Case Studies & What to Avoid
by Rob Usinger & Iram P. Valentin
Mr. Usinger is an insurance company Director, where his primary focus is on claims involving financial institutions and insurance companies. He can be reached at [email protected]
Iram P.Mr. Valentin is a partner in the Hackensack, New Jersey office of Kaufman Dolowich & Voluck, LLP, where he focuses on professional negligence defense, financial services litigation and complex civil litigation. He can be reached at [email protected]
Premium financing involves the lending of funds to procure life insurance by individuals (or companies). The practice of premium finance is not new.
For example, premium financing and premium financing companies have been regulated in the State of New York as far back as 1960 and in Florida as early as 1963. Although not a new practice, the use of premium financing appears, at least anecdotally, to be on the rise.
In certain circumstances, premium financing is entirely appropriate. However, we have noticed an increasing body of claims involving premium financing that illustrate the many potential pitfalls surrounding this practice. This article discusses the expanding role of premium financing and offers guidance to prevent future claims.
What is premium financing
Premium financing is typically provided by a premium finance company to an individual who seeks to obtain life insurance without the outlay of a large amount of personal funds to pay premiums. Insurance companies also may offer premium finance programs for their own insurance products.
Premium finance loans are now always recourse loans. Interest rates are tied to certain indices, such as the 1 year LIBOR, and financing can be used for almost any type of life insurance. Although profiles can vary, premium financing was traditionally suitable for individuals who desired large life insurance policies with death benefits of $5 million or more and either lacked the liquid assets to pay premiums (but had substantial non-liquid assets) or as result of some other estate planning benefit that could be gained by obtaining a large life insurance policy without the out-of-pocket outlay of large premiums.
Most of the time, premium financing was appropriate for individuals with some level of affluence, be it liquid or non-liquid. Anecdotally, we are seeing a trend of much smaller policies being financed.
Issues with premium financing
Premium financing is currently regulated – and appropriately used – in some capacity in all fifty states. In fact, no state prohibits the use of premium financing for insurance. However, even under ideal circumstances, premium financing presents potential issues.
Oftentimes, the premium finance agreement and the insurance contract itself have different terms. An example is where the insurance company has a rating downgraded and the premium finance contract requires a certain rating below which the insurance company has now fallen. This could lead the premium financing company to terminate or alter the contract, forcing the borrower to assume premium payments personally, increase the amount of collateral required by the premium finance company and/or force the client to pay back any outstanding debt on the financing.
Premium financing arrangements also run into problems when the life insurance contract is of the accumulating cash value variety and tied to certain sub-accounts that are invested in the market. Often, the policy is sold on the theory that the market gains in the underlying accounts on the policy will serve to cover the cost of the premium financing resulting in the misleading sales pitch of “free insurance.”
In reality, there is no guarantee that the accounts in the policy will perform optimally and when they do not, the above will fail to happen, leading to the borrower having to make up the difference or lose the policy. In the current environment, where premium financing rates are relatively low, we do not see this type of claim very often. However, if and when interest rates increase, we believe many new premium finance cases will emerge as the generally variable rates on the financing increases, making it more of a challenge for the sub-accounts to keep pace.
Also, there is a strong incentive for agents or brokers to sell premium-financed life insurance. Higher-limit life insurance policies carry large commissions and premium financing makes the purchase of those life insurance policies possible for many more people or, in the alternative, it facilitates the purchase of insurance that the buyer may not have pursued absent the availability of premium financing. It should be noted that in certain places where rebating is legal, like California, future claimants are induced into a premium financed arrangement by receiving a small rebate on the commission the agent or broker received for the sale of the policy.
One of the most common claims is for the agent (or broker) to be accused of misleading the claimant into financed insurance by promising that after two years (the contestability period of life insurance) the policy can be easily sold in the secondary market for profit.
Insurance companies are not particularly fond of what is referred to as Strange-Owned Life Insurance (“STOLI”) because, in concept, a certain proportion of life insurance policies will naturally lapse for the failure to pay premiums and this is factored into the overall business model.
When outside investors purchase a life insurance policy, however, they tend to pay the premiums and keep policies in-force, including those that would have otherwise lapsed, as they have invested in the future but not immediate death of the insured individual. In other words, they are betting on the life of the insured, but expect to make it past the contestability period in order to then alienate themselves from the policy. Nonetheless, the secondary insurance market is extremely volatile and the value of the policy will vary based on the health of borrower at the time of sale.
This is a guarantee that no agent (or broker) should ever make and financed insurance should never be sold on the speculation that the opportunity will exist for a secondary market sale in the future. Further, such arrangements, whether or not known by the agent (or broker), may be called into question for various reasons, as illustrated in the following cases.
STOLI Premium financing fits very neatly with the concept of STOLI and this has not gone unnoticed by insurance companies who have initiated litigation alleging the lack of insurable interest. In many states, such as New Jersey, the timing of the idea of STOLI is critical. If the policy was sold originally with the goal of immediately selling it, the insurance carrier will be allowed to maintain an action based on lack of insurable interest.
In Lincoln Nat. Life Ins. Co. v. Calhoun, a New Jersey federal district court denied defendant’s motion to dismiss where it was apparent to the court that defendants only procured the policy to sell it to a stranger in the future. In Sun Life Assur. Co. v. Berck, a Delaware federal district court, interpreting Delaware law on an issue of first impression, allowed plaintiffs to survive a motion to dismiss even though the two year contestability period had expired.
Of interest in the Lincoln Nat. Life Ins. Co. case is the fact that the plaintiff did not even know the source of the financing for the initial premium or the intended buyer, but the court felt confident it would find this in discovery. In Sun Life Assurance Co. of Canada v. Paulson, a Minnesota federal district court held that the defendant’s intent to transfer the policy at purchase time was “irrelevant” without identifying the third party buyer who lacked insurable interest.
Fiduciary and “Special Relationship” Considerations
In many jurisdictions, an insurance agent or broker is not considered a fiduciary. In New Jersey, an insurance professional is said to owe a fiduciary duty. This is a significant distinction to isolate for the defense of insurance agents or brokers when they are sued in connection with the sale of polices.
However, even the non-fiduciary distinction can be overcome by a showing that the agent or broker “assumed” a special duty by his actions. In a case not involving a breach of fiduciary duty, the concept of special relationship may haunt the agent or broker. For example, in Triarsi v. BSC Grp. Servs., LLC, the New Jersey Appellate Division recognized that a special relationship may arise between an insured and an insurance agent (or broker) which imposes greater duties upon the agent or broker.
The Court in Triarsi recognized that the alleged breach of fiduciary duty claim was actually one asserting a claim for professional negligence. Nevertheless, it recognized the existence of a “special relationship” on the part of the agent due to the alleged course of conduct. When insurance agents or brokers promote premium financing and hold themselves out as “experts” in premium financing, they open the door to assuming a special relationship and duties beyond that of a mere insurance policy salesperson.
In Helton v. American General Life Ins. Co., for example, the court found that an agent or broker who had arranged for the purchase of premium-financed insurance by a group of plaintiffs had assumed a “duty to advise” plaintiffs and was, therefore, held to a higher, more difficult to defend, standard of care. As the court characterized the facts in Helton, “this was more than a simple purchase of life insurance…”
What to avoid
Premium financing insurance claims tend to be large because the policies typically have high limits, the premiums are large and often collateral is lost or is being pursued with vigor by the premium financing company.
Often, claimants are unsophisticated, presenting as land rich and cash poor. Because of the potential exposure of a high-limit policy, one claim can have a very detrimental effect on an insurance company’s agent or broker’s errors and omissions program, especially if the program is small.
We advise caution when dealing with premium financed insurance. It is imperative that the borrower use an attorney experienced in premium financed transactions. The attorney will assist the borrower and an attorney’s mere involvement in the transaction presents a future defense for the insurance agent or broker. Agents or brokers also need to acquaint themselves with the borrower’s investment profile.
Defenses based on the notion that the agent or broker was merely a conduit for the policy and nothing more have proven unconvincing where the agent or broker had even the slightest notion that the borrower could not afford the policy without financing or was seeking financing.
It appears that once an agent or broker promotes the idea of premium financing, he or she may propel him or herself into a fiduciary standard or special relationship. Therefore, it is imperative that the agent or broker is cognizant of the implications.
As interest rates rise in conjunction with the use of premium financing, we are poised for a concomitant increase in these types of claims.
If companies are going to allow their agents to deal in premium financed insurance sales, then they will likely have to enhance their risk management program. In addition, we suggest certain smaller sub-limits connected to premium financing claims in the companies’ errors and omissions policies.
In sum, the use of premium financing should raise a red flag. ♦