in insurance premiums.
An insurance agent sold policies to senior citizens by telling them that they could get free insurance if they financed multi-million-dollar life insurance policies. The agent said that the retirees would get the death benefits before they sold their policies to a third party. In the case, a retiree, with a net worth of $600,000, was listed as having a net worth of $10 million on application documents.
“Financial planners must be knowledgeable of both the state’s case law and state’s insurable interest law with respect to life insurance,” says Suzanne Gradisher, a law professor and director of the financial planning program at the University of Akron in Ohio. “It is important because a life insurance policy will be valid only if the policy owner has an insurable interest in the life of the insured as defined by the relevant state.”
If you don’t know the rules, says Gradisher, you could write an invalid policy. A number of state Supreme Court cases over the years have voided insurance claims due to insurable interest law.
Cases won by insurance companies over the years have suggested these caveats:
- There must be proof of an actual business partnership between the purchaser of a life insurance policy and the insured—even if the policies are purchased so that the beneficiary can purchase the insured’s property upon his or her death.
- A client change of the beneficiary on his or her policy could spell trouble. If a cousin or other relative is named a beneficiary when there is a sole surviving sibling, for example, an insurable interest lawsuit could arise.
- A policy taken out on an in-law could be voided—even if the in-law approves of the policy. At least one court ruled such a relationship contained no insurable interest.
Apart from life insurance, courts have also voided contributions to a state retirement plan left to a friend, based on the concept of insurable interest. The beneficiary either had to be closely related to the deceased by blood or marriage, or have a financial interest in the continuation of the deceased’s life.