A CLOSER LOOK AT A.R.S. 20-1104
Insurable Interest
Rules
for Charities—What’s it all about?
New techniques
resurrect problems from the past
BY MATT DONOVAN
"Charity
Oversight and Reform: Keeping Bad Things from Happening to Good Charities" was the topic at a Senate Finance
Committee hearing on June 22nd. Topics included involvement of charities in tax
shelters, valuation of tangible and intangible property, and governance and
best practices.1 The message was clear:
charities had better behave.
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ARTICLE REPRINT RELATED ARTICLES May 20, 2004 May 2004 |
One area of concern for
federal lawmakers is efforts to loosen the state insurable interest laws for
charities. These rules are important because they determine when a charity can
purchase life insurance on an individual.
In a letter dated May 26,
2004, to Frank Keating, President of the American Council of
Life Insurers, a prominent trade association, Sen. Gordon H. Smith (R-OR)
and Senator Kent Conrad (D-ND), both members of the Senate Finance Committee,
outlined their concerns: promoters of complex insurance transactions seeking
modification to state insurable interest laws to allow unrelated financial
investors, indirectly through charitable organizations, to buy life insurance
on large numbers of the charity’s donors.2
Their concern is that
this runs counter to the long standing public policy of limiting those who can
rightfully buy an insurance policy on the lives of a specific person. Further,
these transactions, to which the charity’s involvement is key, likely create
attractive opportunities for third party investors but leave little, if
anything, for the charity.3
Insurable
Interest Laws – A Quick History
“Insurable
interest”—even among professional advisors—is not exactly a household phrase.
However, the public policy underlying the insurable interest rules gets right
to the heart of why life insurance is not considered just another financial
instrument, and why it is given special treatment under the tax code. So what’s
the big deal if the insurable interest rules are relaxed for charities? The
answer warrants a quick history lesson.
In the 1700s, life
insurance in
[N]o insurance shall
be made by any person or persons … wherein the person or persons for whose use,
benefit, or on whose account such policy or policies shall be made, shall have
no interest, or by way of gaming or wagering; and that every assurance contrary
to the true intent and meaning hereof shall be null and void to all intents and
purposes whatsoever.7
In the
It is not easy to
define with precision what will in all cases constitute an insurable interest,
so as to take the contract out of the class of wager policies. It may be stated
generally, however, to be such an interest, arising from the relation of the
party obtaining the insurance, either as creditor of or surety for the assured,
or from ties of blood or marriage to him, as will justify a reasonable
expectation of the advantage or benefit of the continuance of his life. It is
not necessary that the expectation of advantage or benefit always be capable of
pecuniary estimation.… [I]n all cases, there must be a reasonable ground,
founded upon the relations of the parties to each other … to expect some
benefit or advantage from the continuance of the life of the insured.
Otherwise, the contract is a mere wager, by which the party taking the policy
is directly interested in the early death of the assured. Such policies have a
tendency to create a desire for the event. They are, therefore,
… against public policy.8
A.R.S. 20-1104.
Insurable interest with respect to personal insurance; definition
A. Any individual of competent legal
capacity may procure or affect an insurance contract upon his own life or body
for the benefit of any person. But no person shall procure or cause to be
procured any insurance contract upon the life or body of another individual
unless the benefits under such contract are payable to the individual insured
or his personal representatives, or to a person having, at the time when the
contract was made, an insurable interest in the individual insured.
B. If
the beneficiary, assignee or other payee under any contract made in violation
of this section received from the insuree any
benefits thereunder accruing upon the death…of the
individual insured, the individual insured…may maintain an action to recover
such benefits from the person so receiving them.
C. “Insurable interest”…includes
only interests as follows:
1. In the case of individuals related
closely by blood or by law, a substantial interest engendered by love and
affection.
2. In the case of other persons, a
lawful and substantial economic interest in having the life, health or bodily
safety of the individual insured continue, as distinguished from an interest
which would arise only by, or would be enhanced in value by, the death…of the
individual insured.
3. An individual party to a contract
or option for the purchase or sale of an interest in a business…has an
insurable interest in the life of each individual party to the contract....
4. A charitable organization…has an
insurable interest in the life of each proposed insured that joins with the
charitable organization in applying for a life insurance policy naming the
charitable organization as owner and irrevocable beneficiary.
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...LILACS clearly conflict with the longstanding public policy that
policy owners should be more interested in the continuation of the insured’s
life than his or her death. |
One way to understand the
benefit that charities already enjoy in
The General Rule, on the
other hand, isn’t as easy. The proposed policy owner must have a lawful and
substantial economic interest in the continuation of the insured’s life as
distinguished from an economic interest that is created or enhanced by the
death of the insured. This is a much more subjective test. Furthermore, the
risk of failing this test is that the policy owner may lose the economic benefits
under the policy (See
subsection B, above).
The Charity Rule allows
charities to operate with certainty. Thus, they know they have an insurable
interest at the time the policy is purchased. However, when applying the
General Rule, charities might legitimately wonder if they pass.
Does a charity have a
substantial economic interest in the continuation of life of its donors? All of them or just the “regulars?” What if the proposed
insured hasn’t made a gift in quite some time? While the likely answer is yes
to these questions, it may not be as clear to the charities they would like.
Therefore, it is worthwhile to note that special rules already exist for
charities.
LILACS—The Scandal De Jour
The current
insurable interest debate is largely focused on complex financial instruments
known as Life Insurance and Life Annuity-based Certificates (LILACS). Lilacs
generally involve the following structure:
The promise to the
charity is a significant payout without any up front cost or capital risk. The
concern, however, is that the charity will end up with little or no benefit
while the bond holders reap the benefits.10 Furthermore, secondary
markets have already developed for the bonds.11 Thus, the charity’s
donors will most certainly have no connection—past or future—to the investors
who will benefit from their deaths.
At present, LILACS and
similar structures are only allowed in a handful of states, such as Texas,
Virginia, Nebraska, and Tennessee.12 Private interest groups have
been lobbying in other states to expand their marketing for these products, but
with mixed results.13 Interestingly, the major life insurance trade
associations have come out in opposition to these techniques.14
The associations fear
that further relaxation of insurable interest rules for charities to allow
LILACS will run contrary to sound public policy by permitting the
purchase—albeit indirect—of life insurance on strangers. It is feared that this
type of legislation could undermine the integrity of life insurance and the
legitimate benefits it provides.15
What’s wrong with
this picture?
While maybe not
to the extreme of wager policies, LILACS clearly conflict with the longstanding
public policy that policy owners should be more interested in the continuation
of the insured’s life than his or her death.
LILAC promoters are going
to great lengths to sanction through charities something they can’t do
directly—raise vast pools of money to buy hundreds of life insurance policies
whose benefits are then used to repay investors. Furthermore, as one
commentator puts it, “In these transactions, the only fixed number is the
commission.”16 If lucky, the charities get the leftovers.
To add tremendous insult
to injury, charities that do participate in LILACS or similar structures could
find themselves in a world of hurt for other reasons as well. These
transactions may create unpleasant and sometimes life threatening side effects
with respect to unrelated business taxable income, debt-financed income,
securities laws, and the private benefit rules.17
Where do we go
from here?
If your charity
or its donors solicits you for a LILAC, run for the hills. Used properly, life
insurance is a viable planning tool for charities, whereby the charity can
receive 100% of the benefit. Besides, in all likelihood, the federal government
and the insurance trade associations will eventually succeed in shutting down
these potentially abusive transactions. In the meantime, if you are looking for
guidance on insurable interest rules, look no further than the past.
FOOTNOTES
1 See “Grassley
Plans Hearing on Charitable Giving Problems, Best Practices,” United States
Senate Finance Committee Press Release June 1, 2004; “Grassley Works to Protect
Charities from Misuse, Exploitation,” United States Senate Finance Committee
Press Release June 22, 2004.
2 The letter was
distributed as an attachment to the Association for Advanced Life Underwriting
(AALU) Washington Report Bulletin No. 04-78.
3 See the article by Mike
Nelson, Insurable
Interest Under Siege, May 12,
2004.
4 Janice E. Greider and William T. Beadles, Law and the Life Insurance Contract, Fourth Edition,
Richard D. Irwin, Inc., Homewood, IL, 1979, p. 134.
5 Ibid.
6 Ibid.
7 Ibid.,
citing 14 Geo. III, Chap. 48.
8 Ibid.,
p. 135.
9 See Stephanie Strom,
“Charities Look to Benefit from a New Twist on Life Insurance,”
10 See Stephanie Strom, “Charities
Look to Benefit from a New Twist on Life Insurance”; Nelson, Insurable
Interest Under Siege: See also Wendy Davis, “Death-Pool
Donations,” Trusts & Estates, May 2004, p. 55.
11 See Stephanie Strom, “Charities
Look to Benefit from a New Twist on Life Insurance.”
12 See AALU Bulletin No.
04-78.
13 See Stephanie Strom, “Charities
Look to Benefit from a New Twist on Life Insurance”;
State of New York Insurance Department Opinion letter dated July 7, 2003 .
14 AALU Bulletin No.
04-78.
15
Ibid.
16
Donald Jay Korn, “Giving
Your All,” Financial Planning, November 2003, p. 70.