Life Insurance: Can A Charity Still Benefit?

Over the past several years, promoters of various schemes

concerning the application for and issuance of life insurance

policies and the subsequent sale of those policies to third parties

have led most charities to look upon any planned giving technique

involving life insurance with a very suspicious eye. This

skepticism is certainly valid, if not prudent. However, the use of

life insurance in a planned giving scenario is not inherently bad;

it is the perversion of the tool by those exercising poor judgment,

motivated by unbridled greed, that has led to the current

environment regarding the use of life insurance. The purpose of

this article is to discuss the use of life insurance as a way for

charities to increase their giving and to provide a checklist for

charities to use in evaluating whether or not a plan utilizing life

insurance is something the charity will want to consider.

Step 1. Is there an insurable interest?

In evaluating the issue of whether there is an insurable

interest on the life of the insured, there are three fundamental

questions that have to be answered. If the answer to any one of

these questions is someone or an entity that does not have an

insurable interest in the insured, then flags should go up and the

charity should walk away.

Who initiates the issuance of a policy?

Who is the owner of the policy?

Who is the beneficiary of the policy?

In the context of life insurance, Section 10110.1(a) of the

California Insurance Code generally defines an insurable interest

as "an interest based upon a reasonable expectation of

pecuniary advantage through the continued life, health, or bodily

safety of another person and consequent loss by reason of that

person's death or disability or a substantial interest

engendered by love and affection in the case of individuals closely

related by blood or law." Moreover, the law provides that an

insurable interest must exist at the time the policy is

effective.1 In this step, the answer can only be either

the insured or a third party. There is no question that an

individual has an insurable interest in his own life and can name

whoever he wishes as a beneficiary of a life insurance policy on

his own life.2 However, a policy obtained by a third

party on the life of another is void unless the third party

"applying for the insurance has an insurable interest in the

individual insured at the time of the

application."3 In order to buy life insurance on

the life of another, there must be an insurable interest in the

continued life of the insured.4 To allow otherwise would

be to sanction wagering on human life.

It has long been established that Qualified

Charities5 have an inherent insurable interest in the

continued lives of their donors and "may effectuate life ...

insurance on an insured who consents to the issuance of that

insurance." 6

Can an irrevocable life insurance trust (an "ILIT")

have an insurable interest in the insured? Practitioners have for

years utilized ILITs as the preferred vehicle through which to

obtain and own life insurance, largely for tax reasons.7

It wasn't until the Chawla case8 that the

issue of whether an ILIT could own a policy at all was raised.

Interpreting Maryland law, the Court in Chawla found that

because the ILIT had "an interest that arises only by, or

would be enhanced in value by, the death ... of the

individual" the ILIT did not have an insurable interest in the

insured and therefore the policy was void. On appeal9

the Fourth Circuit affirmed the lower Courts ruling on other

grounds, but found that the District Court's ruling as to

whether an ILIT has an insurable interest in the individual insured

"unnecessarily addressed an important and novel question of

Maryland law" and vacated that portion of the District

Court's ruling. It is, as they say, hard to unring the bell.

The issue of an ILIT's insurable interest in an insured is

"on the table" and must be addressed. Many states have

either changed their statutes, or have adopted a "look

through" principle whereby in order to determine whether an

ILIT has an insurable interest, you would need to look through the

ILIT to the trustee or beneficiary of the trust.

Step 2. Is the policy going to be financed?

In order to manage the costs of a life insurance policy, it may

be necessary to procure financing to cover the policy premiums. So

long as funds are borrowed to meet a demonstrated financial or

business need, premium financing is considered a legitimate way to

finance life insurance policies.10 In fact, almost all

insurers will accept applications that include the legitimate need

for premium financing arrangements.11 There is nothing

wrong with financing the acquisition of any asset, including life

insurance. Whether the economics of the financing vehicle justify

its use with respect to a particular policy in a specific set of

facts is outside the scope of this article; but, on its face the

concept of premium financing is just fine. However, there is no

such thing as a free lunch and there's no such thing as

legitimate free insurance. A red flag should be raised when the

life insurance is advertised or promoted as free insurance. If the

insured does not have at least some level of financial risk and/or

detriment, then the chances are that there could be an issue.

Nonrecourse financing should be avoided. Other financing

arrangements should be analyzed on a case-by-case basis to verify

that the financing tool make sense under the circumstances. In

evaluating whether a donor has incurred any financial cost or

detriment by causing an ILIT to purchase insurance on his life

through any financing arrangement, it is important to understand

that in addition to contributions of cash to the ILIT or guarantees

given to the lender, the insured will incur a real cost and

financial risk when he names a charity as beneficiary since the

insured is ceding all or part of his excess capacity to purchase

additional life insurance. Remember, financial risk is only one

aspect of skin in the game. Even though required for family or

business reasons, future purchases of life insurance may be

prohibited or sharply curtailed. It is imperative that the would-be

insured is made fully aware of his true financial risk/cost when

entering into a program.

The skin-in-the-game theory is not mandated by any state or

federal law. It is a theory created by the insurers and lenders to

differentiate proper funding techniques from STOLI, IOLI and/or

CHOLI. Is there really a need for additional skin in the game if

the charity is the only beneficiary of the ILIT, the donor receives

no cash and no tax deduction is taken? If, on the other hand, the

beneficiary is a family member or business associate, then,

...