Life insurance is unique among financial instruments because it is predicated on a specific relationship between the owner and the insured. Unlike a stock or a bond, which can be bought by anyone, a life insurance policy requires the existence of an **Insurable Interest** at inception. This doctrine, established in the 18th century to prevent gambling on human lives, remains the primary legal weapon insurance carriers use to deny multimillion-dollar claims today. The rise of **Stranger-Originated Life Insurance (STOLI)** schemes has led to a wave of litigation where carriers argue that policies owned by investors or poorly structured trusts are “void ab initio” (void from the start). For trustees and estate planners, failing to prove a valid insurable interest is not just a compliance error; it creates a “phantom asset” that looks valuable on paper but is worthless in court.

I. The Foundation: The Insurable Interest Doctrine

The legal concept dates back to the **Gambling Act of 1774** in England, which sought to stop the practice of “wagers” on the lives of public figures.

The Definition: To purchase a life insurance policy, the applicant must have a reasonable expectation of benefit or advantage from the *continued life* of the insured, or an expectation of loss from their death.

The Critical Timing Rule: Unlike property insurance (where interest must exist at the time of loss), for life insurance, insurable interest must exist **only at the moment of inception** (when the policy is issued). If the interest exists at the start, the policy remains valid even if the relationship later ends (e.g., divorce or termination of employment).

Valid Categories of Interest

• **Blood/Affection:** Spouses, parents, and children generally have an automatic unlimited insurable interest in each other.
• **Economic/Creditor:** A business partner, employer (Key Person), or creditor has an interest up to the amount of the financial risk.
• **Trusts (ILITs):** A trust has an insurable interest only if the *beneficiaries* of the trust have an insurable interest in the insured.

II. The STOLI Scheme (Stranger-Originated Life Insurance)

STOLI refers to a practice where investors induce seniors to take out life insurance policies with the predetermined intent to transfer ownership to the investors.

The Mechanism:

1. **The Inducement:** An agent approaches a wealthy senior (age 70-85) offering “free insurance” or an upfront cash payment.

2. **Non-Recourse Financing:** An investor lends the senior money to pay the premiums for the first two years. The loan is “non-recourse,” secured only by the policy.

3. **The Transfer:** Once the two-year contestability period expires, the senior “chooses” not to repay the loan. The lender forecloses on the policy, becoming the owner and beneficiary.

4. **The Payoff:** The investor pays future premiums and collects the death benefit when the senior dies.

The Legal Violation: Courts view this transaction as a sham. The senior is merely a “conduit” or a straw man used by the investor to gamble on the senior’s life. Since the investor (a stranger) had no insurable interest at inception, the policy is effectively a wager.

III. The “Void Ab Initio” Nightmare

The legal consequence of a STOLI determination is catastrophic. Unlike a policy cancelled for non-payment (which can be reinstated), a STOLI policy is declared **void ab initio**.

1. Retroactive Nullification

This means the contract never legally existed. It is a nullity from day one.

The Consequence: The carrier does not have to pay the death benefit, no matter how many millions of dollars in premiums were paid over the years.

2. The “Retained Premium” Trap (The Delaware Rule)

In many jurisdictions (like New York), if a policy is voided, the carrier must refund the premiums paid. However, in **Delaware** (where many high-end trusts and STOLI schemes are domiciled), the landmark case *PHL Variable Insurance Co. v. Price Dawe* established a stricter standard.

If the carrier can prove the applicant committed **fraud** (e.g., lying on the application about the intent to sell), the carrier may be allowed to void the policy *and* **keep the premiums** as damages. The investor loses everything—the death benefit and the capital investment.

IV. The Two-Year Contestability Myth

A dangerous misconception among trustees is that “after two years, the policy is incontestable.”

Standard Rule: Most policies have a 2-year contestability clause. After 2 years, the carrier cannot deny a claim due to misstatements about health (e.g., failing to disclose smoking).

The STOLI Exception: Courts have increasingly ruled that **lack of insurable interest cannot be waived**. A contract that is void as against public policy (a wager) is void forever. The 2-year clock never runs out on a STOLI claim. A carrier can challenge the validity of a policy 10 years after issuance, or even after the death of the insured.

V. Estate Planning Risks: The “Wet Ink” Trust

Legitimate estate planning can sometimes accidentally mimic the appearance of STOLI, inviting litigation.

1. The “Chawla” Warning

In the case *Chawla v. Transamerica*, a court initially ruled that a trust did not have an insurable interest in the insured because the trust document allowed the insured to sell the policy. While overturned on other grounds, it sent shockwaves through the industry.

Risk Factor: Creating an ILIT and immediately discussing the sale of the policy, or having a third party pay the premiums directly, can look like a “straw man” arrangement.

2. Third-Party Premium Payments

If the premiums for a grandmother’s policy are paid directly by a non-family LLC or a hedge fund, the carrier’s algorithms will flag this as potential STOLI.

Fiduciary Defense: Trustees must ensure a clear paper trail of “donative intent.” The premiums should ideally come from the grantor’s funds (gifted to the trust), and the trust should have distinct beneficiaries (children/grandchildren) with a genuine interest in the grantor’s longevity.

VI. Protecting the Portfolio: Fiduciary Best Practices

For trustees managing large policies, defensive documentation is essential.

1. Establish Intent at Inception

The “state of mind” at the moment of application is the