Much has been written lately about Stranger (Owned or Originated) Life Insurance, (“STOLI” or “SOLI”), a concept by which an investor seeks to profit from a life insurance policy on the life of another, with whom the investor has no personal relationship. Generically, a STOLI transaction involves an investor (or an agent for potential investors) identifying a person late in life, or with limited remaining life expectancy, who is able to successfully obtain a substantial life insurance policy and financially inducing that person to obtain the policy with the proceeds ultimately, or under certain defined circumstances payable to the investor. If the costs of procuring and maintaining the life insurance policy are less than the death benefit paid to the investor, the investor realizes a gain. In this sense, the investor profits from the death of another.
While many legitimate investments are based on the investor taking a position on and profiting from the outcome of a certain contingency, the law has traditionally tried to distinguish the concept of investment, or even gambling, from that of insurance, which is generally viewed as protection against loss.
There are a number of facets of insurance law which recognize this distinction between insurance for profit or wagering and insurance against loss, and all of them are directed at precluding the use of insurance to obtain financial gain in the face of negative societal outcomes. For example, both state laws and exclusions found in property insurance policies prohibit arson for profit.
Another example is found in the application of limitations (by policy provision and/or state law) regarding so called “replacement cost coverage,” under property insurance policies. It might be feasible to buy up a city block of properties in a distressed area, for far less than it would cost to replace the structures on such properties, and to obtain replacement cost property insurance for such properties. The owner of this city block would thus be in a better position after a massive fire than before, if his insurance company replaced the destroyed buildings with new construction. There are however rules and/or statutes designed to mitigate the profit potential in this scenario. While the insured in this example would ordinarily be paid and could even be advanced, the actual loss sustained (usually measured as replacement cost less depreciation) the difference, (e.g. total replacement cost) is only paid if the insured actually replaces the damaged structures. Under this scenario, unless the insured actually replaces, its insurance recovery is limited to the depreciated value of its investment. When the insured actually replaces, the replacement cost insurance is only reimbursing for an actual loss (the increased cost of replacement). While the insured still benefits from replacement cost in this instance, (it now owns a modern and thus more valuable city block notwithstanding its location in a distressed area), society also benefits as well because the block was in fact fully rebuilt, thereby improving the neighborhood and the city’s tax base. The insurance in this instance is neither an investment, nor a wager and is only a protection against loss.
The concept of “insurable interest” is another example of a legal doctrine designed to preclude the use of insurance as investment or wager. Insurable interest is the common law doctrine that limits recoveries to those who have a measurable pre-existing interest in the subject matter to be insured. The insurable interest doctrine would preclude an investor or speculator from Boston from obtaining a fire insurance policy on an abandoned home in Detroit and profiting from an infamous Devils Night fire. Because the Bostonian neither owns nor has any pre-policy relationship with the Detroit property, he has no insurable interest in it. Thus even if he could get an insurer to issue a policy on the Detroit property, in the event of a fire, the insurer will be able to successfully challenge the loss payment because the insured had no insurable interest in the property at the time the policy was written or at the time of the loss.
The requirement of an insurable interest is not meant to limit the use of insurance to certain kinds of interests in property. For example, under Massachusetts law, prior to policy procurement, “any person has an insurable interest in property, by the existence of which he receives a benefit, or by the destruction of which he will suffer a loss, whether he has or has not any title in, or lien upon, or possession of the property itself.” See Womble v. Dubuque Fire & Marine Ins. Co., 37 N.E.2d 263 (1941). Indeed, the Court in Womble noted the flexibility of and rationale behind the insurable interest concept: “The requirement of an insurable interest when the risk is assumed arose merely to prevent the use of insurance for illegitimate purposes. It should not be extended beyond the reasons for it by excessively technical construction.”
In the context of life insurance, illegitimate purposes include creating a financial incentive for the death of another. As the U.S. Supreme Court noted long ago in Grigsby v. Russell, 222 US 149, 155 (1911):
A contract of insurance upon a life in which the insured has no interest is a pure wager that gives the insured a sinister counter interest in having the life come to an end.
The definition of insurable interest in the life insurance context is a matter of state law, either by common law or by statute. New York’s statutory definition is typical:
The term, “insurable interest” means:
(A) in the case of persons closely related by blood or by law, a substantial interest engendered by love and affection;
(B) in the case of other persons, a lawful and substantial economic interest in the continued life, health or bodily safety of the person insured, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the insured.
NY Insurance Law § 3205 (a) (McKinney 2010)
So what happens when a SOLI or STOLI transaction meets the doctrine of insurable interest, head on? In one recent case, Kramer v. Phoenix Life Ins. Co., 2010 N.Y. Slip Op. 8376 (Nov. 17, 2010) New York’s highest court refused to invalidate several SOLI transactions, involving more than $56 million in life insurance on the life of a prominent New York attorney which was procured a few years before his death for the ultimate benefit of investors. A copy of the slip opinion appears here.
In responding to certified questions from the U.S. Second Circuit Court of Appeals the New York Court of Appeals found that New York law did not prohibit a person from obtaining life insurance on his own life for the sole purpose of transferring such insurance to investors. Notwithstanding a strongly worded dissent, the Court found such transactions to be compliant with existing New York statutory requirements which expressly permitted immediate transfers of interests in life insurance as long as it was initially procured by the insured, who by definition has an insurable interest in his own life:
[W]e recognize the importance of the insurable interest doctrine in differentiating between insurance policies and mere wagers …, and that there is some tension between the law’s distaste for wager policies and its sanctioning an insured’s procurement of a policy on his or her own life for the purpose of selling it. It is not our role, however, to engraft an intent or good faith requirement onto a statute that so manifestly permits an insured to immediately and freely assign such a policy.
While the STOLI or SOLI industry may find substantial comfort from the decision in Kramer, it may be too early to pop the champagne in New York or elsewhere, and the flexible concept of “insurable interest” may yet put such contracts in jeopardy. First, as noted by the Court in Kramer, the New York legislature had, by the time the decision was issued, acted to broadly define and prohibit “stranger-originated life insurance” and to preclude insured initiated life settlement contracts (sales of insured procured policy proceeds) until two years after policy issuance in most cases. See NY Insurance Law §7813, §7815 ( effective May 18, 2010). Similar statutes are in place or under consideration in other states, and other state courts may not be as lenient in interpreting the insurable interest doctrine. As the dissent noted:
There are good reasons why the common law, as reflected in both Warnock and Grigsby, invalidated stranger-originated life insurance. Even if we ignore the possibility that the owner of the policy will be tempted to murder the insured, this kind of “insurance” has nothing to be said for it. It exists only to enable a bettor with superior knowledge of the insured’s health to pick an insurance company’s pocket.
Courts in the US have a very long track record against allowing insurance to be used as an investment or a wager, and when insurable interest meets stranger owned or originated life insurance, it may not be a matter of “hail-fellow-well-met.”