Over the past several years, promoters of various schemes concerning the application for and issuance of life insurance policies and the subsequent sale of those policies to third parties have led most charities to look upon any planned giving technique involving life insurance with a very suspicious eye. This skepticism is certainly valid, if not prudent. However, the use of life insurance in a planned giving scenario is not inherently bad; it is the perversion of the tool by those exercising poor judgment, motivated by unbridled greed, that has led to the current environment regarding the use of life insurance. The purpose of this article is to discuss the use of life insurance as a way for charities to increase their giving and to provide a checklist for charities to use in evaluating whether or not a plan utilizing life insurance is something the charity will want to consider.
Step 1. Is there an insurable interest?
In evaluating the issue of whether there is an insurable interest on the life of the insured, there are three fundamental questions that have to be answered. If the answer to any one of these questions is someone or an entity that does not have an insurable interest in the insured, then flags should go up and the charity should walk away.
- Who initiates the issuance of a policy?
- Who is the owner of the policy?
- Who is the beneficiary of the policy?
In the context of life insurance, Section 10110.1(a) of the California Insurance Code generally defines an insurable interest as "an interest based upon a reasonable expectation of pecuniary advantage through the continued life, health, or bodily safety of another person and consequent loss by reason of that person's death or disability or a substantial interest engendered by love and affection in the case of individuals closely related by blood or law." Moreover, the law provides that an insurable interest must exist at the time the policy is effective.1 In this step, the answer can only be either the insured or a third party. There is no question that an individual has an insurable interest in his own life and can name whoever he wishes as a beneficiary of a life insurance policy on his own life.2 However, a policy obtained by a third party on the life of another is void unless the third party "applying for the insurance has an insurable interest in the individual insured at the time of the application."3 In order to buy life insurance on the life of another, there must be an insurable interest in the continued life of the insured.4 To allow otherwise would be to sanction wagering on human life.
It has long been established that Qualified Charities5 have an inherent insurable interest in the continued lives of their donors and "may effectuate life ... insurance on an insured who consents to the issuance of that insurance." 6
Can an irrevocable life insurance trust (an "ILIT") have an insurable interest in the insured? Practitioners have for years utilized ILITs as the preferred vehicle through which to obtain and own life insurance, largely for tax reasons.7 It wasn't until the Chawla case8 that the issue of whether an ILIT could own a policy at all was raised. Interpreting Maryland law, the Court in Chawla found that because the ILIT had "an interest that arises only by, or would be enhanced in value by, the death ... of the individual" the ILIT did not have an insurable interest in the insured and therefore the policy was void. On appeal9 the Fourth Circuit affirmed the lower Courts ruling on other grounds, but found that the District Court's ruling as to whether an ILIT has an insurable interest in the individual insured "unnecessarily addressed an important and novel question of Maryland law" and vacated that portion of the District Court's ruling. It is, as they say, hard to unring the bell. The issue of an ILIT's insurable interest in an insured is "on the table" and must be addressed. Many states have either changed their statutes, or have adopted a "look through" principle whereby in order to determine whether an ILIT has an insurable interest, you would need to look through the ILIT to the trustee or beneficiary of the trust.
Step 2. Is the policy going to be financed?
In order to manage the costs of a life insurance policy, it may be necessary to procure financing to cover the policy premiums. So long as funds are borrowed to meet a demonstrated financial or business need, premium financing is considered a legitimate way to finance life insurance policies.10 In fact, almost all insurers will accept applications that include the legitimate need for premium financing arrangements.11 There is nothing wrong with financing the acquisition of any asset, including life insurance. Whether the economics of the financing vehicle justify its use with respect to a particular policy in a specific set of facts is outside the scope of this article; but, on its face the concept of premium financing is just fine. However, there is no such thing as a free lunch and there's no such thing as legitimate free insurance. A red flag should be raised when the life insurance is advertised or promoted as free insurance. If the insured does not have at least some level of financial risk and/or detriment, then the chances are that there could be an issue. Nonrecourse financing should be avoided. Other financing arrangements should be analyzed on a case-by-case basis to verify that the financing tool make sense under the circumstances. In evaluating whether a donor has incurred any financial cost or detriment by causing an ILIT to purchase insurance on his life through any financing arrangement, it is important to understand that in addition to contributions of cash to the ILIT or guarantees given to the lender, the insured will incur a real cost and financial risk when he names a charity as beneficiary since the insured is ceding all or part of his excess capacity to purchase additional life insurance. Remember, financial risk is only one aspect of skin in the game. Even though required for family or business reasons, future purchases of life insurance may be prohibited or sharply curtailed. It is imperative that the would-be insured is made fully aware of his true financial risk/cost when entering into a program.
The skin-in-the-game theory is not mandated by any state or federal law. It is a theory created by the insurers and lenders to differentiate proper funding techniques from STOLI, IOLI and/or CHOLI. Is there really a need for additional skin in the game if the charity is the only beneficiary of the ILIT, the donor receives no cash and no tax deduction is taken? If, on the other hand, the beneficiary is a family member or business associate, then, perhaps, the insured, no longer a donor, should have additional skin in the game.
Step 3. Is there a plan to sell the policy from the outset?
There may come a time when a policy owner no longer needs or wants an existing life insurance policy; in this context the owner has every right to sell the policy to a third party for its fair market value. In Grigsby v. Russell, the Supreme Court noted that life insurance possessed all the ordinary characteristics of property, and therefore represented a transferable asset.12 The decision established a life insurance policy as property that contains specific legal rights, including the right to: name the beneficiary, change the beneficiary designation, assign the policy as collateral for a loan, borrow against the policy, and sell the policy.13
Under the California Insurance Code, insurable interest is only required at the time the contract becomes effective, and is not required at the time the loss occurs.14 Consequently, in California, the owner of a life insurance policy can sell the policy to a third party on whatever economic terms can be negotiated, transfer the policy to such third party, and when the insured dies, the third party will collect the death benefit. Again, there is nothing wrong with this concept.
The problem arises when there is a prearranged plan to sell the policy to a third party. This is where greed and stupidity often intersect. There are countless articles, blogs, commentaries, news stories and the like concerning what has become known as Stranger Owned Life Insurance (commonly known as "STOLI"). As discussed above, there is nothing wrong with financing life insurance. Similarly there is nothing wrong with selling a life insurance policy. The problem arises when investors (who are otherwise strangers to the insured) initiate a plan whereby a policy will be taken out on the life of the insured that calls for financing the premium and selling the policy to a third party investor group for a profit. In fact, in this scenario, the problem begins at the beginning of this article with insurable interest and continues through the premium finance methods used to finance the policy and ultimately ends with the sale of the policy to a third party investor for a profit. This is not the legitimate use of life insurance, but pure and simple wagering on the life of the insured.
The purpose of this article is not to discuss at any length the history or impropriety of STOLI, or its cousin Investor Owned Life Insurance ("IOLI"). Suffice is to say that there is nothing new under the sun, and so it is with the basic tenants of STOLI and IOLI. Investors have been trying for over 125 years to find ways of profiting from life insurance on others by doing indirectly what the law would not allow them to do directly. Indeed, while affirming that life insurance is property that can be sold, the Court, in Grigsby v. Russell, drew an important distinction between a policy backed by a legitimate insurable interest and one originally backed by an insurable interest, but clearly purchased with the intent to sell to a third party investor without an insurable interest.15 When an arrangement is specifically designed to circumvent wellestablished insurable interest laws, it will likely be void. In fact, many states have adopted or are considering legislation—such as SB 1543 pending in California—that is designed to restrict the sale of policies and otherwise govern the life settlement industry. In an effort to protect legitimate life settlement transactions and prohibit the use of STOLI type transactions, Organizations such as The National Association of Insurance Commissioners ("NAIC") and The National Conference of Insurance Legislators ("NCOIL") have also weighed in on the issue.16 The best practice is, where there is even the hint of a plan to sell the policy at some point in the future, the best course is to stay away.
The Combination: CHOLI
Life insurance policies that are purchased by charities on the lives of key donors with the intent to buy and hold the policies can be very useful tools if implemented properly. There are an infinite number of schemes that have been proposed to charities that include independently legitimate techniques, which when combined, create a recipe for disaster. It is when charities attempt to "rent-out" their insurable interest for the private gain of others that charities should beware. These complex arrangements are closely related to the STOLI and IOLI schemes, and are often referred to as Charitable-Owned Life Insurance ("CHOLI"), and the like. Though each scheme includes variations, most include the same core techniques. Historically, one of the defining elements of a CHOLI scheme is the planned sale of a policy. Ordinarily, investors initiate the arrangement by encouraging charities to purchase life insurance policies on their senior donors, the premiums are then borrowed from a financial institution, and shortly after procuring the policy, the policy is sold to a life settlement investor group. The life settlement company ordinarily does not have an interest in the life of the insured, but in fact an interest in his early death. It is not the transfer of the policy, but rather the original purchase of a policy with the intent to transfer to an investment group, that goes against the very purpose of established insurable interest laws. Most states insurable interest laws would not allow these investor groups to purchase such policies directly, thus they "borrow" the insurable interest of the charity to acquire the policy as an investment. These life settlement groups are essentially gambling on the life of the insured.
Regulation Anyone?
Over the past couple of years, almost half the States have initiated some type of regulatory activity aimed at addressing STOLI issues and others have issued regulatory guidance on the issue. The Federal response was contained in the Pension Protection Act of 2006 ("PPA 2006").17 Originally, PPA 2006 proposed a 100% excise tax on CHOLI, which would have effectively ended the use of the technique. However, the final version was changed to a reporting requirement, which required charities involved in insurance plans from August 17, 2006 to August 17, 2008, to report detailed specifications of the arrangement to the IRS. IRS Forms 8921 and 8922 require charities to report and disclose the specifics of each life insurance transaction, including information about the charity, the other participants in the transaction, and a detailed description of the financial arrangement. The information provided by IRS forms 8921 and 8922 will be used as part of a two-year study of CHOLI that will be released in 2009. The study will evaluate whether the activities of participating charities are consistent with their tax-exempt status.
Even though PPA 2006 required charities to report any transaction in which a charity and any other person had an interest in a life insurance policy, it important to note that if the interest of a charity was merely as a beneficiary of a trust, it does not appear that there was a reporting requirement. It makes sense. PPA was intended to capture those charities that may have been involved in CHOLI transactions. There is a distinct difference between a charity actively participating in the transaction, owning the policy, and possibly using its taxexempt status to benefit others, a charity that is simply the beneficiary of a trust, with no rights, powers or duties with respect to the trust or its activities. Moreover, IRS Notice 2007-24 specifically provides that "under Section 6050V(d)(2)(B)(ii), an insurance contract is not an applicable insurance contract if the applicable exempt organization's sole interest in the contract is as a named beneficiary." In other words, if a charity is just a beneficiary and never had and does not have any other interest in a life insurance policy, PPA 2006 would not apply to that charity. Surely, being the beneficiary of an ILIT would be more remote.
Although the sun has set on the federal legislation, it has definitely not set on the issue; it will be interesting to see what the Service does with its findings when announced in February of 2009.
Risk to the Charity
Involvement by a charity in an IOLI/CHOLI type scheme may put the charity in danger of a variety of risks, including, but not limited to a number of tax risks. In addition, it is a fundamental tenet of any charitable organization that its taxexempt status is "not to be used to enrich or benefit an individual (or entity) other than those for whom (or which) the charitable status was granted and intended." 18 Therefore, involvement in CHOLI scheme that benefits investors may risk a charity's tax-exempt status.
In addition, Involvement in CHOLI schemes could put a charity at risk of being entangled in litigation. CHOLI schemes are complex financial transactions and the resulting tax and legal issues can be significant. If an insurance carrier were to refuse to pay on a policy citing a lack of insurable interest, for example, the investors may well involve the charity in legal action. Securities and licensing issues could be raised in the event of litigation. This result could have not only detrimental financial consequences, but the stain to the charity's reputation for having participated would be far greater.
For several reasons, including the foregoing, a prudent charity will not involve itself in a CHOLI scheme. However, it is important to remember that not all transactions proposed to a charity are CHOLI transactions.
Step 4. But Wait, Don't Panic.
At the outset, I indicated that the purpose of this article was to discuss the use of life insurance as a way for charities to increase their giving, and to provide a checklist for charities to use in evaluating whether or not a plan utilizing life insurance is something the charity will want to consider. Here's the Checklist:
1. Is there total transparency? Total transparency requires complete knowledge of the transaction not only by the charity, but equally as important, by the donor, the insurance company and the lender, as well as the ability to verify all aspects of the transaction. If there is total transparency, then move on to number 2.
2. Is the charity's donor list being hijacked? Is a promoter or investor asking for access to the charity's donor list, or in any way attempting to position itself as the contact point for the donor? If so, walk away; if not move on to number 3.
3. Is the insured actively involved in the process? If the would-be insured barely even knows what's going on, stop. If a charity's donors want to use life insurance as a way to enhance their ability to give to the charity and are actively involved in the process, then move on to number 4.
4. If an ILIT is to be used, will it have an insurable interest? Generally, if the insured is a donor of the charity, and the charity is a beneficiary of the ILIT, it seems there will be an insurable interest. Move on to Number 5.
5. Is the Trustee of the ILIT a true independent trustee? If the trustee of the ILIT is an independent trustee or designated by the donor, then proceed to Number 6.
6. Is a finance arrangement used to pay the policy premiums? Financing the premiums constitutes a legitimate way to pay for the policy if it fulfills a demonstrated financial or business need. Move on to Number 7.
7. Is additional skin in the game required? If the donor is actually contributing money or is otherwise at risk to some financial degree such that the insurance is not without cost, then move on to Number 8.
8. Is there any evidence of a plan for the ILIT to sell the policy? If there is a plan to sell the policy at some point in the future, then the charity should never be involved. If on the other hand, if there is no plan to sell the policy, and certainly if the trust document precludes the sale of the policy to a third party, then proceed to Number 9.
9. Is the lender entitled to the death benefit? If the finance arrangement entitles the lender to a portion of the death benefit above and beyond the repayment of the principal, interest on the loan, and justifiable costs associated with making the financing available for the long-term, then a charity should not be involved. If however, the arrangement is traditional financing model, where the lender is paid only to recoup its costs and the remainder of the death benefit is paid to the charity, continue to Number 10.
10. Is there a plan to transfer the ownership of the policy to the lender in exchange for forgiveness of the loan? Similar to selling the policy, if there is a plan to transfer the policy to the lender in order to satisfy the loan, the charity should not be involved. Conversely, if the loan will be repaid by the death benefit, proceed to Number 11.
11. Does the Charity ever have any interest in the policy? If the charity
- has no interest in the policy; and
- the charity is only a beneficiary of a trust established by the donor; and
- there is no renting of the charity's exempt status; and
- no deduction is available to the donor, then proceed with the transaction.
In closing, the following examples may provide some guidance:
Example 1. If a donor applies for a life insurance policy and names a charity as the beneficiary of that policy, there is certainly an insurable interest. Then, if the donor finances the premium on such policy (having some financial risk concerning the loan) and does not have an intent to sell the policy at the time the policy becomes effective, the transaction should be fine and when the donor dies, the charity will receive, very appropriately, all of the death benefit after the lender is paid.
Example 2. If a donor forms a revocable trust, naming himself as trustee and a charity as the beneficiary of the trust, and then causes the trust to apply for and obtain an insurance policy on the life of the donor, it is difficult to see how there could not be insurable interest. Then, if the trust finances the premium on such policy (having some financial risk concerning the loan) and does not have an intent to sell the policy at the time the policy becomes effective, the transaction should be fine. When the donor dies, the trust will collect the death benefit, and after paying the lender, will distribute the net proceeds to the charity, as the beneficiary of the trust.
Example 3. If a donor forms an irrevocable trust, naming an independent third party as the trustee and a charity as the beneficiary of the trust, and then consents to the trust applying for and obtaining an insurance policy on the life of the donor, it is difficult to see how there could not be insurable interest. Then, if the trust finances the premium on such policy (having some financial risk concerning the loan) and does not have an intent to sell the policy at the time the policy becomes effective, the transaction should be fine, when the donor dies, the trust will collect the death benefit, and after paying the lender will distribute the net proceeds to the charity, as the beneficiary of the trust. Charities can indeed still benefit from life insurance policies.
Footnotes
1 California Insurance Code Section 10110.1(d)
2 Section 10110.1(b); Paul Revere Life Ins. Co. v. Fima, 105 F3d 490 (9th Cir. 1997).
3 Section 10110.1(e)
4 Cal. Ins. Code § 280.
5 A charitable organization that meets the requirements of Section 214 or 23701d of the California Revenue and Taxation Code. IRC Section 501(c)(3)
6 Cal. Ins. Code § 10110.1(f).
7 The ILIT applied for and owned a policy from inception, the three-year rule (IRC Section 2035) would not apply and since the ILIT held the policy and assuming the insured had no incidents of ownership, the reach of IRC Section 2042 could be avoided.
8 Chawla v. Transamerica Occidental Life Insurance Company 2005 WL 405405 (E.D. Va. 2005).
9 Chawla v. Transamerica Occidental Life Insurance Co., 440F.3d. 639 (4th Cir.2006)
10 Stephan Leimberg, Investor Initiated Life Insurance: A Sober Look is Needed! (2007), http://www.acli.com/NR/rdonlyres/3CB50E64-DA1D-4B10-BC9DBA81B22A7ED6/ 10012/LeimbergStephanOutline2.pdf.
11 Id.
12 Grigsby v. Russell, 222 U.S. 149, 156 (1911).
13 Chris Orestis, Protecting the Golden Goose, Insurance News Net Magazine, April, 2008, at 27.
14 Cal. Ins. Code § 10110.1(d).
15 Id.
16 In an effort to deter STOLI transactions, NAIC's Viatical Settlements Model Act ("NAIC Act") prohibits settlement of life insurance policies for five years from the date the policy is issued when the policy is purchased for the purpose of selling into the secondary market. Similarly, NCOIL's Life Settlement Model Act ("NCOIL Act") proscribes regulation to deter the use of STOLI transactions. Though the NCOIL Act does not have a five-year prohibition, it provides a definition of STOLI and characterizes a violation of STOLI as a fraudulent settlement act.
17 Pension Protection Act of 2006, Pub. L. No. 109-280, § 1211, 120 Stat. 780.
18 Stephan Leimberg, Dying for Charity: A New Breed of Golden Goose that Lays Rotten Eggs? (2004), http://cpsinsurance.com/prodspread/leimberg/Sept04%20Leimberg.pdf.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
