Life insurance can be a very beneficial financial product, whether used to protect the financial interests of one’s family, to reduce the impact of estate taxes, or to assist a business upon the loss of a key employee. Occasionally, a company or individual, believing themselves to be very clever, will purchase a life insurance policy on a person in whom they have no “insurable” interest, hoping to cash in when the insured dies. When the person dies, the payment of the proceeds is usually challenged by either the insurance company (which claims the proceeds should not be paid at all) or the decedent’s family (who claim the proceeds should be paid to them).
Generally, the law requires the purchaser of insurance to have an insurable interest in the person or property being insured. Under the law of most states, including Illinois, an insurable interest arises from a substantial economic interest in the life of the person to be insured, which is generally interpreted to be a substantial pecuniary benefit from the continued life of the employee. If there is no insurable interest, the insurance policy is simply a wager that places the owner of the policy in the position of preferring that the person will die or the property will be destroyed. Such gambles are void because they are against public policy.
Company-owned life insurance policies are commonly purchased to fund buy-sell agreements, to provide funds to the company to ease the economic hardship that will result on the death of a key executive, to provide additional security to a lender, or to recover an up-front signing bonus paid to an executive who dies prematurely. But does a company have an insurable interest in all of its employees, or only those in key positions?
In a recent case, a United States Court of Appeals held that an Oklahoma company, which had purchased life insurance policies on all of its employees and was the beneficiary of the policies, did not show a substantial economic interest in the life of the decedent, an hourly wage-earner, and thus was not entitled to retain proceeds of $340,000.
The insurable interest is determined at the time the insurance policy is issued. If circumstances change – for example, a company purchases a key man life insurance policy on a senior vice president who later takes early retirement – the fact that the company originally had an insurable interest in the person will not void the life insurance policy. Further, the beneficiary of the life insurance policy need not have an insurable interest in the insured, so a person may name any other person or entity the beneficiary of a life insurance policy.
There is pending legislation in the United States House of Representatives that would restrict company-owned life insurance to a limited class of employees (i.e., highly compensated employees), require notice to the insured employees, establish disclosure and record-keeping requirements, and, as a penalty, impose income tax on life insurance proceeds paid to companies that fail to follow the standards imposed. This legislation is still being considered by the House Ways and Means Committee.
Please do not hesitate to contact us if you have any questions regarding insurable interest considerations or use of life insurance in business planning.