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Third-party ownership of life insurance

Lesson 24 of 93 · All lessons · Up next: Life settlements →

Third-Party Ownership of Life Insurance

Every life insurance policy involves three roles, and they do not have to be filled by the same person:

  • The policyowner holds all of the contractual rights and duties: paying premiums, naming and changing the beneficiary, assigning or surrendering the contract, borrowing against cash value, and selecting settlement options.
  • The insured is the person whose death triggers payment of the death benefit. The insured must consent to the coverage and is the subject of underwriting, but holds no policy rights unless he or she is also the owner.
  • The beneficiary receives the proceeds when the insured dies.

When the owner and the insured are the same person, the arrangement is often called first-party or insured-owned coverage. Third-party ownership exists whenever someone other than the insured owns a policy on that insured's life.

A diagram titled Third-Party Ownership of Life Insurance. Four boxes form a triangle with the insurance company in the middle. At the top left, a blue box labeled POLICYOWNER, described as a third party such as an employer, trust, spouse, or business co-owner. At the top right, a green box labeled INSURED, described as the life covered, who consents and is underwritten but holds no policy rights. In the center, a white box labeled INSURER, which takes direction only from the owner. At the bottom center, an orange box labeled BENEFICIARY, named by the owner. An arrow runs from the policyowner down and across to the insurer, labeled pays premiums and holds all rights. Another arrow runs from the insured down and across to the insurer, labeled consent plus evidence of insurability. A vertical arrow runs from the insurer down to the beneficiary, labeled death benefit, generally income-tax-free. A dashed curved arrow runs from the policyowner around the left side to the beneficiary, labeled names and changes beneficiary, showing that the owner, not the insured, controls the beneficiary designation. A gray box at the lower right lists two guardrails: first, insurable interest must exist at application; second, a transfer for value can make proceeds taxable.
In third-party ownership, the owner controls the contract, the insured only consents and is underwritten, and the insurer pays the owner-designated beneficiary.

Why arrange ownership this way

Third-party ownership is normal, not exotic. Common examples include:

  • Key person insurance — the employer applies for, owns, pays for, and is the beneficiary of a policy on a valuable employee.
  • Buy-sell funding — in a cross-purchase plan each business owner owns a policy on the other owners; in an entity plan the business owns the policies.
  • Trust ownership — a trust owns the policy so that the insured personally holds none of the ownership rights, a central technique in estate planning.
  • Family situations — a parent or grandparent owning coverage on a minor child, one spouse owning coverage on the other, or a divorce decree requiring that coverage on a former spouse be owned by the parent raising the children.

Insurable interest and consent

A third party cannot simply insure a stranger. Under the Texas Insurance Code provisions governing life insurance, the applicant must have an insurable interest in the insured — a close family relationship, or a lawful economic interest such as that of an employer, business partner, or creditor. Insurable interest must exist when the policy is applied for, not at the time of death; without it the contract is an unenforceable wager. The insured's consent is also required when another person applies for coverage on his or her life.

Rights follow the owner

The insurer takes direction only from the owner. The insured cannot change the beneficiary, take a loan, or surrender a policy he or she does not own. An owner may transfer ownership by absolute assignment, and many contracts allow a contingent owner to be named in case the original owner dies first.

Tax consequences

  • Death proceeds paid because of the insured's death are generally excluded from the beneficiary's gross income under federal tax law.
  • The transfer-for-value rule limits that exclusion when a policy is transferred for valuable consideration: only the consideration paid plus premiums paid afterward escape tax, and the excess is taxable income. Recognized exceptions include transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, to a corporation in which the insured is a shareholder or officer, and transfers where the transferee's basis carries over from the transferor.
  • Premiums a third-party owner pays are generally not deductible.

Exam tip: the insured's signature is needed to apply; the owner's signature is needed to change anything.

Key terms

Sample questions

Third-party ownership of a life insurance policy exists whenever:

  • Someone other than the insured owns a policy on that insured's life
  • The named beneficiary is a different person from the insured
  • More than one beneficiary shares the death proceeds
  • The insured names a contingent beneficiary in addition to a primary beneficiary
Reveal answer

Correct answer: Someone other than the insured owns a policy on that insured's life

Third-party ownership is defined by who holds the ownership rights, not by who receives the money. When the policyowner is anyone other than the insured — an employer, a business partner, a trust, a parent, a spouse — the arrangement is third-party ownership. When owner and insured are the same person, the coverage is first-party or insured-owned.

An employer applied for, owns, and pays premiums on a key person policy insuring Maria, its chief engineer, with the employer as beneficiary. Maria writes to the insurer asking that her husband be named beneficiary instead. How should the insurer respond?

  • Make the change, because the insured's wishes control the death benefit
  • Make the change only if Maria's husband also signs the request
  • Decline, because naming and changing the beneficiary is an ownership right that belongs to the employer
  • Decline, because a beneficiary designation may never be changed once the policy is issued
Reveal answer

Correct answer: Decline, because naming and changing the beneficiary is an ownership right that belongs to the employer

The insurer takes direction only from the policyowner. Naming and changing the beneficiary is one of the ownership rights, along with paying premiums, borrowing against cash value, assigning, and surrendering. Maria is the insured, and an insured who is not the owner holds no policy rights. Only the employer may request the change.

Under the Texas Insurance Code provisions governing life insurance, when must a third-party applicant's insurable interest in the insured exist?

  • At the time the policy is applied for
  • At the moment of the insured's death
  • Continuously from application until the insured's death
  • Only when the applicant is a creditor of the insured
Reveal answer

Correct answer: At the time the policy is applied for

Insurable interest must be present when the policy is applied for. It is not required to survive until the insured's death — a policy is not voided merely because the relationship later ends, for example when an employee leaves or a marriage ends. Without insurable interest at application, the contract is an unenforceable wager on a human life.

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