A stranger-originated life insurance (STOLI) policy is a life insurance policy obtained as an investment for a stranger, rather than for the benefit of the insured's beneficiaries. Public policy disfavors STOLI policies because, among other things, legislators consider them to be wagers on human life. See, e.g., N.Y. Ins. Law §7815(c) (“No person shall directly or indirectly engage in any act, practice or arrangement that constitutes stranger-originated life insurance.”).

When an insurance company discovers that it has issued a STOLI policy, it may seek to challenge its validity on the basis of fraud. Often, an insurer's ability to succeed depends on whether a state incontestability law—commonly providing that a life insurer may not challenge the validity of a life insurance policy after a period of time, such as two years—permits or bars its challenge.

A recent decision by the U.S. Court of Appeals for the Second Circuit, AEI Life v. Lincoln Benefit Life Co., 892 F.3d 126 (2d Cir. 2018), highlights the importance of knowing which state incontestability statute applies to a challenge to a STOLI policy. The determinative legal consideration in the AEI Life case was whether it was governed by the rules of New York or New Jersey. That was important because, perhaps surprisingly, the states interpret their incontestability laws quite differently.

Background

The AEI Life case arose in May 2008, when Lincoln Benefit Life Company, an insurance company with its principal place of business in Lincoln, Neb., received an application to insure the life of Gabriela Fischer, who was 77 years old at the time. The application represented that Fischer had a net worth of $87 million, an annual income of $1.5 million, and unearned income of $5 million. A confidential financial statement included in the application stated that Fischer had assets totaling $1 million in cash, $10 million in accounts receivable, $40 million in real estate, and $30 million in other business interests.

Three individuals signed the application and declared the information truthful: Fischer, her son (who also was trustee of the Gabriela Fischer Trust), and an insurance broker. An accountant verified Fischer's net worth as stated in the application.

Lincoln approved Fischer's application and issued the requested life insurance policy, which provided that Lincoln would pay $6,650,000 to the policy's beneficiary—the Fischer Trust—upon Fischer's death.

As the Second Circuit subsequently pointed out, the financial information in the application was false and fraudulent: Fischer never owned $1 million, did not earn $1.5 million per year, and did not have the resources to make the initial payment of $151,450 and premiums of $205,000 per year. The Second Circuit explained that a stranger to the policy deposited $1 million into the Fischer Trust shortly after Fischer's application was submitted, and this money was used to make all the payments due to Lincoln under the policy.

In 2011, the Fischer Trust sold the policy and, two days later, it was resold it to AEI Life, a bona fide purchaser that did not know about any fraud when it bought the policy.

Lincoln discovered the fraud in 2013—well after the policy's two-year contestability period had passed—and sought to invalidate the policy through a declaratory judgment action that it brought in the U.S. District Court for the District of New Jersey.

After that court dismissed the case for lack of subject matter jurisdiction, AEI filed its own lawsuit in the U.S. District Court for the Eastern District of New York, seeking a declaratory judgment that the policy was incontestable as a matter of law. AEI contended that New York law applied and that its incontestability law barred Lincoln's challenge. For its part, Lincoln pointed to a policy provision that it asserted favored application of New Jersey law; the provision stated, “This certificate is subject to the laws of the state where the application was signed. If any part of the certificate does not comply with the law, it will be treated by us as if it did.”

The district court, applying New York law, ruled in favor of AEI Life, AEI Life v. Lincoln Benefit Life Co., 225 F. Supp. 3d 136 (E.D.N.Y. 2016), and Lincoln appealed to the Second Circuit.

New York and New Jersey Law

As noted above, New York and New Jersey have different rules regarding incontestability clauses.

Section §3203(a)(3) of New York's insurance law requires all life insurance policies to contain a two-year incontestability clause providing:

[T]hat the policy shall be incontestable after being in force during the life of the insured for a period of two years from its date of issue, and that, if a policy provides that the death benefit provided by the policy may be increased, or other policy provisions changed, upon the application of the policyholder and the production of evidence of insurability, the policy with respect to each such increase or change shall be incontestable after two years from the effective date of such increase or change, except in each case for nonpayment of premiums or violation of policy conditions relating to service in the armed forces.

New York courts have decided that an incontestability clause “renders void any defense that the life insurance policy was invalid at its inception.” Ganelina v. Public Administrator, New York Co., 39 Misc.3d 952 (N.Y. Sup. Ct. 2013). Moreover, the law does “not provide for exceptions for claims of fraud or lack of an insurable interest.” Principal Life Ins. Co. v. Erno Altman Ins. Trust, No. 10-CV-1936 (E.D.N.Y. Sept. 20, 2011) report and recommendation adopted, No. 10-CV-1936 (E.D.N.Y. March 13, 2012).

As one court has observed, the legislature specifically permitted insurers to include exceptions to the incontestability clause for fraud in disability and health insurance policies in New York's insurance law, “but did not provide for such an exception for life insurance policies.” Halberstam v. United Stated Life Ins. Co. in City of N.Y., 36 Misc.3d 497 (N.Y. Sup. Ct. 2012).

Simply put, a policy governed by New York law cannot be voided for fraud or lack of insurable interest once the two-year contestability period has expired. The New York Court of Appeals explained in New England Mutual Life Ins. Co. v. Caruso, 73 N.Y.2d 74 (N.Y. 1989), that “[t]his inequity may be avoided, and the public purpose underlying the insurable interest requirement implemented, by a rule which encourages the insurer to investigate the insurable interest of its policyholders promptly within the two-year period. Such investigations would not only eliminate 'wagering' contracts but would do so promptly.”

In New Jersey, N.J. Stat. Ann. §17B:25-4 also requires that all life insurance policies include a two-year incontestability clause:

[A] provision that the policy … shall be incontestable, except for nonpayment of premiums, after it has been in force during the lifetime of the insured for a period of 2 years from its date of issue.

Unlike under New York law, however, under existing New Jersey law “an insurer may deny a claim if the insured committed fraud in the policy application” even after the two-year incontestability period has passed. Ledley v. William Penn Life Ins. Co., 651 A.2d 92 (N.J. 1995); Lincoln National Life Ins. Co. v. Calhoun, 596 F. Supp. 2d 882 (D.N.J. 2009) (“A life insurance policy may be rescinded or voided where an applicant makes a misrepresentation on a policy application that is material.”).

In other words, New Jersey allows an insurance company to contest the validity of a policy obtained by fraudulent means even after two years have expired after the policy became effective, but New York does not. This is a critical difference between New York and New Jersey law.

The Second Circuit's Decision

The Second Circuit affirmed the district court's ruling in favor of AEI Life.

In its decision, the circuit court explained that the “central issue on appeal” was whether New York or New Jersey law applied.

The circuit court first ruled that the policy provision relied on by Lincoln to argue that New Jersey law governed the policy was a “conformity clause” rather than a choice-of-law clause because it did not reflect the parties' intent to select the law of a specified state. A conformity clause, the circuit court said, had the effect of excising a provision of an insurance policy that conflicted with or was voided by state law and replacing the provision with the prevailing state statute or judicial rule of law.

Then, to determine whether New Jersey or New York law applied without an effective choice-of-law provision in the Lincoln policy, the Second Circuit looked to New York's conflict-of-law rules and, in particular, to the “center of gravity” rule.

The Second Circuit noted that the district court found that the policy had been negotiated, contracted, signed, and issued in New York to individuals residing in New York; the broker and general agency who sold the policy were located in New York; the trust was executed and operative in New York; and transfers of the trust's funds were made through a New York bank account.

By contrast, the circuit court pointed out, the district court detected “only minimal contacts” with New Jersey; ruled that Fischer, her son, and the broker falsely stated that the application was signed in New Jersey, when it was in fact signed in New York; and found that Lincoln—which was licensed to provide insurance in New Jersey, not New York—submitted the form used for the Fischer policy to the New Jersey Department of Insurance.

The Second Circuit pointed out that the two most important factors under New York's “center of gravity” rule were the place of contracting and the place of performance, and it held, based on the district court's factual findings, that the place of contracting was New York (the state in which “the policy was negotiated, contracted, and signed”) and that the place of performance was New York (the state where the premiums were billed and where the claim was to be paid).

With that resolved, Lincoln's fraud defense was effectively blocked by the incontestability clause. The Second Circuit, applying New York law, then rejected Lincoln's efforts to avoid the incontestability clause by contending that Fischer's policy was void ab initio—before the incontestability clause even took effect—because the policy constituted a wager on human life. The circuit court found that under New York law, wagering insurance contracts entered for the benefit of parties that lacked an insurable interest were “simply voidable, not void ab initio,” and, therefore, could not be challenged after the expiration of the two-year period.

Relying on New York's incontestability law, the Second Circuit similarly rejected Lincoln's other arguments that the policy was void ab initio, and it affirmed the district court's decision.

Conclusion

Choice-of-law issues in STOLI cases of course are not limited to New York and its neighboring state of New Jersey. For example, in Wilmington Trust, N.A. v. Lincoln Benefit Life Co., No. 17-23669-Civ-COOKE/GOODMAN (S.D. Fla. Sept. 20, 2018), the question was whether the court should apply Florida or Delaware law. As can be seen from the AEI Life decisions, the resolution of disputes over STOLI policies may come down to the state law that is found to apply.

Evan H. Krinick, managing partner of Rivkin Radler, can be reached at [email protected].