The U.S. Court of Appeals for the Seventh Circuit recently issued an opinion on how Wisconsin law addresses life insurance policies where the beneficiary is unrelated to the insured. See Sun Life Assurance Co. of Canada v. U.S. Bank Nat’l Ass’n, No. 16-1049 (7th Cir. Oct. 12, 2016). The decision recites a longstanding common-law rule that “you cannot own an insurance policy on the life of a stranger.” Id., slip op. at 2. But, oddly, it both recognizes and fails to address developments in financial instruments (and Wisconsin law) that significantly undermine this common-law rule.
The facts, as briefly summarized by the court, are these: In 2007, Sun Life issued a $6 million life insurance policy on the life of Charles Margolin, then 81 years old. In 2011, U.S. Bank bought that policy from the policyholder and became the beneficiary. Mr. Margolin died in 2014. When U.S. Bank filed a claim under the policy, Sun Life refused to pay, insisting it needed to investigate the policy’s validity. U.S. Bank sued, alleging that Wisconsin law requires Sun Life to pay the beneficiary (U.S. Bank) and imposes penalties for Sun Life’s failure to make prompt payment. After U.S. Bank prevailed in the trial court, Sun Life appealed. See id., slip op. at 3-4.
The Seventh Circuit begins with the common-law rule, which “forbids a person to own an insurance policy that insures someone else’s life unless the policy owner has an insurable interest in that life.” Id., slip op. at 1. At common law, an insurable interest exists if the insured’s death is likely to impose a cost on the policyholder. So, in examples provided by the Seventh Circuit, people can insure their spouse and children’s lives, or creditors can insure their debtors’ lives. See id., slip op. at 1-2. Absent an insurable interest, the common law regards an insurance policy on another’s life as a wager. Id., slip op. at 2 (citing Conn. Mut. Life Ins. Co. v. Schaefer, 94 U.S. 457, 460 (1876)). Even worse, the court notes, “insuring a stranger’s life gives the policy holder an inventive to shorten that life.” Id. (citing Grigsby v. Russell, 222 U.S. 149, 154-55 (1911)).
The court then addresses a wrinkle Wisconsin has added to the common law’s prohibition against insuring a stranger’s life. At common law, an insurance policy where the policyholder lacked an insurable interest was deemed void and the policy was canceled. But Wis. Stat. §631.07(4), adopted in 1975, alters the remedy so that, while the insurer is still required to pay, the court may equitably award the proceeds to someone other than the specified beneficiary. There’s an intuitive fairness to the Wisconsin approach: the insurance company cannot obtain a windfall from premiums paid on an invalid policy, the person most equitably entitled can receive the policy proceeds, and the insurer—rather than any individual—bears the burden of making sure only valid policies get underwritten.
Section 631.07(4) also requires U.S. Bank to prevail, the Seventh Circuit reasons. Note that §631.07(4) allows—but neither requires nor establishes a process for—an equitable analysis to determine who should receive the policy proceeds. See, e.g., Martin v. Tower Ins. Co., 119 Wis. 2d 48, 51, 349 N.W.2d 90 (Ct. App. 1984). The Seventh Circuit asserts that no one with an equitable claim superior to U.S. Bank’s stepped forward, but it provides no information about what, if any, consideration the trial court gave to whether such parties might exist. See Sun Life, slip op. at 4. Instead, the court simply says that, in the absence of an equitable claim, U.S Bank is entitled to the policy proceeds, plus penalties. Id.
The court is unconvinced by three arguments Sun Life offers to the contrary. First, it holds that Wisconsin insurance laws trump conflicting statutory provisions, so that Wis. Stat. §895.055’s prohibition on gambling contracts does not nullify the insurance policy. See id., slip op. at 4-5. Second, it holds that §631.07(4) does not violate the Wisconsin Constitution’s prohibition on state authorization of gambling, because §631.07(4) does not allow gambling contracts, but merely changes the remedy when a life insurance policy is tantamount to such a contract. See id., slip op. at 5. (This is true but ignores §631.07(2), discussed below.) Third, because Sun Life had no basis for refusing payment, the court enforces the penalties for not paying the policy benefit promptly. See id.
The case raises additional issues that the Seventh Circuit does not address. They are rooted in the court’s recognition that “U.S. Bank is designated in the [case] caption as securities intermediary,” and “Margolin’s policy either is a security or has been bundled together with other life insurance policies to create a security or securities.” Id., slip op. at 3. The court then cites to a 2009 New York Times article about the creation of securities from bundles of life insurance contracts but quickly moves on without considering the implications of U.S. Bank’s status or securitization. That is surprising, because both seem highly relevant.
The Times article summarizes securitization of life insurance policies. Elderly or terminally ill policyholders who decide to sell their policies receive cash payouts for a fraction of the policies’ value—on a $1 million policy, the payout might be $400,000, or a little more or less, depending on the insured’s life expectancy—and the purchaser takes ownership and assumes the premium payments. “The earlier the policyholder dies, the bigger the return—though if people live longer than expected, investors could get poor returns or even lose money.” Jenny Anderson, Wall Street Pursues Profit in Bundles of Life Insurance, NY Times (Sept. 5, 2009). Purchased policies, called “life settlements” or “viatical agreements,” can be bundled together, and interests in the aggregated policies can be created, sold, and traded as securities. (The process is analogous to how residential mortgages are often bundled and securitized.)
The Seventh Circuit acknowledges that Mr. Margolin’s policy was securitized. But the court ignores that Wisconsin law expressly allows this practice. Since 2007, Wisconsin securities law has included “life settlement investment or similar agreement” in the statutory definition of “security.” Wis. Stat. §551.102(28). And, while the Wisconsin insurance code follows the common law in forbidding the issuance of a life insurance policy where the policyholder lacks an insurable interest, there is an exception where the person insured “has given written consent to the issuance of the policy.” Wis. Stat. §631.07(2). Because the exception provides that such a policy can be valid at the time of issuance, there seems to be no legal impediment to transferring the beneficial interest in an otherwise-valid policy by written agreement. This exception is a significant—though unmentioned—departure from the common-law foundation of the Seventh Circuit’s analysis.
To be sure, there may be significant moral and practical concerns about creating a secondary market for life insurance benefits—with or without the additional complications that follow from bundling the assignments of the benefits into securities. But Wisconsin law allows these arrangements (as long as they are handled in certain ways) and will not give a blanket excuse to insurers that seek to avoid paying beneficiaries without an insurable interest. The Seventh Circuit’s opinion in Sun Life demonstrates that principle, and a broader look at Wisconsin law underscores that the court reached the legally correct outcome.