Delaware Supreme Court Holds That Life Policies Can Be Challenged For Lack Of An Insurable Interest Even After The Contestability Period Expires, Impacting Life Settlement Investors
By: Tom Crabb and Karen Asher-Cohen
Adding to the risks faced by those who invest in life settlements, on September 20, 2011 the Delaware Supreme Court held that a life insurance policy can be challenged by the insurer for lack of an insurable interest even after the two year contestability provision in the policy has expired. Accordingly, the returns such investors must earn will likely increase – and the purchase prices paid to viatical settlement providers will decrease – to account for this greater risk. Delaware’s ruling is contrary to earlier decisions by the high courts of New York and Michigan, setting up a patchwork of decisions that moreover raises the costs and uncertainty of settling life insurance policies in states that have yet to weigh in on the issue.
The case of PHL Variable Insurance Company v. Price Dawe 2006 Insurance Trust, Case No. 174, 2011 (Del. 2011), concerned a very common life insurance trust arrangement. A gentleman named Price Dawe settled a statutory trust with a family trust as the beneficiary. Price Dawe was the beneficiary of the family trust. PHL Variable issued a $9 million life insurance policy on Mr. Dawe, with the Dawe Trust being both the owner and beneficiary of the policy. The policy contained a standard two-year incontestability clause. Just over a month after the policy was issued, a third party investor named GIII bought the beneficial interest in the Dawe Trust for $376,111. Mr. Dawe died three years after the policy was issued. After the Dawe Trust (with GIII as beneficiary) made a claim for the death benefit, the life insurer contested the policy, claiming that Dawe misrepresented his income and assets in order to obtain the $9 million policy and, more importantly, that Dawe never intended to retain the policy and instead intended from the outset that the policy would be immediately transferred to GIII. That is, it was a stranger-originated life insurance policy, with Dawe used as a straw man to conceal a wager on Dawe’s life by GIII.
The Supreme Court first addressed the issue of whether Delaware law permits an insurer to challenge the validity of a life insurance policy based on a lack of an insurable interest after the policy’s two year contestability period expires. The Court held that it does because a life insurance policy lacking an insurable interest is void as against public policy and “thus never comes into force, making the incontestability provision inapplicable.” The Court first noted the purpose of such clauses to “provide security in financial planning for the insured, while also providing an insurer a reasonable opportunity to investigate any misrepresentations in the application.” The Court then looked to the state’s Insurance Code, which requires life policies to have a provision that the policy shall be incontestable after it has been “in force during the lifetime of the insured for a period of not more than 2 years after its date of issue…” The Court held that a policy lacking an insurable interest at the outset never becomes “in force” because it violates Delaware’s clear public policy against wagering on the life of another. Because the policy never legally went into effect, the contestability clause never went into effect. Accordingly, a life insurer in Delaware may contest a policy for lack of an insurable interest after the contestability period of the policy expires. Because life settlement investors typically rely on the policy being uncontestable after two years, the risk that the policy could be invalidated thereafter, plus the litigation risk even if the policy is upheld, are both increased significantly, which in turn naturally raises the returns such investors will have to earn on such policies to account for the higher risk. The trust business in Delaware may suffer as well, as potential settlors of high dollar trusts will likely move to states with less litigation risk.
The Court also held that Delaware law does not prohibit an insured from procuring a policy on his or her own life and immediately transferring the beneficial interest in that policy to a third party with no insurable interest, “so long as the insured procured or effected the policy and the policy is not a mere cover for a wager.” A policy that is validly issued “in good faith” is then immediately assignable to anyone regardless of whether he or she has an insurable interest. The Court said that the “key distinction is that a third party cannot use the insured as a means or instrumentality to procure a policy that, when issued, would otherwise lack an insurable interest.” Payment of premiums by the insured, as opposed to the stranger, is “strong evidence that the transaction is bona fide.” This is in alignment with the view of the other states that have considered the issue. Finally, the Court held that a trustee of a trust such as the Price Dawe Trust has an insurable interest in the life of the trust’s creator as long as the individual insured actually establishes and funds the trust. This final holding is also in alignment with the majority, if not all, the other states that have considered the issue. The last two holdings pale in significance to the first, which adds to the uncertainty and costs faced by life settlement investors.