There's no such thing as a free lunch. (1)
Since ancient times, people have recognized the usefulness of money because of its capacity to facilitate the exchange of goods. (2) Indeed, it would be difficult to find someone in modern American society that would refuse a "free" gift of $340,000. Yet such offers exist today in the form of speculator-initiated life insurance policies ("SPIN-Life"). (3) Consider the following letter from an attorney to a senior citizen:
I have been working with certain bankers, life insurance professionals and actuaries who, along with me, can assist you with gaining access to ... funds to provide a benefit to your family or to your favorite charity in a little more than two years at no cost to you through non-recourse "premium financing." We can accomplish this by using your excess "insurance capacity." This program is offered to individuals who are between the ages of 75 and 90 and who have a net worth in excess of $5,000,000. Following is a simple example to demonstrate the concept: John Smith is 80 years old. He [h]as a net worth of $10 million and has $2 million of existing insurance on his life. [Our law firm] will work with John to take advantage of his excess "insurance capacity" (approximately $8 million) to purchase a new life insurance policy on John (with an $8 million death benefit). During the underwriting process, we arrange for a "premium finance company" to agree to pay the premiums on John's behalf for the first 24 months (on a "non-recourse" basis, so John has no financial risk). Therefore, John will own the policy but will not be obligated to pay the annual premiums (which in this example could be approximately $300,000 per year including accrued interest). After 24 months have passed, John's health and the policy's fair market value will be reevaluated. Offers to purchase the policy will be obtained from "life settlement" companies and the best offer will be selected. John then sells the policy to a life settlement company (usually in the range of 10-15% of the death benefit). Since the policy in this example had a death benefit of $8 million, the sale price could range between $800,000 and $1.2 million. The sale proceeds must first repay the "non-recourse" loan to the "premium finance company," then John (or his designated beneficiary) will receive the excess, if any. In this example, assuming a $1 million sale price and a repayment of $600,000 to the "premium finance company," John will receive $400,000--this amount will be treated as a long-term capital gain currently taxed at 15%, netting John $340,000 after taxes! I have enclosed the necessary forms to begin the insurance underwriting process. If you are interested in applying for this program, please complete the forms and return them in the enclosed envelope.... I look forward to working with you on this amazing opportunity! (4)
Receiving such a letter appears to be an amazing opportunity indeed. Such an opportunity, however, although seemingly free, comes with a cost. This Note shows that SPIN-Life insurance policies contradict the nature and purpose of life insurance and should be considered securities or wagers, not insurance contracts; make human lives a commodity; violate current insurable interest laws and public policy against wager contracts; and should be declared void ab initio.
Part I of this Note provides an overview of the nature and purpose of insurance in general. Part II explains the requirement of an insurable interest and how such a requirement relates to an insurance contract. Part III sets forth a brief explanation of life insurance in particular, and how the insurable interest requirement makes a life insurance contract distinct from other contracts. Part IV delineates what SPIN-Life policies are, how they differ from other life insurance policies, and why they are problematic. Part V offers actions that state legislatures, state insurance departments, and insurance companies can take to discourage SPIN-Life insurance policies and prevent the death of the traditional understanding of life insurance.
I. A BRIEF OVERVIEW OF THE HISTORY AND NATURE OF INSURANCE
In order to understand why SPIN-Life policies violate insurable interest laws and should not qualify as life insurance contracts, it is necessary to consider the fundamentals of insurance in general. The origins of insurance can be traced back to Phoenician, Babylonian, and Greek merchants insuring their goods as they traveled around the Mediterranean Sea several centuries before Christ. (5) To protect against damage or loss to cargo, merchants entered into agreements to share among themselves on a pro rata basis the loss that any one of them suffered. (6) This form of insurance against risks at sea (marine insurance) was continued and developed by Italian merchants from the twelfth to sixteenth centuries, eventually leading to a formalized insurance business at Edward Lloyd's coffee house (7) in London in the sixteenth and seventeenth centuries. (8) Those desiring to obtain insurance to safeguard against marine risks provided pertinent information about the cargo, crew, and ship, and interested members of the upper class at Lloyd's contractually agreed to pay for the total amount at risk if "a fortuitous loss occurred." (9)
From these beginnings emerged the principles that define insurance. Although there is not a universally agreed upon definition of insurance, (10) certain elements are necessary for a contract to be an insurance contract. Essentially, insurance consists of a contractual agreement whereby one party transfers the risk of a fortuitous future event, in exchange for monetary consideration, to an insurance company that distributes the risk among a group of people subject to the same type of risk by establishing a common fund. (11) Thus, insurance is composed of three primary elements: (1) insurance risk, (2) risk shifting, and (3) risk distribution. (12) These three elements set insurance apart from other contracts and provide its particular nature. (13) Insurance risk--the type of risk that qualifies a contract as insurance--"is coverage for exposures that have the potential for financial loss. (14) Although people often confront non-insurance risks in their daily lives, "a product must transfer insurance risk to qualify as an insurance product." (15)
Yet, these three elements--insurance risk, risk shifting, and risk distribution--were not always clearly understood throughout the historical development of the insurance contract. The blurring of wagering contracts (16) with insurance contracts became prevalent in eighteenth-century England. (17) People began to purchase "insurance" on the lives of people with whom they had no relation or connection, including those on trial for capital crimes, (18) public figures and celebrities, (19) people suffering from gout and alcoholism, or those preparing to fight in a duel. (20) These agreements were wagering contracts because the owners of the policies lacked a cognizable interest or relation to the lives covered by the insurance. (21) That is, without an interest or relation to the insured persons, the policy owners lacked risk to shift to the insurance company since they suffered no loss upon the deaths of the people whose lives were insured, making the transactions pure wagers.
Instead of trying to protect against a loss resulting from the insured person's death, the policyholder wanted the person to die--and the sooner, the better. (22) In fact, it was not uncommon for policyholders to use various means to try to accelerate the death of the unknowing stranger whose life they insured, including offering drinks to those suffering from alcoholism. (23) In 1746, the English Parliament passed a statute "to put an end to insurances without real interest, which in process of time had become a cover for mere gaming contracts." (24) Although this statute pertained only to marine risks and insurance, the English Parliament adopted a similar statute in 1774 declaring any life insurance contract without an "interest" between the policy owner and the insured person's life to be null and void in an effort to stop gambling on human lives. (25)
Even though the English Parliament passed these statutes as part of an ongoing effort to suppress wagering in general, (26) they had the effect of formalizing the requirements for an insurance contract. (27) This historical link to an attempt to formalize an understanding of what constitutes insurance should not be overlooked. By passing these statutes and providing an implicit definition of what constitutes insurance, the English Parliament made an important distinction between an insurance contract and a wagering contract. (28) While some modern commentators argue that life insurance is not distinct from a wagering contract, (29) these English statutes introduced an idea that helped form the insurance industry by formalizing, in a general way, the requirements of an insurance contract. (30) Insurance shifts risk that already exists, which is tied to the concept of "insurable interest," (31) while "gambling involves creating risk that did not exist previously." (32)
II. THE INSURABLE INTEREST REQUIREMENT
Insurable interest is "any lawful and substantial economic interest in the safety or preservation of the subject of the insurance free from loss, destruction, or pecuniary damage." (33) In other words, the person seeking insurance (the owner) must have a particular interest or relation to the subject that is insured. A possible loss or damage to the subject of insurance presents a risk to the person seeking the insurance precisely because the person has an interest or relation to the subject that is insured. It is this risk which the person seeking insurance wants to shift to the insurance company, and for which he seeks compensation if the risk of loss or damage from a fortuitous future event occurs.
The United States adopted the doctrine of insurable interest through common law, (34) and later codified it in statutory law by various state legislatures. (35) Although an insurable interest was not immediately required for the validity of an insurance contract in all jurisdictions in the United States during the nineteenth century, it was not long before the insurable interest requirement became universal. (36)
Insurable interest within the context of life insurance is "an interest, arising from the relations of the party obtaining the insurance ... as will justify a reasonable expectation of advantage or benefit from the continuance" of the person whose life is insured, (37) or a probability of a loss caused by the person's death. (38) The relations between the parties may be based on pecuniary ties or a relationship of blood or marriage, (39) although the language that is used to describe insurable interest is often broad and left to judicial interpretation. (40) Insurable interest is therefore based on the relationship between the parties--not on whether someone pays the premiums of the policy. (41)
The insurable interest requirement provides a two-fold public policy purpose for life insurance: (1) to prevent people from wagering on human lives, and (2) to "eliminate an incentive for the beneficiary of a life insurance policy to hasten the demise of the insured." (42) Although the English Parliament originally passed the insurable interest statutes in a concerted effort to eliminate gambling from legitimate insurance contracts, (43) modern emphasis on the requirement attempts to reduce moral hazard (44)--life insurance policies are not meant to serve as an inducement to murder. (45) In the United States, therefore, in order to obtain a life insurance policy, there must be an insurable interest in the life that is to be insured, (46) otherwise the contract violates public policy and is considered null and void. (47)
With regard to the insurable interest requirement, there exist two categories of life insurance policies: (1) policies procured by people insuring their own lives, and (2) policies procured on the lives of others. (48) Concerning the first category of life insurance policies, an established principle recognizes that every person has an insurable interest in his own life. (49) This principle logically follows from the idea that each person possesses an interest in the continuation of his own life and knows who would benefit from his existence and who would suffer loss from his death. Therefore, insurance companies typically permit a person who takes out a policy on his own life to name any beneficiary on the policy. (50)
The ability of a person to procure a life insurance policy on himself and designate any desired beneficiary is nevertheless restricted. Courts have held that there must be "good faith" on the part of the person seeking insurance when entering into the life insurance contract, such that the policy is not a cover for a wager. (51) Thus, a person is not permitted to seek insurance on himself based on collusion with others when really the transaction is a mere disguise for a wagering contract. (52) In other words, a person seeking insurance on himself "must really, not just nominally, be the person who contracts with the insurance company." (53) Occasionally, the person seeking insurance is not the true applicant. A "question sometimes arises as to who in fact and in legal contemplation made the contract of insurance with the insurer." (54) Although the insured signs the application, someone else may have been the true cause of initiating the application and paid for the policy. (55) Therefore, "[m]ere signing of an application for life insurance does not amount to 'taking out' the policy within the meaning of the rule that a person may take out a policy on his or her own life payable to whom he or she desires." (56) If the insured is not the "true" applicant, the policy may be considered void in certain instances, (57) namely, if the applicant lacks "good faith" through fraud, collusion, or intent …