Virginia State Bar

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Trusts and Estates

A Section of the Virginia State Bar.

Winter 2007 Newsletter

Newsletter - Trusts and Estates

Volume 21, No. 1

INSURABLE INTEREST IN TRUSTS

by Mark Cohen
Cohen and Burnett, P.C.

Before the first Chawla1 decision came down, I had never been concerned over whether a trust, as an entity unto itself, would need to have an insurable interest on the life of the insured. After all, we have been putting life insurance into trusts for years without such problems. Nevertheless, the district court in Chawla shocked us by construing Maryland law to require that a trust, not the beneficiaries of the trust, have an insurable interest in the life of the insured. On appeal,2 the Fourth Circuit vacated that part of the district court’s holding because it was unnecessary to the decision, but did not refute its rational. Thus, we now have a district court opinion that, although vacated as unnecessary, can still be cited as authority for the proposition that a trust as an entity is required to have an insurable interest in the insured, independent of the beneficiaries.

If true, it would be the rare insurance trust that has an insurable interest in the life of the insured. In Chawla, for example, the district court held that the trust did not have an insurable interest in the insured, even though the insured was the sole lifetime beneficiary of the trust.3 Generally, when there is no insurable interest, the insurance company may rescind the policy, or, in some states, the proceeds are held in resulting trust for the benefit of the insured’s estate. This article discusses the law of insurable interest, the Chawla cases, and concludes with the statutory fix that is being considered in Virginia’s 2007 legislative session.

Common Law of Insurable Interest

Under the common law, “before a person can validly procure insurance upon the life of another, he must have an insurable interest in that life.”4 This rule is premised upon the view that contracts in which the procurer lacks an insurable interest in the insured are mere gambling contracts and as such are against the public interest. The theory is that “the public has an interest, independent of the consent and concurrence of the parties,” in discouraging one party from wagering upon the life of another.5 In light of the strong public policy which underlies the insurable interest doctrine, courts have held that “[t]he parties to a contract of insurance cannot, even by solemn agreement, override the public policy which requires the beneficiary to have an insurable interest.”6 While the courts and legislatures of this country have generally agreed that an insurable interest is required for an individual to procure insurance upon the life of another, they have experienced some difficulty in determining what interest constitutes an insurable interest.

The Supreme Court defined insurable interest 124 years ago as:

[s]uch an interest, arising from the relations of the party obtaining the insurance, either as creditor of or surety for the assured, or from the ties of blood or marriage to him, as will justify a reasonable expectation of advantage or benefit from the continuance of his life . . . . there must be a reasonable ground, founded upon the relations of the parties to each other, either pecuniary or of blood or affinity, to expect some benefit or advantage from the continuance of the life of the assured.7

The Texas Supreme Court in Drane v. Jefferson Standard Life Ins. Co.,8 provided a more definitive explanation of what is meant by an insurable interest that is based on a reasonable expectation of pecuniary benefit or advantage from the continued life of another. The court stated that it is an interest determined by monetary considerations, viewed from the standpoint of the beneficiary - would the beneficiary regard himself as better off from the standpoint of money, would he enjoy more substantial economic returns should the insured continue to live, or would he have more in the form of the proceeds of the policy should the insured die.9

Whether an individual has an insurable interest in another also may be determined by examining the “loss or disadvantage [which] will naturally and probably arise, to the party in whose favor the policy is written, from the death of the person whose life is insured.”10

To summarize the common law, an insurable interest falls into three broad categories:

(i) The insured. The insured has an unlimited insurable interest in his or her life, and can designate anyone as the beneficiary;

(ii) Someone who has a close relationship, either by blood or marriage, with the insured. In this case, there is no need to show monetary needs associated with the insured’s continued life; and

(iii) A person or entity that gains some monetary benefit or avoids some loss from the continued life of the insured. The value of the monetary benefit or loss determines the amount of the insurable interest. This is typical of business buy/sell agreements and pension trusts.

Insurable interest must exist at the time the policy is procured, but it need not exist thereafter.

Statutory Definitions

An informal survey of the state statutes on insurable interest shows that they tend to track the common law rule by breaking down the definition of insurable interest into two parts: the first being a close relationship; the second being an economic interest in the insured’s continued life. The statutes then typically add a third part, which is really an expansion of the second (economic interest) for buy/sell agreements, partnership and operating agreements, and pensions.11 A small, but growing number of states are enacting statutes that address insurable interest in trusts.12

Chawla, A Simple Insurance Fraud Case That Went Too Far

Vera Chawla was a close friend of Harald Giesinger, who, by age 72, when he filled out the insurance application, was not in good health. He was suffering from a significant alcohol-abuse problem, as well as a slowly growing brain tumor that had required surgeries in both Austria and at George Washington University Hospital. On the insurance application, which was signed by both Giesinger and Chawla, he lied about these and other serious medical conditions. Transamerica denied coverage at first because it correctly concluded that Mrs. Chawla did not have an insurable interest in Giesinger. Chawla then resubmitted the application as trustee of the “Harold Giesinger Special Trust,” of which Harold Giesinger was the sole lifetime beneficiary, remainder to Chawla, and the policy was issued.

Giesinger died a year later from heart failure and Chawla filed a claim to collect the proceeds ($2.45 million). Transamerica refused to pay and rescinded the policy on the grounds that (i) there were material misrepresentations in the policy, and (ii) the trust did not have an insurable interest. Chawla sued to collect the death benefits. The district court held for Transamerica on both grounds, finding that either one alone would be a sufficient ground to rescind the policy.

The rationale for the second ground is what shocked us. The district court, construing the Maryland statute on insurable interests, determined that, in order to procure an insurance policy, the benefits must be payable to a person with an insurable interest at the time the policy was issued. Since the trust procured the insurance policy, the court held that the trust, not the beneficiary of the trust, must have an insurable interest in the life of the insured. The court then reviewed the Maryland statute on insurable interest and found in each case that the trust did not have an insurable interest:

Plaintiff fails to demonstrate the existence of an insurable interest as defined by statute. Maryland law creates various classes of insurable interests. For example, one has an insurable interest in those “related closely by blood or law, a substantial interest engendered by love and affection is an insurable interest.” Md. Code Ann., Ins. Section 12-201(b)(2)(i). An insurable interest may also exist where one has “a lawful and substantial economic interest in the continuation of the life, health, bodily safety of the individual.” Md. Code Ann., Ins. Section 12-201(b)(3)…13

In the instant case, the Trust had title to the decedent's residence. During his lifetime, the decedent possessed the right to receive all income from the Trust and the right to occupy the residence. However, 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 that decedent had lived. Further, the Trust suffered no detriment, pecuniary or otherwise, upon the death of the decedent. As such, the Trust maintained no insurable interest in the life of the decedent.14

On appeal, the Fourth Circuit affirmed the district court’s first holding, rescission of the policy on the ground of material misrepresentation. With respect to the second holding, the court stated:

Because the district court correctly awarded summary judgment to Transamerica on the misrepresentation issue, its alternative ruling appears to have unnecessarily addressed an important and novel question of Maryland law. And, as a general proposition, courts should avoid deciding more than is necessary to resolve a specific case. This important aspect of the doctrine of judicial restraint has particular application when a federal court is seemingly faced with a state-law issue of first impression.15

Unfortunately, the Fourth Circuit did not reverse the district court’s second holding; it merely vacated it, without determining whether the district court judge’s opinion was good law. Thus, there is now an argument that an insurer may deny a trustee’s claim for policy proceeds on the grounds that the trust did not have, and in most cases, cannot have an insurable interest.

The potential problem is compounded in states that impose a constructive trust on the proceeds in favor of the estate of the insured. First, the proceeds are included in the estate of the insured for estate-tax purposes under Internal Revenue Code Section 2042(1). Second, they may be taxed as ordinary income. Only payments in the nature of insurance proceeds qualify for the exclusion from gross income, and if there is no insurable interest, the payments are not “insurance.”

State Law to the Rescue

If the district court’s rational is correct, a simple solution is to have the insured procure the policy first and then assign it to the trust. Assuming the purchase and immediate assignment is not held to be a purchase by the trust through the insured as its agent; the trust will have no issue with insurable interest. The draw back, of course, is that the proceeds will be brought back into the estate of the insured, if the insured dies within three years of the transfer. 16 Unfortunately, that approach will not help with existing irrevocable life insurance trusts.

A better approach is to create the trust and procure the insurance policy in a state that has enacted a statute giving a trust an insurable interest. As indicated above, a number of states have such statutes and more are considering them. States which have not already done so should seriously consider enacting such statutes to clear up any uncertainty in the law.

Virginia, in its 2007 legislative session will be considering the following amendment to its insurable interest rules, Section 38.2-301, which is patterned after the law in the State of Washington:

5. In the case of a fiduciary, as defined in Section 64.1-196.1, other than the trustee of a domestic business trust or foreign business trust, as defined in Section 13.1-1201, the lawful and substantial economic interest required in subdivision 2 shall be deemed to exist in (i) the individual insured who established the fiduciary relationship or for whose benefit the fiduciary holds the insurance policy, and (ii) each individual in whom the individual insured who established the fiduciary relationship or for whose benefit the fiduciary holds the insurance policy has an insurable interest; This paragraph shall determine the lawful and substantial economic interest required in subdivision 2, with respect to life insurance policies, whether owned by a fiduciary before or after the date of enactment.

Conclusion

Thanks to the district court’s decision in Chawla, and the lack of direction from the Fourth Circuit, the life insurance industry has been presented with a rational for rescinding virtually all policies currently held in irrevocable life-insurance trusts. One can only imagine the trouble such an approach would create. All states should enact legislation, such as that under consideration in Virginia, to resolve the uncertainty created by the Chawla cases.

Mark Cohen is the founder of Cohen and Burnett, P.C. and Legacy Analytics, L.L.C. Mark received his Bachelor of Arts Degree in Political Science from California State University, Long Beach in 1980. He received his Juris Doctor from the University of Arizona in 1984. In 1989 he received his Master of Laws in Taxation from William and Mary. Mark also received his Certified Financial Planning License in 2000. From 1984 until 1988 Mark served as a Judge Advocate for the United States Navy. He then became a tax manager at Goodman & Company, and later became an associate for Adams, Porter & Radigan before opening his own firm in 1991. Mark is a past president of the Northern Virginia Estate Planning Council, and currently serves on the Legislative Committee for the Wills, Trusts, and Estates Section of the Virginia Bar Association. He is a member of the Virginia Bar Association, Arizona Bar Association, and the American Bar Association Mark is the Virginia Reporter to the UTC, and is a popular speaker at estate planning seminars.

1Chawla, ex rel Geisinger v. Transamerica Occidental Life Ins. Co., No. Civ. 03-1215, 2005 U.S. Dist. LEXIS 3473 (E.D. Va. 2005), aff’d in part, vac’d in part, 440 F.3d 639 (4th Cir., 2006).
2440 F.3d 639 (4th Cir., 2006).
3Chawla, Id. at 19-20.
42 J. Appleman, Insurance Law and Practice Section 761, at 101 (1966).
4Interstate Life & Accident Co. v. Cook, 19 Tenn. App. 290, 86 S.W.2d 887, 889 (1935), quoting 1 Couch, Cyc. of Insurance Law, Section 295, at 769-70.
5Interstate Life & Accident Co. v. Cook, 19 Tenn. App. 290, 86 S.W.2d 887, 889 (1935), quoting 1 Couch, Cyc. of Insurance Law, Section 295, at 769-70.
6Id. See also Rubenstein v. Mutual Life Ins. Co. of New York, 584 F. Supp. 272, 279 (E.D. La. 1984) ("because an insurable interest is required by law in order to protect the safety of the public by preventing anyone from acquiring a greater interest in another person's death than in his continued life, the parties cannot, even by solemn contract, create insurance without an insurable interest").
7Warnock v. Davis, 104 U.S. 775, 779, 26 L. Ed. 924, 926 (1882).
8Drane v. Jefferson Standard Life Ins. Co., 139 Tex. 101, 104, 161 S.W.2d 1057, 1058-59 (1942).
9Id. 161 S.W.2d at 1059.
10Cooper's Adm'r v. Lebus' Adm'rs, 262 Ky. 245, 250, 90 S.W.2d 33, 36 (1935) quoting Adams' Adm'r v. Reed, 38 S.W. 420, 422, 18 Ky. L. Rep. 858, (App.1896).
11See Leimberg Information Services, Inc. at http://www.leimbergservices.com for a recently updated, comprehensive collection of state insurable interest statutes.
12See, e.g., 18 Del. C. Section 2704 (Delaware); Rev. Code. Wash. (ARCW) Section 48.18.030 (Washington).
13Chawla, supra, 2005 U.S. Dist. LEXIS 3473, 17 (4th Cir. 2006).
14Id. at 18.
15440 F.3d 639, 648 (4th Cir., 2006).
16IRC Section 2035. To pay the tax in such a case, many policies now offer a rider to double the coverage if the insured dies within three years of the purchase of the policy.