Third-party ownership of life insurance

Three roles, not necessarily three people

Every life insurance contract has three roles. The insured is the person whose life is covered — the death that triggers the claim. The owner (often called the applicant or policyowner) is the party who applies for the contract, pays the premium, and holds the legal rights in it. The beneficiary is whoever receives the death benefit.

In the simplest case one person fills two of those roles: you buy a policy on your own life and name your spouse as beneficiary. You are both insured and owner. Third-party ownership is the case where the owner is someone other than the insured — a parent owning a policy on a child, a spouse owning a policy on the other spouse, a business owning a policy on a key employee, a trust owning a policy on the person who created it, or a creditor owning coverage on a borrower.

Florida's Insurance Code states the principle plainly: the word insured is not to be read as preventing a person other than the insured, with a proper insurable interest, from applying for and owning a policy on the insured and being entitled to its benefits and rights (Fla. Stat. 627.631, which sits in the health-insurance part; the same idea governs life insurance through the insurable-interest rules below).

What the owner actually holds

The owner holds the incidents of ownership — the bundle of contract rights. In the standard treatment these are the rights to:

• name and change the beneficiary;
• assign the policy, absolutely or as collateral;
• borrow against or withdraw the cash value;
• surrender the policy for its cash value;
• elect nonforfeiture options and dividend options;
• convert or exchange the policy where the contract allows.

The insured, when not the owner, holds none of these. The insured cannot change the beneficiary, cannot cash the policy in, and cannot stop the owner from doing either. That is why the insured's consent matters so much at the front end.

Florida's group-life provisions confirm that these incidents are transferable: a person insured under a group life policy may assign all or any part of his or her incidents of ownership, including the conversion privilege and the right to name a beneficiary (Fla. Stat. 627.571).

The gatekeeper: insurable interest

Third-party ownership is only allowed when the owner has an insurable interest in the insured's life. Under Fla. Stat. 627.404(1), any individual of legal capacity may insure his or her own life for the benefit of anyone. But nobody may procure insurance on the life of another person unless the benefits are payable to the insured or the insured's personal representatives, or to a person who had an insurable interest in the insured at the time the contract was made. That interest need not exist after the inception date — a divorced spouse who bought the policy while married may keep it.

Fla. Stat. 627.404(2)(b) lists the interests Florida recognises for life insurance:

• an individual's interest in his or her own life;
• a person closely related by blood or by law, with a substantial interest engendered

by love and affection;

• a person with an expectation of substantial pecuniary advantage from the insured's

continued life and substantial loss from the insured's death;

• each party to a contract to buy or sell an interest in a business entity, in the

other parties' lives, for the purpose of that contract only;

• a trust or trustee, in the life of the grantor or a person the grantor has an

insurable interest in, so long as the proceeds are primarily for trust beneficiaries who themselves have an insurable interest;

• a guardian, trustee, or other fiduciary, in the life of anyone for whose benefit it

holds property;

• a 501(c)(3) charitable organization, in the life of anyone who consents in writing

to the charity owning the policy;

• a trustee, sponsor, or custodian of a retirement or employee benefit plan, in the

life of any plan participant who consents in writing — and no retaliation is allowed against a participant who declines;

• a business entity, in the lives of its owners, directors, officers, partners,

managers, and key employees or key persons, if written consent is obtained before the insurance is purchased — again with no retaliation against anyone who refuses.

Notice the pattern in the last three: where the owner is an institution rather than a relative, Florida requires the insured's written consent. In practice the insured signs the application in every third-party case, and the insurer is entitled to rely on the applicant's statements about insurable interest (Fla. Stat. 627.404(3)).

Common third-party arrangements

• Family. A parent owns a policy on a minor child; a spouse owns a policy on the

other spouse. Blood or legal relationship plus affection supplies the interest.

• Business. Key person insurance — the business is owner, premium payer, and

beneficiary on an employee whose loss would hurt it financially. Buy-sell funding — in a cross-purchase plan each owner owns a policy on each of the others.

• Creditor. Credit life insurance is insurance on the life of a debtor in connection

with a specific loan, written in favour of a creditor (Fla. Stat. 627.677(1)).

• Trust. An irrevocable life insurance trust (ILIT) owns the policy so the proceeds

stay out of the insured's taxable estate. The trustee, not the insured, holds every incident of ownership.

• Charity. A donor consents in writing and the charity owns and is beneficiary of a

policy on the donor's life.

Two traps to watch

Ownership passes with the owner, not the insured. If a third-party owner dies before the insured, the policy is an asset of the owner's estate unless a contingent owner was named. Producers should name one whenever the owner and insured differ.

Three different people means a gift. When the owner, insured, and beneficiary are all different parties, the death benefit is treated as a gift from the owner to the beneficiary — the so-called Goodman triangle. Keeping the beneficiary the same as the owner, or the owner the same as the insured, avoids it.

Finally, remember the difference between changing the owner and changing the beneficiary. An absolute assignment transfers all incidents of ownership to a new owner permanently. A collateral assignment pledges the policy as loan security and gives the lender only a limited, temporary interest in the proceeds. Naming a new beneficiary changes who is paid at death, but leaves ownership exactly where it was.