Buy-Sell Coverage, a $2 Million Bookkeeper, and an Investor Bearing Gifts
Prairie Stone Landscaping has three equal owners - Alex (38), Ben (52), and Carmen (61) - and $1.2 million in annual revenue. They want the business to own a $1 million policy on each owner to fund a buy-sell. They also want the company to buy a $2 million policy on Wendell, a 62-year-old bookkeeper who earns $58,000 and has no ownership stake, no client relationships, and no succession role. Separately, an investor approaches Alex offering to pay all premiums on a $5 million policy on Alex's life with the investor named beneficiary; Alex would be told to "assign" the policy to the investor after two years. Ben had a heart attack 14 months ago and plans to answer "no" to the heart-related application question.
1. Evaluate insurable interest for each of the three proposed policies.
Read the worked answer
Owners' policies ($1 million each). Insurable interest exists: co-owners have a pecuniary interest in one another's continued life, and the business has an interest in each owner. The weakness is amount - the face should be tied to the buy-sell valuation (what the entity or survivors must actually pay), not a round number. Insurable interest must exist at policy inception; a properly executed buy-sell agreement also determines who owns the policy, who pays premiums, and who receives proceeds.
Wendell's $2 million. An employer can insure a key employee, but the benefit must bear a reasonable relationship to the loss the business would suffer. Two million dollars - roughly 34 times salary - on a bookkeeper with no equity, no revenue responsibility, and no role the business cannot replace looks like a wagering contract dressed as key-person coverage. Expect underwriting and regulatory scrutiny, and expect a challenge at claim time.
The investor's $5 million policy. This is stranger-originated life insurance. The beneficiary must have an insurable interest at inception; a policy procured from day one with the intent to transfer it to an investor who has none is contrary to public policy and void, and anti-STOLI statutes specifically restrict financing arrangements and advertising built around later settlement. The producer must decline to write it.
2. Ben intends to answer "no" about his heart attack. What are the consequences, and what should happen instead?
Read the worked answer
A heart attack 14 months ago is plainly material to the underwriting decision, so answering "no" is a material misrepresentation on the application.
If the insurer finds out before the contestable period ends (typically two years from issue): it can rescind the contract, refund premiums, and deny any claim; the insurer may also pursue fraud remedies, and both Ben and any producer who coached the answer face exposure under state insurance fraud law.
After the contestable period: statutory incontestability generally bars the insurer from using a misstatement to deny a claim, but that is a legal shield, not a plan. The policy still fails for nonpayment, lack of insurable interest, or fraud in jurisdictions that carve out fraud, and the family can spend years in litigation over a death benefit they assumed was safe.
Instead: disclose the history and let underwriting work. Realistic outcomes include a rated (substandard) offer, a postponement until treatment history matures, or a graded-benefit product - all preferable to a contested claim. The producer's job is to submit the truth and manage expectations, not to help the client beat the question.
3. Before any application is signed, what structural decision should the agent push the owners to make, and why does it matter to the insurance?
Read the worked answer
They must choose and document the buy-sell structure: entity-purchase (redemption) or cross-purchase - and that choice drives the insurance.
- Entity purchase: the business owns and is beneficiary of each policy; premiums are generally not deductible; on death, the entity pays the deceased owner's estate and the surviving owners get no basis step-up. Fewer policies, but the surviving owners' cost basis does not increase.
- Cross-purchase: each owner owns policies on the others; more policies as the number of owners grows, but survivors receive a step-up in basis in the acquired interest.
Either way the agreement should set the valuation method, the funding obligation, and an exit mechanism. Without a written agreement, the "insurable interest" the agent is relying on is informal, and the amount of coverage has no anchor other than a guess.