Ruling Permits Life Insurance Company’s Claims To Proceeds In Case Involving Alleged STOLI Fraud

September 30, 2010 | Appeals | Insurance Coverage

Legal Bulletin

Almost a century ago, the U.S. Supreme Court recognized the importance of the “insurable interest” requirement in connection with life insurance policies. In Grigsby v. Russell, the Court explained that, “[a] contract of insurance upon a life in which the [policy owner] has no interest is a pure wager that gives the [policy owner] a sinister counter interest in having the life come to an end.”  Today, state laws generally require an insurable interest to exist at the time a life insurance policy is issued, with definitions of insurable interest recognizing that an individual has an insurable interest in his or her own life or the life of a close blood relation, and also where there exists an economic interest in the continued life of the insured.

An individual who obtains life insurance on his or her own life generally is permitted to transfer ownership of the policy to a person or entity that lacks an insurable interest. Insureds, however, may begin to run afoul of the insurable interest requirement when they intend at the time of a life insurance policy’s issuance to profit by transferring the policy to a stranger with no insurable interest. In fact, a market known as the stranger-originated life insurance policy (“STOLI”) market is growing for just such insurance – and the legality of STOLI plans is increasingly at issue in the courts.

Recently, a federal district court in New Jersey was faced with an insurance carrier’s claim for rescission of two life insurance policies it had issued because of an alleged STOLI fraud. The policies’ owners moved to dismiss the insurer’s action. The court’s decision, in The Lincoln National Life Ins. Co. v. Schwarz, in which it refused to dismiss the insurance company’s complaint, highlights the issues frequently faced in STOLI litigation and provides significant guidance to life insurance companies and to participants in the STOLI market on when such policies may – or may not – be enforceable.

Background

According to Lincoln National Life Insurance Company, in May 2006, applications for life insurance policies on the life of 85 year old Valeria Schwarz were submitted to Lincoln National that identified the Valeria Schwarz Irrevocable Life Insurance Trust as the proposed owner and sole beneficiary of the proposed policies. According to Lincoln National, the applications were signed in New Jersey on May 3, 2006 by Valeria Schwarz, as the proposed insured; Yoel Schwarz, as a trustee of the Valeria Schwarz Irrevocable Life Insurance Trust, as the proposed owner of the proposed policies; and Abraham Weinstock, as the broker of the proposed policies.

According to the applications, Valeria Schwarz had total assets and a net worth of $10.3 million and an annual earned income of $433,000. Additionally, in response to Questions 63 and 64 of the applications, the applicants represented to Lincoln National that they had not been involved in any discussion about the possible sale or assignment of the policies to a life settlement, viatical, or other secondary market provider.

In June 2006, Lincoln National issued and delivered to the trust two life insurance policies insuring the life of Valeria Schwarz, one in the amount of $2.5 million and the other in the amount of $2 million. After the issuance of the policies, premium payments were forwarded to Lincoln National on checks that indicated that the trust was the depositor and account owner. Likewise, at all times, Lincoln National was directed to send, and did send, all policy account notices and statements to the trust.

Valeria Schwarz died on February 12, 2009, at the age of 87. Approximately one month later, the trust submitted a claim for death benefits under the policies to Lincoln National. Lincoln National thereafter commenced a death claim investigation and subsequently asserted that the submission of the applications and the resulting policies were part of a conspiracy and collaborative effort by the applicants and/or those acting on their behalf, or in concert with them, and other entities engaged in STOLI transactions to profit at Lincoln National’s expense from a gamble upon the life of Valeria Schwarz. Lincoln National contended that, in furtherance of the fraudulent scheme, the applicants and/or those acting on their behalf or in concert with them had falsely, knowingly, and intentionally made fraudulent and material misrepresentations and/or omissions to Lincoln National concerning Valeria Schwarz’s finances, the existence of other life insurance and/or applications, and the true purpose behind the procurement of the policies.

Lincoln National filed suit against the trustees, seeking a declaration that the policies were void, void ab initio, or voidable due to a lack of insurable interest at the inception, and that no death benefits were payable. The trustees moved to dismiss the complaint.

Insurable Interest

In its decision, the court first examined Lincoln National’s arguments regarding insurable interest. It noted that Lincoln National argued that there was no insurable interest at the inception of the policies because they “were procured at the behest of, and/or under the direction of, a party or parties with no insurable interest in the life of the insured.” The court added that Lincoln National pointed to alleged misrepresentations made during the application process, and that it contended that after a reasonable opportunity for discovery it would demonstrate that (i) the policies were issued to, at the behest of, and/or in accordance with a plan initiated to transfer the policies, directly or indirectly, in the secondary market; (ii) Valeria Schwarz was financially incapable of funding the polices and, in fact, had not funded the policies, directly or indirectly; and (iii) the policies were to benefit strangers in the event of her death.

In response, the defendants asserted that an insurable interest existed even where life insurance policies were purchased with the intention to be sold. Moreover, they contended that even if the trust had immediately transferred the policies to someone else, which Lincoln National had not alleged, the policies would still be enforceable.

The court disagreed with the defendants. It observed that another New Jersey district court had recently construed New Jersey law regarding insurable interests in a case with similar facts.  In that case, the plaintiff insurance company sought a finding that a life insurance policy held by the defendants was void ab initio because, “at the time [defendant insured] applied for a life insurance policy, [defendant insured] intended to sell his policy to ‘stranger investors’ in the secondary life insurance market[.]” In response, the defendants filed a motion to dismiss, asserting that it was “legally permissible for an individual applying for life insurance to have a pre-existing agreement with a stranger lacking an insurable interest in the life of the person applying for insurance.” After noting that neither the U.S. Court of Appeals for the Third Circuit nor the New Jersey Supreme Court had addressed the issue before it, the court denied the defendant’s motion to dismiss, explaining: “This [c]ourt finds that because issues of intent are crucial to this determination, dismissal at this juncture would be premature. . . . Here, [the plaintiff] is entitled to proceed and attempt to discover whether, and with whom, [the insured] had arranged to sell the [p]olicy at the time the [a]pplication was submitted to [the plaintiff].”

The court in the Lincoln National case stated that it found further support for Lincoln National’s position that these types of “wager” arrangements should not be enforced in New Jersey because of the state courts’ strong distaste for contracts that are contrary to public policy. Moreover, it continued, other state and federal court decisions demonstrated that “the majority view is that life insurance contracts that lack a person with an insurable interest at inception are akin to wagering contracts, and therefore void ab initio.” The court then declared that, in its view, the New Jersey Supreme Court would likely follow decisions from other state and federal courts that have held that a lack of insurable interest by an insured at the inception of a life insurance policy caused the policy to be void ab initio. In that regard, it continued, the New Jersey Supreme Court would likely hold that the STOLI arrangement, as alleged by Lincoln National, would be akin to a wagering contract, and therefore, void ab initio.

The court stated that, contrary to the trustees’ arguments, Lincoln National had adequately pleaded that the policies lacked a person with an insurable interest at their inception – and that it had not only pleaded that the life insurance policies “were procured by individuals with no insurable interest in [Valeria] Schwarz’s life,” but also that the policies were “sought by, and intended for, persons who were complete strangers to [Valeria] Schwarz and had no legally cognizable interest in [her] life.” Finding that Lincoln National had sufficiently pleaded that the policies lacked a person with an insurable interest at their inception, it held that it would be “premature to dismiss” Lincoln National’s claim.

The Incontestability Clause

The court then addressed the trustees’ arguments that the policies’ incontestability clauses barred Lincoln National’s action because it was commenced after the expiration of the two year contestability period contained in each of the policies; the incontestability clause stated: “We will not contest this certificate after it has been in force during the insured’s lifetime for 2 years from the Issue date.”

The court acknowledged that established law supported the trustees’ interpretation of the effect of incontestability clauses. However, it continued, in response “to instances of insurance fraud,” there had recently been a “significant shift” in case law “creating certain exceptions to the incontestability of life insurance policies after the expiration of the two-year period of contestability.”

Moreover, the court noted, New Jersey had enacted the New Jersey Insurance Fraud Act “to confront aggressively the problem of insurance fraud . . . [by] requiring the restitution of fraudulently obtained insurance benefits,” and the New Jersey Supreme Court had recognized that “[i]nsurance fraud is a problem of massive proportions that currently results in substantial and unnecessary costs to the general public in the form of increased rates.”

The court then concluded that for the purposes of the defendants’ motion to dismiss, Lincoln National had adequately pleaded that the incontestability clause did not bar its claim. Simply put, the court ruled, Lincoln National’s allegations that the trustees had submitted applications that contained false and incomplete information, that they had knowledge that the information was not accurate, and that they had made misrepresentations with the knowledge that Lincoln National would rely on the incorrect information were sufficient for it to deny the trustees’ motion to dismiss.

Conclusion

The court’s decision in the Lincoln National case does not mean that the insurance company will not have to pay the death benefits under the policies it had issued. The insurer, however, now has the opportunity to demonstrate, after discovery and further proceedings, that the policies should be deemed void. The ultimate resolution of this case, and other cases working their way through the courts, including in New York, will do much to clarify the law in cases involving alleged STOLI fraud.

For Further Information

For further information about life insurance coverage issues, or about insurance coverage issues in general, please contact Mr. Rivkin (at (516) 357-3269 or via email at [email protected]), or your regular Rivkin Radler attorney.

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