M E M O R A N D U M

To: Members of the Insurable Interest Drafting Committee

From Roger Henderson, Chair, and Robert Jerry, Reporter, Insurable Interest Drafting Committee

Re: Commentary on Proposed 8/29/08 Amendment to Uniform Trust Code

Date: September 1, 2008

Attached is a document titled “[Amendment to Uniform Trust Code]” and identified as “8/29/2008 draft” (hereafter referred to as the “8/29 draft”). This draft is formatted as it would appear if inserted as the last section of Article 1 of the Uniform Trust Code (hereinafter referred to as the “UTC”). 1 Because the UTC uses the term “settlor”, that term, instead of the term “grantor” (which appears in a number of statutes enacted to date), is used in the 8/29 draft. The purpose of this memorandum is to explain the considerations involved in the preparation of this draft.

Nine states 2 have statutes that address, either directly or indirectly, the Chawla problem (see spreadsheet and comparison documents). The statutes vary in a number of ways, but the underlying purpose of each is to enable a trust or trustee to purchase and own insurance on the lives of certain categories of individuals without being vulnerable to a claim that the insurance policy is void on account of the trust’s or trustee’s lack of an insurable interest in the life on which the insurance is purchased. Given that our effort to amend the UTC has as its purpose creating a safe harbor for the trustee (and, more specifically, the trust planner), the scope of the safe harbor should be sufficiently broad to protect all commonly used estate planning arrangements where life insurance is used to fund some portion or all of the trust.

SECTION [_]. INSURABLE INTEREST; APPLICABILITY.

Subsection (a), line 5: “In addition to any insurable interest otherwise recognized under the law of this state”

The 8/29 draft has an explicit provision that both limits the reach of the amendment to the UTC while at the same time making it clear that it supplements existing law in the state dealing with insurable interests for the purpose of life insurance. Thus, the proposed language is intended to resolve the Chawla problem within the confines of the UTC without having, as its purpose or effect, collateral impact on the law of insurable interest. If the state already has a provision in its insurance code that deals

with the Chawla issue the UTC provision is designed to complement it, not conflict with it. This is important because at least nine states 3 have statutes that address the Chawla- type situation and the 8/29 draft should not present any obstacle to adopting the UTC or amending it in a state that adopted the UTC prior to it being amended.

Each of the nine states referenced above place their statutory language relating to the insurable interest of a trustee or trust in the state’s insurance code. Although this is a logical location for the placement of such language, it is just as logical to include such a provision in the UTC, so long as it does not conflict with the general insurable interest statutes in a jurisdiction that adopts or amends the UTC. By limiting the language of the proposed amendment, NCCUSL would adhere to its longstanding tradition of leaving the drafting of model acts relating primarily to insurance to other entities, most notably the NAIC. We should anticipate, however, that a state considering the NCCUSL model as the means to solve the Chawla problem might choose to place the NCCUSL model, or the substance of the NCCUSL model, in the state’s insurance code. 4 Nothing in the attached proposal would confound that effort.

In summary, the proposed language provides a safe harbor for ILITs regarding the Chawla issue and does it without preempting any existing language in state insurance codes relating to a trustee’s insurable interest or the law of insurable interest generally. The enactment of the proposed model would leave the state insurance code as a separate, independent source of law for evaluation of whether a trust or trustee has an insurable interest in the life of a person on whose life the trust or trustee has purchased insurance. We believe this is the optimum solution to the uncertainty created by Chawla.

Line 9: “(1) a settlor of the trust”

Of the nine states with statutes addressing the Chawla issue, seven 5 utilize the structure of initially stating that a trustee or trust has an insurable interest in the insured life in a set of listed circumstances. Six 6 of these seven statutes begin the list by stating that a trust or trustee has an insurable interest in the life of the grantor of the trust. This should not be controversial. An individual has an unlimited insurable interest in his or her own life; thus, a trust created by that individual, or that trust’s trustee, should have an unlimited insurable interest in the life of that individual.

Note that this language in paragraph (1), line 9, is “STOLI neutral.” In other words, this language does not prevent life insurance once acquired by a trust or trustee from being assigned to an individual who or other entity which lacks an insurable interest in the life of a grantor. Thus, there is nothing about this formulation which is designed to, or can be used to, frustrate a STOLI transaction. This outcome, however, is consistent with the general rule that supports the assignment of a life insurance policy from an owner who has an insurable interest to a third party who does not have an insurable interest in the insured life. 7

Two states – Florida and Maryland – qualify the paragraph (1), line 9, language with a requirement that the life insurance proceeds be primarily for the benefit of trust beneficiaries having an insurable interest in the life of the insured. If the purpose of the statute in these states were simply to provide a broad safe harbor for the ILIT, this qualifying language could be omitted. It may be that the qualifying language was inserted to satisfy an anti-STOLI concern, namely that such an ILIT could be created but the life insurance policy, or a beneficial interest in the trust, subsequently assigned to a party lacking an insurable interest in the grantor or someone in whom the grantor had an insurable interest. The qualifying language requires that the life insurance proceeds be “primarily for the benefit of trust beneficiaries having an insurable interest in the life of the insured,” which would effectively prevent the safe harbor from extending to ILITs created for the purpose of implementing a STOLI plan.

The difficulty with the Florida-Maryland qualification is that “primarily” is an uncertain standard. If all trust beneficiaries are spouses or immediate family members, the standard is clearly met. If some significant proportion of the beneficiaries constitutes remote family members or spouses or children of remote family members, whether the test is met will turn on the clarity of the state’s general insurable interest law. This ambiguity will inevitably have some impact on how ILITs are drafted as attorneys seek to avoid getting close to this “primarily” boundary line and may discourage the creation of ILITs that are designed to benefit broad classes of beneficiaries.

Line 10: “(2) an individual in whom a settlor of the trust has an insurable interest”

Each of the six statutes which begins the list by recognizing the trustee’s insurable interest in the grantor also includes a provision that recognizes an insurable interest in the life of an individual in whom the grantor has an insurable interest. This, too, should not be controversial. An individual may purchase insurance on the life of anyone in whom that individual has an insurable interest up to, generally speaking, the amount of that interest. 8 By extension, a trust created by a grantor, or a trustee for that trust, should have an insurable interest equal to the insurable interest the grantor possesses in other individuals.

Four of the six statutes -- Delaware, Georgia, South Dakota, and Virginia -- provide a safe harbor for any ILIT where the trust or trustee has an insurable interest in the life of anyone in whom the grantor has an insurable interest. (Virginia and Delaware have a further limitation in this text that refers to the “grantor for federal income tax purposes.”) This provision, which is the equivalent of paragraph (2) of subsection (a) in the 8/29 draft, is unqualified in each of those jurisdictions. Thus, these statutes provide the broadest safe harbor for the trustee.

Two of the six statutes – Florida and Maryland – qualify the paragraph (2) language with a requirement that the life insurance proceeds be primarily for the benefit of trust beneficiaries having an insurable interest in the life of the insured. This requirement also applies to the paragraph (1), line 9, language, as discussed above. The analysis of the qualifying language presented there is equally applicable here.

Two states – Florida and Maryland -- include a category in their statute which provides that the trust or trustee has an insurable interest in an individual related closely by blood or law to the grantor. This is a restatement of the general rule of what constitutes an insurable interest in personal insurance. This language is redundant of and superfluous to the language in the proposed paragraph (2) in the 8/29 draft and is therefore not included here.

Note that the proposed paragraph (2) simply adopts the law of the state in question for purposes of determining the scope of the category of individuals in whom the trustee will have an insurable interest under this provision. In all states, grantors have insurable interests in spouses and minor children. Beyond these generalities, states diverge somewhat on the question of what more distant relationships involve insurable interests. No effort is made by this proposed provision to modify, clarify, or alter any state’s underlying law of insurable interest. Instead, this proposed model embraces the premise that the law of insurable interest is best left to the states or to organizations that draft model provisions for insurance codes.

ILITs commonly are funded with second-to-die policies, which essentially insure two lives (usually spouses, both of whom are grantors of the trust) and where the proceeds are not paid until the second of the two insured lives expires. Because the second life in a second-to-die policy will almost always be a person in whom the grantor (and “first life”) has an insurable interest, it is a premise of this draft that paragraphs (1) and (2) are sufficient to provide a safe harbor for the practice of using second-to-die policies to fund ILITs. 9

Like paragraph (1) of the 8/29 draft, paragraph (2) is STOLI-neutral. Thus, subsection (a) does not seek to discourage STOLI transactions, and it does not speak by its terms to whether assignment of policies purchased by owners on the lives of others in whom the owner has an insurable interest should be assignable to third parties lacking an insurable interest in the insured life or to whether beneficial interests in trusts owning such policies should be assignable to third parties lacking such insurable interests.

An assumption underlying the 8/29 draft is that although virtually all ILITs involve life insurance that is taken out on the life of the grantor or on the joint lives of the grantors in second-to-die arrangements, there are times when it is taken out only on the life of the grantor’s spouse, or on immediate relatives, or someone else in whom the grantor has an insurable interest under the applicable state law. Thus, a premise of this draft is that a simple, two-category statute is sufficient to provide an adequate safe harbor for attorneys drafting ILITs. Another premise of this draft is that it should not address the STOLI issue by adding law that would either encourage or discourage STOLI transaction relative to what is allowed or disallowed in current law.1 0

The question for the Drafting Committee’s consideration is whether a model with the two categories found in paragraphs (1) and (2) of subsection (a) is sufficient to solve the Chawla problem. It seems apparent that those drafting statutes that have been enacted to date to remedy the Chawla problem believed that additional language was necessary to resolve the Chawla problem, although in some of these cases it may be that the additional language was directed more at STOLI than at Chawla. This issue is discussed below.

Is the simple two prong approach in the 8/29 draft a sufficient response to the Chawla problem?

As a general proposition, the existing state statutes approach the Chawla problem from two different directions – and sometimes from both directions. One approach looks at the problem as one involving the grantor’s relationship to the insured life, and the other approach looks at the relationship of trust beneficiaries to the insured life. There is a consensus in most of the nine states that it is necessary to look at the problem through the “grantor lens,” and there is general agreement among these states on what the substance of the statute, viewed through this lens, should be. That consensus understanding is reflected in the language in six states’ statutes that appears in paragraphs (1) and (2) of subsection (a) in the 8/29 draft. As stated above, it is the premise of this draft that these two provisions resolve the Chawla problem. When the trust beneficiary approach is used to address the Chawla problem, there is no consensus on what additional language should be included in the statute. There are several alternative constructions of this additional language in existing state statutes, as illustrated on the following table:	A trust or trustee has an insurable interest in a policy taken out on the life of: Delaware
If multiple beneficiaries of a trust have an insurable interest in the life of the same individual, the trustee has the same aggregate insurable interest in such individual’s life as such beneficiaries with respect to proceeds of insurance on the life of such individual or any portion of such proceeds that is allocable in the aggregate to such beneficiaries’ interest in the trust	Florida
(6) any person for whose benefit the trust holds property, and in the life of any other individual in whose life the person has an insurable interest so long as the life insurance proceeds are primarily for the benefit of persons having an insurable interest in the life of the insured [unclear if “so long as” clause modifies only the text before the comma or all text in (6)]	Georgia
Aggregation provision similar to Delaware
An “other person” (meaning, someone other than an individual closely related by blood or by law where there is a substantial interest engendered by love and affection) where there is a lawful and substantial economic interest in having the life, health or bodily safety of the individual insured continue, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the individual insured
An individual in whom the grantor otherwise has an insurable interest if the life insurance proceeds are primarily for the benefit of trust beneficiaries having an insurable interest in the life of the insured	South Dakota
Aggregation provision similar to Delaware
Trust has an insurable interest in subject of the insurance to extent that the beneficiary of the trust has the insurable interest
Each person in whose life a trust beneficiary has an insurable interest

Anyone else to the extent that person has an insurable interest with respect to proceeds of insurance on the life of such person that are allocable to such person’s interest in such trust

(5) An individual in whom the grantor otherwise has an insurable interest if the proceeds are primarily for the benefit of trust beneficiaries having an insurable interest in the life of the insured

Anyone else to extent any beneficiary of the trust has an insurable interest with respect to proceeds of insurance on the life of such person;

Maine

Maryland

Anyone else to extent a trust beneficiary has an insurable interest in the life of the “anyone else”

Utah

Virginia

Washington

A person for whose benefit the trustee holds property; and in the life of anyone else in whose life the person has an insurable interest

Let us consider first the Maryland statute, as it was one of the early and most direct responses to Chawla. (These comments are equally applicable to the Florida statute, which was adopted in 2008 and differs from the Maryland statute in minor, non-substantive respects.) If the sole purpose of the Maryland statute were to provide a broad safe harbor for attorneys preparing ILITs, the statute could have ended after the first three categories were articulated (i.e., after the “first prong” of the two-prong statute). Instead, the statute proceeds with text that qualifies the safe harbor created by all three categories. This qualifying language is probably best understood as anti-STOLI language. In other words, as stated above in a different context, if the purpose of the statute in Maryland were simply to provide a broad safe harbor for the ILIT, this qualifying language could have been omitted. It is possible that a concern was expressed during the drafting of the statute that after an ILIT is created the life insurance policy, or a beneficial interest in the trust, could subsequently be assigned to a party lacking an insurable interest in the grantor or someone in whom the grantor had an insurable interest. This concern, if it was manifested, was addressed by the qualifying language requiring the life insurance proceeds to be “primarily for the benefit of trust beneficiaries having an insurable interest in the life of the insured.” This effectively prevents the safe harbor from extending to ILITs created for the purpose of implementing a STOLI plan.

In three states -- Delaware, Georgia, and South Dakota – the statutes have an “any other person” category which limits the trustee’s or trust’s insurable interest to the scope of the interest that a trust beneficiary has in the life of the insured. In South Dakota, the statute’s structure recognizes an insurable interest in the trust or trustee in the life of “anyone else” to the extent a trust beneficiary has an insurable interest in the life of that person. In Delaware and Georgia, the statute recognizes an insurable interest in the trust or trustee in the life of “anyone else” to the extent that person has an insurable interest with respect to proceeds of the insurance that are paid on the life of that person that are allocable to that person’s interest in the trust (presumably in that person’s status of a trust beneficiary). This difference may have substantive significance, in that proceeds of life insurance do not exist until death, and thus a trust in Delaware or Georgia could, arguably, lack an insurable interest in an insured in circumstances where the trust is designed to provide a lifetime benefit for the insured with disposition of the proceeds to occur upon the insured’s death. In South Dakota, the trustee’s insurable interest is coterminous with the scope of the trust beneficiary’s insurable interest in the life of the “any other person.”

Under the language of the statutes in all three states (Delaware, Georgia, and South Dakota), a stranger-recipient of proceeds of the insurance resulting from an assignment would not have an insurable interest in the life of the insured, and would not have an interest to which the proceeds could be allocated. Thus, a STOLI arrangement would not be protected by this category in the statute. Thus, the “any other person” language in these statutes is probably appropriately understood as being directed at eliminating the possibility that the provision would become a loophole through which STOLI transactions would be statutorily authorized. If this interpretation of the origin of the language is correct, it must be noted that the anti-STOLI approach is tempered in these jurisdictions by the fact that the other categories in the statutes are STOLI-neutral; that is, the other categories do not prohibit an ILIT from being established by a grantor or a person in whom the grantor has an insurable interest and the life insurance policy being subsequently assigned to a stranger.

The “anyone else” category in the Virginia statute is similar to the statutes in Delaware, Georgia, and South Dakota, but is slightly broader, thereby providing a larger safe harbor for the ILIT. In Virginia, the third category in the statute states that a trustee has an insurable interest in the life of each person in whose life a trust beneficiary has an insurable interest. Under this structure, it would seem that so long as a trust beneficiary has some interest in the life of the insured, the trustee obtains a full interest in the life of the insured. This contrasts with the South Dakota statute, where the insurable interest is limited to the extent the trust beneficiary has an insurable interest in the life of the “anyone else,” and contrasts with the statutory language in Delaware and Georgia which is tied to an allocable portion of the proceeds.

Two states – Washington and Florida – have trust beneficiary provisions that accomplish similar results through different language. In both of these states, a trustee has an insurable interest in the life of a person for whose benefit the trustee holds property. Under this provision, a trustee has an insurable interest in the life of each trust beneficiary. These statutes both go further to state that the trustee has an insurable interest in the life of anyone else in whose life the trust beneficiary holds an insurable interest. In Washington, it appears that this interest is a full insurable interest, regardless of the size of the economic interest. In Florida, the interest is also a full insurable interest, but there is a separate requirement (which is like the Maryland proviso, which is also repeated in another section of the Florida statute) that the proceeds be primarily for the benefit of persons having an insurable interest in the life of the insured.

Subsection (b), lines 10-19.

To this point, little attention has been paid to this subsection which provides a transition once the proposed model is enacted. We need to examine it closely at the next committee meeting to make sure it captures, and conversely excludes, the appropriate transactions.

Two alternatives are offered for your consideration, and we turn first to Alternative B, which is taken in substance from the Maryland statute, which, in turn, appears to have been based on Section 1106 of the UTC). Section 1106, however, does not contain the last clause of the Maryland statute which restricts application of the Maryland anti-Chawla statute to “life insurance policies that are in force and for which the insured is alive on or after June 1, 2006”.

As a consequence, neither the Maryland statute nor Alternative B of the 8/29 draft subsection would apply ab initio to a situation where, prior to the effective date, the person whose life is insured dies. Consequently, this version only “cures” a lack of insurable interest, if the person insured is alive on or after the date it goes into effect. If there is no insurable interest when the person dies, no remedy is provided . Nor could it because rights under the policy would be determined as of the date of death and if no valid insurable interest existed, then the policy would be void. This would be true despite the fact an insurable interest under life insurance is only required at the inception of the policy and not subsequently. At death, one would merely look to see if a valid insurable interest existed at the time the policy was taken out. If there were none, then the policy would not be enforceable. The same result, arguably, would obtain under the UTC, even though it is not explicitly stated.

Alternative B, however, would be problematic if it were to be used as an amendment to the UTC because it would duplicate the language in Section 1106 without recognizing, as does Section 1106, that there may be exceptions to this general rule of applicability.1 1 However, rather than leave the issue that is explicitly addressed in the Maryland statute and in Alternative B that identifies the applicable life insurance policies to which the section applies, we thought it best to speak to that issue, and that is why Alternative A is offered as the preferred solution regarding the applicability issue. With this background, it is easier to see the value of the Alternative A approach, but that is not the only reason for setting out Alternative B.

If a jurisdiction opted for including subsection (a) of the 8/29 draft as part of its insurance code, or otherwise as a provision independent of the UTC or other trust law in that jurisdiction, then a provision arguably might be needed to make it clear that a life insurance policy lacking an valid insurable interest is not “cured” if the insured dies before the effective date of the legislation. In that case, the jurisdiction could choose either Alternative A or Alternative B, depending on the circumstances.1 2