Fixing Oklahoma’s insurable interest laws
By Steven P. Cole and Gary F. Fuller
The insurable interest provisions of the Oklahoma Insurance Code  are flawed. The flaw was exposed by the Chawla cases consisting of the decision of the United States District Court for the Eastern District of Virginia, and, on appeal, the decision of the United States Court of Appeals for the Fourth Circuit. Despite the difficult task of pleasing the special interests of the insurance industry and trust companies and the trusts and estates bar, the flaw can and must be legislatively fixed.
The Chawla Cases
The Chawla cases involved outright deceit and large sums of money, making for good litigation. Harald Giesinger applied for a $1 million life insurance policy on his life with Transamerica Occidental Life Insurance Company, proposing to name his friend, Vera Chawla, as owner and beneficiary. In the application, Harald lied about his medical history, including numerous maladies stemming from a fatal addiction to alcohol.
Transamerica refused to issue the policy due to Chawla lacking an insurable interest in Harald’s life. The proposed owner and beneficiary were thus changed to the “Harald Giesinger Special Trust,” naming Harald and Chawla as co-trustees, and the policy was issued.
The trust was irrevocable and its res consisted of Harald’s residence. The trust agreement provided that during Harald’s life, he retained the right to all income from the trust and the right to occupy the residence. At his death, the trust property was to be distributed solely to Chawla.
Subsequent to the issuance of the policy, the trust sought to have Transamerica increase the policy coverage to $2.45 million. Transamerica approved a new application and an endorsement upgraded the policy’s coverage on Harald’s life to the increased amount.
Harald died about a year following the increase in coverage. On Harald’s death, Chawla, acting as trustee of the trust, filed a claim for the policy’s benefits with Transamerica. After an extensive investigation, Transamerica rescinded the policy and refunded the premiums paid on the policy in the sum of about $47,000.
Chawla, as trustee, filed suit in the district court. Construing Maryland law , the district court granted summary judgment in Transamerica’s favor finding: 1) that material misrepresentations of fact in the application invalidated the policy; and 2) the trust maintained no insurable interest in Harald’s life.
On appeal, the Fourth Circuit reviewed de novo the district court’s summary judgment. The Fourth Circuit affirmed summary judgment to Transamerica on the misrepresentation issue and vacated the district court’s ruling on the insurable interest issue, explaining that a ruling on the alternative issue of insurable interest was unnecessary and that “judicial restraint has particular application when a federal court is seemingly faced with a state-law issue of first impression.”
A Flaw Exposed
Notwithstanding the Fourth Circuit’s decision in Chawla, the district court’s decision exposed a flaw in Maryland’s insurable interest statute. The Maryland statute prohibited a person acquiring life insurance on another individual’s life unless the life insurance were payable to:
- The individual insured,
- The individual insured’s personal representative; or
- A person with an insurable interest in the individual insured at the time the insurance contract was made.
In order to qualify as a payee of the policy, the trust had to be a “person” with an insurable interest in Harald. Under Maryland law, the trust was a “person.” However, the trust was not related to Harald closely by blood or law and, since it held only Harald’s residence, it did not have a substantial economic interest in the continuation of the life, health or bodily safety of Harald. By Maryland law, an interest that arises only by the death of an individual (e.g. the policy) is not an insurable interest. Accordingly, the trust did not have an insurable interest in Harald’s life.
Viewing the trust as a “person” is akin to viewing the trust as a “separate entity.” An alternative approach not available under the Maryland statue would have been to examine the insurable interest of the trust’s beneficiaries and attributing their interests to the trust. Thus, in determining whether an insurable interest exists, two approaches appear possible: 1) an entity view and/or 2) the attribution of beneficiaries view, but Maryland did not afford the latter.
Unfortunately, Oklahoma’s insurable interest law is like Maryland’s, providing that no person shall procure life insurance upon the life of another individual unless the benefits “are payable to the individual insured or a personal representatives [sic], or to a person having, at the time when the contract was made, an insurable interest in the individual insured.” Section 3604(C) of the Oklahoma Insurance Code10 defines “insurable interest” as follows:
“Insurable interest” with reference to personal insurance includes only interests as follows:
- In the case of individuals related closely by blood or by law, a substantial interest engendered by love and affection;
- In the case of other persons, a lawful and substantial economic interest in having the life, health, or bodily safety of the individual insured continue, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disability, or injury of the individual insured . . . .
The district court’s conclusion in Chawla would have been the same had Oklahoma law applied. Maryland and Oklahoma share an identical flaw. They both view a trust as a separate entity, requiring that the trust have an insurable interest, if the trust acquires life insurance on the life of an individual.
Fiduciary Liability and Tax Exposure
Having exposed the flaw in the Oklahoma statue, the consequences must be considered. There is substantial exposure to fiduciaries for liability. Also, the tax exposure to the insured’s estate could be monumental.
A very common estate planning tool is an irrevocable life insurance trust, called an “ILIT” by estate planners. The tool involves an individual (“grantor”) establishing an ILIT for the benefit of family members  naming a third party, often an independent, unrelated party, as trustee, for the purpose of causing the ILIT to obtain life insurance on the grantor’s life. The grantor will fund the trust with a substantial gift, the income and principal of which can be used to pay life insurance premiums, or the grantor may fund the trust with periodic cash gifts which can be used to pay insurance premiums as they become due. The death benefits of the policy are payable to the trustee of the ILIT. According to the plan, the death benefits are not subject to income tax and are not included in the grantor’s estate for federal or Oklahoma estate tax purposes. One would assume there are hundreds of life insurance policies issued to ILITs created by Oklahoma residents who are the named insured under the policies.
It appears that the trustee of an ILIT may not have an insurable interest in the life of an Oklahoma grantor of the ILIT under Oklahoma law even if the trustee and the insured were related. Like the trust in Chawla, the ILIT would not be related closely by blood to the grantor. Also, trusts formed solely to hold insurance would not have a substantial economic interest in having the life, health or bodily safety of the individual insured continue. As in Maryland, an interest which arises only by the death of the individual insured is not an insurable interest in Oklahoma. Following the entity view of trusts, an ILIT would almost never be able to satisfy the insurable interest rule.
Under Section 3604(B) of the Oklahoma Insurance Code , if a life insurance contract is made where there is no insurable interest, “an executor or administrator . . . may maintain an action to recover [the death] benefits from the person receiving them.” Accordingly, if an ILIT is created under Oklahoma law having no insurable interest in the insured and the insurance company pays a death benefit to the ILIT, then the estate of the insured would have an action against the trustee to recover the proceeds of the policy following the insured’s death.
The risk of fiduciary liability is substantial. It appears that the trustee of the ILIT would have liability exposure for purchasing a life insurance policy and paying premiums where there is no insurable interest.
The personal representative of the estate would also have personal liability exposure for not pursuing a claim to recover death benefits from an ILIT trustee where an insurable interest is lacking. The risk of the personal representative would, of course, be greatest where the beneficiaries of the ILIT and the estate are not the same.
Even if the insurance company were inclined to honor a life insurance policy owned by an ILIT, the insurance company might refuse to pay both the ILIT trustee and the insured’s estate. Instead, the insurance company might prefer to interplead the death benefit and let the parties fight it out in court.
From a tax perspective, the absence of an insurable interest in the ILIT would be a train wreck. If the insurance company were made to pay a personal representative based on contract law and not the insurable interest statute, it is questionable whether the payment would be excludable from taxable income of the recipient under Code Section 101(a)(1). Also, with the proceeds being payable to the estate instead of the ILIT trustee, the proceeds would be includable in the estate of the insured for estate tax purposes under Code Section 2042(1).
This is a real and substantial problem. If fiduciaries, including legal counsel, have not already cautioned beneficiaries, interested parties, and clients concerning this issue, they should do so now.
Legitimate Uses of Life Insurance
There are numerous legitimate uses for life insurance in an ILIT. As discussed above, life insurance is often purchased in an ILIT for family members. Sometimes life insurance is procured in the context of a divorce to insure liquidity for the payment of alimony. With the spread of second or combined families, it is not uncommon to obtain life insurance on behalf of step-children and step-grandchildren. Some obtain life insurance to care for unique needs or to provide for individuals sharing a special relationship to the insured, including maids, long time care-takers or friends.
Legitimate uses of life insurance by ILITs should be protected. Fiduciary liability and tax consequences of the ownership of the life insurance should be certain.
The Chawla decisions were rendered about the same time that the life insurance industry began to react to a relatively new development known as investor-owned life insurance (“IOLI”). IOLI transactions vary but are typically structured as an arrangement where a lender loans the insured money to buy insurance for two years. If the insured dies within the two-year period, the bulk of the policy proceeds are paid to the named beneficiary after a portion is used to repay the loan. On the other hand, if the insured survives the two year period, the insured can: 1) keep the policy (subject to the loan) and start paying interest and future premium payments, 2) transfer the policy to the lender to satisfy the loan, or 3) sell the policy to an investor group for a sizeable profit over the loan amount. Unless the insured keeps the policy, a third party ends up owning the policy on the life of the insured and could stand to profit on the insured’s death. The life insurance industry has opposed IOLI resulting from these arrangements on the grounds that it threatens the tax-favored status of life insurance and that it represents an arbitrage between an annuity and life insurance. According to a recent article in The New York Times, however, “insurers are worried because they count on many customers canceling their policies before they die. . . .” If investor groups purchase life insurance policies and hold the policies until the insured’s death, the insurance business becomes much less profitable.
The life insurance industry has moved aggressively to ban IOLI. According to a June 15, 2004, newsletter by the National Association of Insurance and Financial Advisors:
The proponents of IOLI proposals have invested significant resources to promote this legislation. In response, state associations, their members, NAIFA, AALU and the ACLI have made extensive efforts to defeat these proposals as they arise in the various states. For the most part, our efforts have been successful, as legislative sessions ended in Alabama, Florida, Maryland, Oklahoma and South Carolina without the enactment of IOLI legislation. Legislation was enacted and signed into law in Tennessee despite the efforts of Tennessee AIFA and its members, and proposals are still pending in New York, Louisiana, and North Carolina.
The IOLI ban is at odds with a growing market for purchasing life insurance from seniors, an outgrowth of the viatical industry. Citing real life examples of seniors selling their life insurance policies to buy medicine, pay bills, and pay for retirement, The New York Times says:
[M]any advocates for the elderly and industry insiders worry that seniors will lose their legitimate ability to sell life insurance policies they have held for years.
In a surprising twist, it is in the interests of the life insurance industry to narrow, restrict and confine “insurable interest.” In their zeal to oppose IOLI, however, the life insurance industry has thwarted efforts to remedy the flaw exposed by the Chawla cases. Accordingly, tension exists among the special interests of the life insurance industry opposing IOLI, the interests of the emerging life settlement market, the needs of the insureds, and the desires of the trust companies and the trusts and the estates bar to protect the legitimate and historic uses of life insurance.
The IOLI situation and fixing the flaw exposed by Chawla, however, are separate and distinct issues. It is wrong and unacceptable to hold a statutory fix to Chawla hostage to solving the IOLI fight. It exposes fiduciaries and insureds alike to unnecessary and significant risk.
The flaw in Oklahoma’s insurable interest statute must be legislatively fixed. Due to the numerous assumed existing ILITs in Oklahoma, any legislation should be “clarifying” legislation and have a retroactive effect.
In the corporate context, Oklahoma based the Oklahoma General Corporation act upon Delaware law. Delaware law is often used as a model for legislation due to the language having been adopted and interpreted there first.
During the 2006 Oklahoma legislative session, House Bill 2905 sought to fix the Oklahoma Insurance Code by borrowing from Delaware law. Section 3604(C), defining insurable interest, would have been expanded with the addition of the following clarifying language:
- The trustee of a trust whenever established by an individual has an insurable interest in the life of the individual and the same insurable interest in the life of any other individual as does any person who is treated as the owner of the trust for federal income tax purposes;
- The trustee of a trust whenever established has the same insurable interest in the life of any individual as does any person entitled to receive any portion of the proceeds of insurance on the life of the individual that are allocable to the person’s interest in the trust;
- If multiple beneficiaries of a trust whenever established have an insurable interest in the life of the same individual, then the trustee of the trust has the same aggregate insurable interest in the life of the individual as the beneficiaries with respect to any portion of the proceeds of insurance on the life of the individual that are allocable in the aggregate to the beneficiaries’ interest in the trust; 
House Bill 2905 was drafted to take a neutral stand on the IOLI fight but to resolve insurable interest as it involves the historic use of ILITs in Oklahoma. The proposed addition to Section 3604(C) would have incorporated both the “entity” view and the “attribution of beneficiaries” view to analyzing the insurable interest of a trust. It was deliberately broad enough to encompass the legitimate and historic uses of life insurance.
House Bill 2905 was vigorously opposed by the life insurance industry and it was defeated. Admittedly, the proposed clarifying language based on Delaware law was strained and difficult to understand.
A more suitable solution is to adopt the approach used under Virginia law. Section 3604(C) would be clarified as follows:
- A trustee of a trust, whenever established, shall be deemed to have an insurable interest in (i) the individual insured who established the trust, (ii) each individual in whose life the owner of the trust for federal income tax purposes has an insurable interest, and (iii) each individual in whose life a beneficiary of the trust has an insurable interest; 
This approach based on Virginia law is straightforward. It is also consistent with the historic use and current practice of the trust companies and the trusts and estates bar in using ILITs. It does not attempt to solve or address the IOLI. As previously expressed, the IOLI fight should not be injected into the need to fix the Oklahoma insurable interest law based on the flaw exposed by Chawla.
The Chawla cases exposed a flaw in Oklahoma’s insurable interest laws. The flaw creates liability exposure to fiduciaries and a monumental tax exposure to estates of insureds. A reasonable legislative solution is to promptly adopt clarifying language based on the Virginia law.
- Title 36 of the Oklahoma Statutes (West 2006).
- Chawla v. Transamerica Occidental Life Ins. Co., No. CIV.A. 03-CV-1215, 2005 WL 405405 (E.D.Va. Feb.3, 2005).
- Chawla v. Transamerica Occidental Life Ins. Co., 440 F.3d 639 (4th Cir. 2006).
- Due to the delivery of the policy and payment of the first premium in Maryland, Maryland law applied.
- Chawla, 440 F.3d at 648.
- Md. Code Ann., Ins. §12-201 (a)(2) (West 2006).
- Md. Code Ann., Ins. §12-201(b)(3) (West 2006).
- See Steve Leimberg’s Estate Planning Newsletter No. 941 (March 9, 2006) at http://www.leimbergservices.com. See also Mary Ann Mancini, “The Chawla Case, Insurance Trusts and the Insurable Interest Rule: ‘Houston, We Have a Problem,’” 31 ACTEC Journal 125 (2005).
- 36 O.S. §3604(A.1).
- 36 O.S. §3604.
- 36 O.S. §3604(C).
- Such as a wife, children, grandchildren, etc.
- By design, the life insurance is applied for and acquired by the ILIT from the outset. If an insured acquires a life insurance policy on his life and transfers the policy to an ILIT and dies within three years of the transfer, the proceeds are included in the gross estate of the insured under Code Section 2035(a) (26 USC §2035(a)). See Donald O. Jansen, “Giving Birth to, Caring for, and Feeding the Irrevocable Life Insurance Trust,” 41 Real Property, Probate and Trust Journal 571, 614-618 (Fall 2006).
- 36 O.S. § 3604(C)(2).
- 36 O.S. § 3604(B).
- 26 USC § 101(a)(1).
- 26 USC § 2042(1).
- Charles Duhigg, “Late in Life, Finding a Bonanza in Life Insurance,” The New York Times (Dec. 17, 2006), and Rachael Emma Silverman, “Life Insurance as an Investment Draws Scrutiny,” The Wall Street Journal Online at http://online.wsj.com/home/us (Feb. 15, 2006).
- Steve Piontek, “It’s Time to Ban IOLI,” National Underwriter at http://cms.nationalunderwriter.com.
- Duhigg, supra.
- “Update: Investor-Owned Life Insurance (IOLI)” NAIFA Frontline, Vol. 2, No. 11 (June 15, 2004).
- The Oklahoma Viatical Settlement Act is codified at 36 O.S. § 4041 et. seq. Viatical settlements involve the purchase of life insurance policies on terminally ill persons while life settlements (sometimes referred to as senior settlements, lifetime settlements, or high net worth transactions) relate to the purchase of policies insuring people with a life expectancy of between 2 and 12 years. See Morton P. Greenberg and John E. Mayer, CFP, “Extracting Hidden Value from Unwanted Life Insurance Policies,” 28 Estate Planning No. 9 at 434 (Sept. 2001). Reportedly, the viatical settlement business got its start in the 1980s when investors began purchasing life insurance from terminal individuals afflicted with the HIV virus and in need of immediate cash. After the medical treatments for HIV improved and the infected individuals lived longer, the profits from viatical settlements were decimated. Some of the viatical settlement businesses that didn’t fail transitioned to life settlements. See Steve Leimberg’s Estate Planning Newsletter No. 1045 (Oct. 30, 2006) at www.leimbergservices.com.
- Duhigg, supra.
- During Oklahoma’s 2006 legislative session, the life insurance industry vigorously opposed legislation designed to address Chawla, HB 2905, for fear that a IOLI loophole might inadvertently appear. Thus, clarifying language was not adopted in Oklahoma in 2006.
- Woolf v. Universal Fid. Life Ins. Co., 1992 OK CIV APP 129, 849 P.2d 1093, certiorari denied (March 24, 1993).
- The proposed clarifying language followed subparagraph 5 of Section 2704 of Title 18 of the Delaware Code Annotated. The clarifying language would have been inserted into Section 3604(C) of Title 36 of the Oklahoma Insurance Code and the existing subparagraph C(4) would have been renumbered C(7).
- The proposed clarifying language follows Section 38.2-301 of Title 38.2 of the Virginia Code Annotated. The clarifying language would be inserted into Section 3604(C) of Title 36 of the Oklahoma Insurance Code and the existing subparagraph C(4) would be renumbered C(5).