What is Insurable Interest?

Insurable interest is one of those insurance terms that agents and companies throw around to consumers who typically don’t have a clue what it means.

Why agents don’t immediately provide the meaning of insurable interest when they use it in a conversation with a client is bewildering when you know the next question will be: “What is insurable interest?”

In an attempt to educate our clients and prospective clients, we’re going to spend a little time discussing insurable interest and how it applies in the world of life insurance and other types of insurance.

What is Insurable Interest and How Does it Apply to Me?

Let’s get the definition out of the way first. Wikipedia offers a very good definition of insurable interest in one paragraph:

Insurable interest exists when an insured person derives a financial or other kind of benefit from the continuous existence, without repairment or damage, of the insured object (or in the case of a person, their continued survival). A person has an insurable interest in something when loss of or damage to that thing would cause the person to suffer a financial or other kind of loss. Normally, insurable interest is established by ownership, possession, or direct relationship. For example, people have insurable interests in their own homes and vehicles, but not in their neighbors’ homes and vehicles, and almost certainly not those of strangers.

I do think it’s appropriate, however, to insert the words “or entity” after the word “person” in the first line of the definition. Entities cannot insure a life or property they do not have an insurable interest in either.

Why is Insurance Interest Important?

The concept of insurable interest dates back to the mid-1700s when the Marine Insurance Act of 1745  and the Life Assurance Act of 1774 were passed. The purpose was to prevent people or entities from gambling on a person’s life ending or property being lost or damaged.

In those days, people would insure other people or property that were high-risk and had a high probability of loss so they could collect on the insurance policies they purchased on the person or property. Going forward, we’ll focus on how insurable interest applies to life insurance.

How Insurable Interest Applies to Life Insurance

At its base, insurable interest protects a person from having another person gamble on their death. For example, Joe knows that his neighbor Fred drinks a lot and abuses drugs frequently. He also knows that Fred frequently drives under the influence and has been hospitalized multiple times in the last five years after overdosing on pain meds.

Knowing that Fred is not long for this world, Joe takes out a “guaranteed issue” life insurance policy on Fred without Fred’s knowledge and makes himself (Joe) the beneficiary of the policy. Joe is gambling that Fred will die soon, and the insurance company will automatically send the death benefit to him.

Since Joe has no insurable interest in Fred’s life, in other words, Joe would not suffer a loss when Fred dies, the life insurance company would void the policy, and the money Joe paid for the life insurance would be returned.

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Who qualifies for Insurable Interest in a Life Insurance Policy?

There are three categories that are used to determine insurable interest in a life insurance policy:

The beneficiary on the policy must be related to the insured person by blood, marriage, or adoption, or they must be financially dependent on the insured person. This will typically include spouses, children, blood relatives, or any person that depends on the income of the insured to get by.

Insurable interest also applies to business relationships. An employer can insure the lives of key personnel because their interest is that they would suffer financially if a key person or a partner in the business died unexpectedly. Often, banks will require small business owners and partners to purchase life insurance to cover a loan made to the business by the bank (consent of the insured person(s) is required.

Creditors are allowed to take out a life insurance policy on their borrowers for the amount of the debt (how their interest appears) as long as the insured (the debtor) gives consent.

There are a couple of exceptions to the insurable interest requirement in life insurance:

Viatical Settlement initiated by a viator. A Viatical settlement is when a person with a chronic or terminal illness sells their life insurance policy to a third party for an amount that is less than the death benefit. The insured person gets cash up-front, and the Viatical company gets the death benefit upon the death of the insured person, and the difference is considered profit to the Viator.

Charitable Donations – An insured person can name a legitimate charitable organization as a beneficiary on their life insurance problem even when no insurable interest exists. Many people want to leave a financial legacy to their church or other charitable organization upon their death.

Stranger Originated Life Insurance (STOLI)

Even though insurance companies pay close attention to a beneficiary’s insurance interest in the insured person listed on a life insurance policy, there are still life insurance claims denied each year by insurance companies. In fact, it happens frequently enough that an acronym was assigned: STOLI.

In these cases, a person unknown to another person originates a life insurance policy on that person solely for the purpose of resale to another party. We know this because more than 150 lawsuits were filed between 2005 and 2010 as a result of STOLI. Some cases were filed by relatives and family members of the insured person, and others were filed by insurance companies.

Many of the cases hinge on when the STOLI was discovered and how the incontestability laws would apply. Even though insurable interest must be proven before the policy is issued, there are many law firms out there that take these cases on in an attempt to get these claims paid by the company or at least recover the premiums paid to the insurance company.