24 December 2012 0 Comments

Challenges to Third Party Ownership of Life Insurance

third party life insuranceIn addition to having to financially justify the total amount of life insurance in force and applied for, the owner applying for a life insurance policy must have an insurable interest.  If the owner of the policy is the insured, that suffices for this requirement to be met.  The same would likely be true if the owner were a living trust with the insured as trustee, an Irrevocable Trust or adult children intended for estate liquidity, or a spouse.

When would a policy owner not have an insurable interest?  When the death of the insured would create no economic loss or obligation to that owner.  I can’t decide to purchase a life insurance policy on a complete stranger, just to receive the death benefits because I think I’ll come out ahead.  There was a case in Los Angeles a few years ago where two elderly women were having strangers apply for life insurance, paying the premium and naming themselves as beneficiaries.  And guess what?  After the policies’ two year contestability periods had passed, these insured’s were mysteriously run over by cars or succumbed to other convenient accidents.  I believe they did not apply as owners, but they were the beneficiaries and the policy ownership might have been changed after the policies were issued, which is permissible unless otherwise precluded by state law.  These ladies are now incarcerated for a very long time.

When an insurance policy is purchased by a business entity on the life of a key employee or owner, there must not only be an insurable interest, but the question of financial justification becomes more complex.  If an individual invests money in a business venture, but plays no role in the management of the business—is only a passive investor—there would be no insurable interest for the business to own a policy on the life of the investor.  However, if that investor also served as an active manager of the business, then there could be an insurable interest inasmuch as the management skills of the  investor would be lost if he died, creating a financial loss to the business.

To determine for how much an insurance company will issue on the life of a key executive you must answer many questions:  How much revenue will be lost if he dies?  Will the net value of the company suffer?  Does he possess unique knowledge, skills or contacts that will take time to replace?  The business must give their agent enough information to satisfy the insurance company underwriter.  It’s not sufficient to merely tie the amount of insurance to a loan to be repaid in the event of his death.  You must relate how the amount of that loan is tied to the individual’s contribution to the success of the company.

Coming up, I’ll be returning to some more specific medical and lifestyle histories that can affect how much is charge for life insurance.

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