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Pitfalls in Using Life and Disability Insurance Products

Text of speech made at the June 24, 2003 meeting of the Professional Planners Forum, Ltd. in New York City.

This talk had its genesis in a rather long morning Danny* and I spent in the Supreme Court building in Mineola waiting for a settlement conference. The calendar was long and I had to keep Danny entertained with the war stories of a litigator so he would not fall asleep and embarrass our client. Not too long ago, Danny recalled that day to me when he asked me to come here and speak to this group. But what to talk about? I am a litigator. I do not do any estate or pension planning. My job is to either tear apart or support what you have created.

Knowing that you all use individual life and disability products in your plans and knowing that there are common misconceptions even among professionals in this area, I thought that I could add something to your knowledge in alerting you to the pitfalls in utilizing these products in your planning as they arise after the fact in litigation.

When your client dies and a claim for the life insurance policy proceeds is filed within two years of the issuance of the policy, the carrier will nearly always do a post-death investigation to see if there is a basis on which to rescind the policy. Contrary to what was said at the last meeting by one member of this group, the carrier is not required to prove fraud to prevail and it is not rare that it succeeds in rescinding the life policy. In my experience, if the carrier seeks to contest, it will usually win.

All that the N.Y. Insurance Law requires is that there be a material misrepresentation in the application. Even an innocent misrepresentation will do and the common position taken by the insured that I told the broker or agent the truth but he failed to write it down will not excuse the misrepresentation.

The test for what is material is stated in section 3105 the N.Y. Insurance Law and it says:

"No misrepresentation shall be deemed material unless knowledge by the insurer of the facts misrepresented would have led to a refusal by the insurer to make such contract."

Some of you may have read earlier this month that Harvey Brown, who was being investigated by the Suffolk County District Attorney for murdering his parents committed suicide. Well, SML had insured his father Haywood Brown on a non-smoker's key man life policy owned by his employer. When SML rescinded for a smoking misrepresentation, his lawyer yelled at me, how can you claim that the misrepresentation about smoking was material, when he was murdered. The legal point is that the misrepresentation goes to the underwriting of the policy not to the cause of death.

What does "such contract" in section 3105 mean? Before 1988, the answer was not clear. About half of the carriers took the position that "such contract" meant the policy applied for, meaning that if the policy applied for was a standard non-smoking policy, the fact that the carrier would be willing to issue the same policy but on a rated or non-discounted basis was irrelevant. The other half of the carriers took the opposite position. They said that "such contract" meant the same policy, regardless of the premium and to do equity, they would reform the policy and pay as much death benefit as the premium paid would buy at the correct rate.

The issue was finally settled by the Second Circuit in JMR Electronics v. Mutual Benefit Life. MBL belonged to the first school of thought and wanted to use a misrepresentation as to smoking history as the test case. At that time there was a 38% differential in premium if you were a smoker. We were easily able to prove that the applicant was a smoker and the argument in the case quickly became what to do about the misrepresentation. The policyholder argued that since recission was an equitable remedy, the Court should do equity by reforming, not rescinding, the policy and simply reduce the face amount to the amount the insured would have been able to buy at the smoker's rate.

We argued that this was a "heads, I win, tails, you lose" kind of argument, which created no incentive on the part of the insured to tell the truth on his application because he would never get less coverage than the correct premium would have purchased and therefore would encourage lying. To protect itself, we argued that the insurer would have to consider every applicant to be a smoker and charge the smoker's rate to everyone, surely not a desirable result.

The lower court and the U.S. Court of Appeals easily sided with the carrier and in the course of resolving the case, decided three important issues:

    1. A misrepresentation as to smoking is material and will justify recission of coverage.
    2. "Such contract" carries with it the concept of premium, so that the same policy at a higher premium is not "such contract," which meant that any misrepresentation which affected premium, not merely rejection in the underwriting process, was material, and
    3. The Court will not reform any policy obtained by misrepresentation.

The situation as to disability insurance is different in that the statute allows the carrier to issue a policy which permits it to establish a recission case after two years, if it can show that the misrepresentation was fraudulent on the part of the applicant, which brings in the question of intent on the part of the applicant. Also, the concept of materiality can be broader, such as misstating one's occupation to avoid a prohibited occupation (e.g. race car drivers), overstating one's annual income or understating other disability coverage (every carrier has tables limiting the amount of coverage it will write from a financial point of view).

So the lesson is this, if you are going to use life or disability products as part of an estate plan, make sure that the application is truthful and complete. If you are going to fill out the application instead of the insured, make sure you record everything the applicant says. Nothing is too minor and get the insured to sign a letter to you saying that the application as completed and signed is truthful and complete and that you recorded everything as he or she told it to you to avoid being sued for malpractice, when the policy is ultimately rescinded.

Disability insurance raises some other issues that will not show up until the time of the claim which can be troublesome. Whenever, you are writing disability insurance on a professional, you should tell the applicant that the coverage will not apply if his or her license to practice his profession had been suspended or revoked at the time of disability. Disability insurance covers factual disability, not legal disability. The situation becomes difficult when the source of the legal disability is not say, Medicaid fraud, but alcoholism, drugs or mental illness. E.g., a lawyer gets disbarred because he stole trust funds to buy drugs; or an anesthetist becomes addicted to fentanil and gets suspended.

Here, there are no bright line answers. By and large, if the illness follows the suspension, there will be coverage; if it precedes the suspension, there will not be coverage and if they are simultaneous or nearly simultaneous, it will depend on how seriously the Court views the infraction leading to the suspension.

There was one actual case some years ago where a dentist who lost his license for fondling his patients under anesthesia, claimed that he had been instructed to touch his patients by "astral beings" and therefore was disabled by reason of mental illness. He lost his coverage case. Being clever in how you word the claim is not going to carry the day.

Another difficult area for professionals claiming disability is the issue of dual occupation. Now our theoretical dentist becomes too successful and hires other dentists to work in his three offices and he no longer treats patients as often. He then gets sick or injured with the result that he can no longer treat patients at all. Is he disabled? Absent a specialty letter, it is going to be a fact question as to whether he spends more of his time managing or treating. If managing, he loses. Now, here is one for you to ponder while I eat dinner. Suppose he spends 60% of his time treating patients, which accounts for 20% of his income and 40% of his time managing his offices from which he earns 80% of his income. Is he disabled? Does it make sense to define his occupation in terms of his least profitable activity? We do not have the answer to that question yet.

Is a specialty letter a good thing to have? The conventional wisdom is that it is because the carrier will not be able to argue that the dentist can still consult or teach. However, if the dentist changes his occupation and he becomes injured or ill in a way so as to be able to carry on his former occupation, but not his new one, the specialty letter is going to operate to defeat coverage.

Finally, as much as we would like to believe that justice is a blindfolded lady holding scales, the simple truth is that sometimes the blindfold slips a bit when the plaintiff or the defendant is famous. In other words, who you are can count in the result and this principle is not limited to insurance litigation.

So where does this leave you. Always realize that individual life and disability products are subject to recission in the event of a misrepresentation that will affect either rejection or premium, that great care needs to go into providing a complete and truthful application and that professionals should be cautioned as to how they lose their benefits through loss of license or too much success.

*The name "Danny" is used to protect the anonymity of the individual.