Buy-Sell Funding, Insurable Interest, and a Stranger With a Check
Dev and Marcus own a 50/50 HVAC company worth roughly $2 million. Their buy-sell agreement says that on a death the survivor buys the decedent's shares at fair market value, but neither has funded the agreement. Dev, 54, has a $500,000 personal term policy with his wife as beneficiary, and he wants to change the beneficiary to the company and declare the buy-sell 'funded.' Separately, a life-settlement broker offers Dev $70,000 to buy that term policy and promises he can 'keep the coverage' through a trust that will pay future premiums. The term is convertible. Dev was diagnosed with early-stage kidney disease after the policy was issued. Marcus supports anything that 'gets the deal done cheaply.'
1. Does the company have an insurable interest in Dev's life, and when must that interest exist?
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Yes, but the analysis turns on timing and on the relationship, not on affection.
- Insurable interest is generally required at the time the contract is made, not at death. A business entity has an insurable interest in a key person or co-owner whose death would cause the business measurable economic loss, and co-owners have insurable interest in one another under a buy-sell obligation.
- Dev's personal term policy was issued when he was a healthy individual insuring his own life. His own life is always an insurable interest, so the policy is valid.
- The problem is not validity; it is ownership and beneficiary designation. Naming the company as beneficiary of a policy Dev owns does not create a properly funded buy-sell. The company has no ownership rights, no control over premium payments, and no ability to force the policy to stay in force. If Dev later changes the beneficiary, the funding evaporates. If Dev dies, the proceeds are includable in his estate because he holds incidents of ownership, and they may be exposed to his creditors.
Correct structure: either the company (entity-purchase) or each partner (cross-purchase) applies for and owns a policy on the other's life, in an amount matched to the agreement's valuation formula, with the buy-sell obligating the survivor to buy and the estate to sell.
2. Analyze the life-settlement broker's proposal. What is it, and why should Dev refuse?
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What it is: a stranger-originated life insurance (STOLI) arrangement disguised as a settlement. The investor is paying Dev $70,000, will become the beneficial owner through a trust, and will pay premiums it funds itself. The investor has no insurable interest in Dev's life; its only 'interest' is a wager on his death.
Why it fails:
- Insurable interest must exist at inception of the arrangement. A policy procured or effectively procured by an investor for its own benefit is a wagering contract and is void or voidable in most states; anti-STOLI statutes also impose penalties and rescission.
- Convertibility makes it worse: the investor will convert the term to permanent coverage it can hold for decades.
- Dev's post-issue kidney disease diagnosis is material to the economics. If the policy is later challenged for misrepresentation in the original application or in the settlement process, the death benefit can be contested, and Dev's family could be left with nothing and a rescission fight.
- Tax and disclosure consequences: the $70,000 is taxable, and Dev may lose the ability to obtain new coverage on his own life at a reasonable price.
Judgment point: The broker's promise that Dev can 'keep the coverage' is not possible. Once the trust owns and pays for the policy, the investor controls it. Dev should decline, and the producer should document the conversation.
3. Marcus asks why they cannot just 'use the policy Dev already has and save the underwriting.' How would you respond, and what happens if the partnership later dissolves?
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Why the existing personal policy cannot be the funding vehicle:
- It is owned by Dev and payable to his wife. Re-designating the company as beneficiary does not give the company control, and it creates a conflict between Dev's estate plan and the business obligation.
- $500,000 is a personal amount chosen for family needs, not the $1 million buy-sell obligation implied by a $2 million company split 50/50. The face amount must be matched to the valuation formula, or the survivor will not have the cash to perform.
- There is no underwriting shortcut worth taking: a properly owned policy on each partner at the right face amount is the only structure that survives a beneficiary change, a divorce, or a creditor claim.
If the partnership dissolves:
- The buy-sell should specify what happens to the policies: typically each owner may purchase the policy on his own life for its interpolated terminal reserve plus unearned premium, or the policies are surrendered and the proceeds split per the agreement.
- Without that clause, the parties can end up owning policies on the lives of people they no longer do business with, which is an insurable-interest problem waiting to be litigated.
Documentation: the buy-sell must be signed, funded with correctly owned and correctly sized policies, and reviewed whenever ownership, valuation, or health changes.