Stranger-Owned Insurance Contracts: Can State Regulation Curb Abuse?

Insurance Law Alert

 

Stranger-Owned Life Insurance or Annuity Policies (“STOLI”) or” ( STOA”) are generally arrangements, at or prior to policy issuance, to initiate or facilitate the issuance of a life insurance policy or annuity contract for the intended purpose of transferring beneficial interest in the policy or contract to third parties who, at the time of policy/contract origination, had no insurable interest in the life of the insured under applicable state law. Given the nature of these contracts, state regulators, including the New Jersey Department of Banking and Insurance, have carefully regulated STOLI and STOA transactions as they can violate the essential social purpose of life insurance, which is protection, not advancement of investment objectives, or use of insurance as a vehicle for financial speculation on human life.

Applying New Jersey law and upholding a partial summary judgment award by the District Court, the United States Court of Appeals for the Third Circuit ruled that stranger-owned life insurance policies are void ab initio, though parties to the policy may, under certain circumstances, be entitled to a refund of premium payments. See Sun Life Assurance Company of Canada v. Wells Fargo Bank, NA, as Securities Intermediary.

In this case, Sun Life Assurance Company of Canada issued a $5 million life insurance policy on Nancy Bergman. The application materials named Ms. Bergman’s irrevocable trust as the sole owner and beneficiary of the policy. Bergman signed the application as grantor of the trust, and her grandson was named as trustee. The trust had four additional members, all of whom were investors and all of whom were so-called “strangers” to the policy and had no insurable interest in the life of Ms. Bergman.

The insurance application and related materials grossly overstated Ms. Bergman’s net worth and income, and the group of investors actually funded the policy. One month subsequent to policy issuance, Bergman’s grandson resigned as trustee, appointed the investors as successor co-trustees, and the terms of the trust were then amended to provide that the majority of the policy benefits would flow to the investors and further to allow the investors to sell the policy without Bergman’s or her grandson’s consent. The trust subsequently sold the policy to a life settlement company, and the majority of the sale proceeds were received by the investors. The policy was later sold to another company. Wells Fargo loaned funds to that new owner, and the loan proceeds were used to pay premiums on the policy. Wells Fargo ultimately obtained the policy as part of a settlement in the new owner’s bankruptcy proceeding and continued to make premium payments.

Upon Bergman’s death, Sun Life denied the death benefit claim of Wells Fargo, concluding that the policy had been fraudulently obtained. Sun Life filed suit seeking a declaration that the policy was void ab initio as part of a STOLI arrangement. Wells Fargo counterclaimed for breach of contract, and sought the full death benefit. The District Court granted partial summary judgment in favor of Sun Life applying New Jersey law and ruling that the policy was void ab initio as an illegal STOLI arrangement due to a lack of insurable interest. The District Court also partially granted summary judgment in favor of Wells Fargo, finding it was entitled to a partial premium refund as it was “innocent” to the illegal transaction. The parties cross-appealed, and the Circuit Court of Appeals certified two questions to the Supreme Court of New Jersey:

(i) Whether a life insurance policy procured with the intent to benefit persons without an insurable interest in the life of the insured violated the public policy of New Jersey, and if so, is that policy void ab initio.
(ii) If such a policy is void ab initio, is a later purchaser of the policy, not involved in the illegal conduct, entitled to any refund of premium.

Upholding the District Court ruling which considered equitable principals and fashioned a compromise award, the Circuit Court determined that the result comported with New Jersey law as announced by its Supreme Court, and answered both questions in the affirmative.

State regulation of STOLI transactions follows several different approaches. Approximately 11 states (including New Jersey, see N.J.S.A. 17B:30B-1) follow an approach based on the National Association of Insurance Commissioners (NAIC) Viatical Settlement Model Act, which prohibits life settlements for the first five years after policy issuance if the transaction exhibits certain indicators of a STOLI. This model permits the settlement of policies at any time due to death, divorce, financial trouble, or illness. Approximately 12 states have enacted legislation based on the model regulation advocated by the National Conference of Insurance Legislators (NCOIL). The NCOIL Life Settlement Model Regulation bans STOLI transactions, contains important life settlement reporting requirements to enable regulators to identify STOLI transactions, and prohibits inducing someone to purchase a policy for the sole purpose of entering into a life settlement. Finally, 7 states have enacted legislation designed to stop STOLIs but which does not follow either the NAIC or the NCOIL model. More than 30 states have enacted legislation to protect seniors in particular in the context of stranger-owned transactions.

While the New Jersey Department of Banking and Insurance does not unilaterally ban stranger-owned insurance contracts, the Department has taken the position, in particular with regard to stranger-owned annuities, that existing law affords carriers substantial mechanisms to monitor, deter and void such transactions where: (i) there is no lawful insurable interest; (ii) the contracts are not “suitable” (see N.J.S.A. 17B:25-34 et seq.); (iii) the transactions contravene New Jersey Department of Banking and Insurance Bulletins 2006-07 and 2010-14; (iv) the transaction constitutes unfair trade practice in violation of the Unfair Trade Practices Act at N.J.S.A. 17:29B-1 et seq. (which prohibits any person from engaging in unfair or deceptive acts or practices in the business of insurance); or (v) the transaction violates the New Jersey Insurance Fraud Prevention Act at N.J.S.A. 17:33A-1 et seq. (which allows for the imposition of both civil and criminal penalties in legal actions for insurance fraud violations commenced by the New Jersey Insurance Fraud Prosecutor’s Office established pursuant to N.J.S.A. 17:33A-16).

As set forth in its 2010 Bulletin No. 2010-14 (July 2, 2010) the Department believes that insurers currently have the ability to eliminate stranger-owned transactions without the need for any new legislation or regulations. The Department has recommended that companies strengthen their monitoring practices to more easily detect such stranger-owned transactions and aggressively report suspected transactions. In addition to stepping up existing monitoring practices, the Department also suggested in its 2010 Bulletin that companies consider the following:

  • Asking applicants and/or producers "targeted" questions, e.g., the purpose of the purchase, the relationship between agent/broker and contract holder, the health status of the insured or annuitant, the source of funds for premium payments, and whether an insurable interest exists between the owner of the insurance policy or annuity contract and the annuitant or insured;
  • Closely monitoring contract deposits and, when appropriate, follow up with calls to annuitants/insureds and contract owners;
  • Redesigning variable life and annuity contracts, e.g., no guaranteed minimum death benefit (GMDB) during the first two years, or bolstering the contestability clause; and
  • Reporting suspected stranger-owned transactions to the Department’s Office of Consumer Protection Services.

The Department’s 2010 recommendations are still viable and, if carefully implemented by carriers, can effectively combat illegal stranger-owned transactions in the interest of insurers, their policyholders and beneficiaries, as well as legitimate third party contract purchasers.

Questions should be directed to Cynthia Borrelli.