Life Insurance as a Wager

We confronted this issue previously in a Georgia case that found its way to the Eleventh Circuit.  You can read about that here.  The upshot is that the prohibition on taking out a life insurance policy when the insured has no insurable interest in the life of the insured is quite specific and easily evaded.

North Carolina law will not enforce a life insurance contract if it serves as a wagering contract on the life of the insured.  North Carolina also permits insureds to sell or assign the policy for any reason following its issuance.  But what if the insured took out the policy for the sole purpose of selling it?  In Columbia Life Insurance Company v. Wells Fargo Bank, N.A., a North Carolina court held that the policy was valid and enforceable.  

The insured in the case, Dr. Trevathan, got a recommendation from a friend that one Wesley Chesson would loan him money for the purchase of an insurance policy.  Dr. Trevathan could use the loan proceeds to pay the insurance premium for two years.  After that time, he could either "(1) surrender the policy to [Mr. Chesson's finance company] in full satisfaction of the loan; (2) pay off the loan balance to [the finance company] and continue to retain the policy for himself going forward; or (3) sell the policy and use the proceeds to satisfy the loan balance."  Dr. Trevathan, who was 81 years old when he purchased the policy, testified that he had no thoughts of his beneficiaries.  The purpose of the transaction was to get access to funds; he had no interest in retaining the policy.  Dr. Trevathan did not disclose his motives to the insurer, and the insurance application stated that the purpose of the policy was "personal and family protection." 

Dr. Trevathan sold the insurance policy for $440,000, which, after reimbursements and commissions to Mr. Chesson, netted him over $200,000 on the transaction.  The insurer duly recorded the transfer.  Years later, Well Fargo bought the policy as intermediary for LSH.  The insurer gave LSH various assurances that the policy was still valid.  Meanwhile, the insurer had flagged the policy as a potential "stranger-initiated life insurance policy" or STOLI.  Eventually, the insurer sought a declaratory judgment that the policy was void ab initio on that basis.   The insurer originally filed in federal court, but the resolution turns on state law, and so the federal court dismissed the case, and the insurer started over in state court.  There were various claims and counterclaims, and in May the North Carolina Superior court issued its ruling on competing dispositive motions.

The STOLI issue has vexed courts over the past two decades, and they have reached no uniform conclusions.  The issue is "whether a valid insurable interest on the life of the named insured existed at the time the alleged STOLI policy was issued."  States have devised different methods for answering the question, and the question had not previously arisen in North Carolina. 

In this case, there was no question that Dr. Trevathan had an insurable interest in his own life.  The insurer argued that the court should also consider, using a totality of the circumstances test, whether the entire scheme was an illegal wager.  Wells Fargo countered that the scheme is only an illegal wager if the parties entered into an agreement at the time the policy was issued that the insured would assign the policy to a stranger.  The court adopted the following rule:

The policy is void as a wagering contract only where there is evidence of an agreement—prior to the policy’s issuance—that the policy would be assigned to a third party and that the third party participated in that agreement. 

In this case, the parties to which the policy was assigned only learned of the policy's existence two years after it was issued.  In those circumstances, the court found that the public policy concerns about wagering on an early death of the insureds were not implicated.  The legislature could set out further rules to limit STOLI schemes but has not done so.

The ruling seems correct under North Carolina law but it also emboldens the Mr. Chessons of the world who are acting as brokers for STOLI schemes.  The court duly notes that the policy gave Dr. Trevathan three options, but his testimony makes it clear that he was only interested in one of those options.  The court does not explain why the policy concerns change if the wager on Dr. Trevathan's life is placed on the day the policy is issued or two years later.