Like to Wager? Don’t Use a Stranger’s Life Insurance Policy!

A life insurance policy is void as a “wager on a stranger’s life” when sold on the secondary market in order to hide from the insurer that there is no insurable interest. A federal court of appeals held that a sequence of transactions amongst several companies to purchase a $5 million “stranger-originated” life insurance policy provided the companies with an interest in the insured’s life ending, voiding the policy. ABA Litigation Section leaders suggest this case is a reminder to practitioners that legal decisions should be balanced with sound public policy.

Unlawful Scheme to Bet on Stranger’s Life

The conflict in Sun Life Assurance Company of Canada v. Wells Fargo Bank began when a 78-year-old man’s insurance broker told him about a program that would allow him to participate in the secondary market for life insurance policies. The program would provide the insured with free life insurance for several years before the policy would be assigned to the strangers who would secretly fund the policy at no expense to the insured. The 78-year-old participated in the program and applied for a $5 million life insurance policy for himself on May 31, 2006. The insured’s purchase was the visible part of a complex web of transactions.

The insured’s application indicated that his family trust would be the primary beneficiary of the policy and that he would be the owner. Because of his age and health, the annual premium for the policy was almost $300,000 and exceeded his adjusted gross income almost every year the policy was in effect.

On the eligibility sheet for the policy, the insured stated that the premiums would be paid by check and not financed. In reality, the secondary market program lent the insured the money for the $300,000 annual insurance premiums through a loan from a bank. The insured made the initial payment for the policy and was reimbursed because he used the $5 million life insurance policy to the bank as collateral for the loan. The insurance company would not have issued the policy if it had known about this loan arrangement.

The loan had a 30-month term. The secondary market program sent notices to the insured explaining that the loan was coming due in April 2009 and that the insured had two options to satisfy the $569,572 debt: (1) the insured could repay the amount himself or (2) relinquish his interest in the insurance policy to the bank. The insured chose the latter option. Subsequently, the bank’s interest in the policy was sold to different interest-holding entities. Wells Fargo was eventually named the record owner of the policy and continued to make the premium payments on the policy on behalf of the interest-holding entities.

The insured died in 2017. Wells Fargo submitted a claim with the insurance company to collect the $5 million benefit under the policy. The insurance company filed suit against Wells Fargo, arguing that the policy was void ab initio because the policy was an illegal contract and was signed for the benefit of strangers in violation of Illinois law. The bank filed several counterclaims and sought either the $5 million policy benefits or repayment of its premium payments of more than $1.8 million.

Court Emphasizes Unlawful Transaction’s Substance over Form

The parties filed cross-motions for summary judgment and the U.S. District Court for the Northern District of Illinois granted the insurance company’s motion. The district court concluded that the intricate web of transactions was designed to appear as an insurable interest to hide that it was a “complicated wager on a stranger’s life.” The court also held that the bank was not entitled to any of its payments paid on behalf of the various interest holders in the original scheme. The court did grant summary judgment in favor of the bank for reimbursement of the $13,000 in premium payments it made on behalf of the last beneficial owner of the policy, a hedge fund, on the theory that the hedge fund was an innocent buyer. The bank appealed the portions of the district court’s decision adverse to it, and the insurance company appealed the reimbursement of the $13,000 in premium payments to the bank.

The U.S. Court of Appeals for the Seventh Circuit upheld the district court’s decision that the policy was void as an unlawful wager on a stranger’s life. The appellate court stated that “Illinois law prohibits the initial sale of a life insurance policy to someone who has no insurable interest in the life of the insured.” An insurable interest exists when the policyholder has an interest in the life of the insured continuing, such as when a person takes out a policy on his or her own life or the life of a close family member. A pure wager exists when a policy is initially purchased or controlled by a party that has no insurable interest. The court explained that such a policy “gives the policyholder a sinister counter interest in having the life of the insured come to an end.”

The court explained that Illinois courts look at the substance of these types of transactions to determine if the policy was initially purchased in good faith. Here, the appellate court concluded that although the policy appeared to satisfy the insurable interest requirement, the policy was nevertheless an unlawful wager for several reasons: (1) The insured took out the policy as part of a broader scheme for the secondary market company; (2) the insured did not need nor could he afford the policy himself; (3) the financing for the policy was concealed from the life insurance company; and (4) there was no serious risk the insured would retain the policy.

As to the $13,000 refund to the bank for payments made on behalf of the hedge fund, the court reversed the lower court’s decision, concluding that the bank had not offered any evidence or argument to establish its right to the refund. The court also explained that the hedge fund was not an innocent party in the scheme and conducted an in-depth review of the policy before purchasing it.

Practitioners Should Be Mindful of Policy Considerations

Litigation Section leaders observe that this case continues to clarify the tension between recognizing that life insurance policies are contracts that can be assigned and not enforcing insurance policies for uninsurable interests. “This decision reaffirms the public health policy not to have a market in the lives of people. We do not allow unlimited freedom of contract,” explains Stephen L. Brodsky, New York, NY, Web and Practice Point Editor for the Section’s Commercial & Business Litigation Committee. “As examples, for good reasons, contracts to sell body parts or to put a ‘hit’ on another are not enforceable contracts. The same rationale applies here,” illustrates Brodsky.

This decision could impact the structure of secondary market arrangements to purchase life insurance policies. “The decision is not going to dramatically change the course of the life settlement market, but it could lead to a course correction for companies pushing the boundaries of a sufficient insurable interest in the life of the insured,” reasons John C. Bonnie, Atlanta, GA, cochair for the Section’s Insurance Coverage Litigation Committee.

Section leaders advise practitioners to be mindful of the serious risk of stranger-originated policy arrangements. “In jurisdictions with similar policies against stranger-originated life insurance, there seems to be a serious risk that the transaction could be determined to be invalid. In this case, the ultimate result was very sympathetic to the life insurer and extremely harsh for the final purchaser of the policy,” comments Jared M. Katz, Santa Barbara, CA, Web and Practice Point Editor for the Section’s Commercial & Business Litigation Committee.

“The transactions leading to legal challenges and judicial scrutiny involve policies that were not organically sought out,” agrees Bonnie. “They are policies that are created in the first place by speculators who combine them with other life policies to create an investment platform. In other words, they are policies that are created specifically to feed investment opportunities in the life settlement market,” he warns.