Life insurance jargon: a life insurance contract must not encourage illegality, immorality, or conduct contrary to public policy.
What this means: there are rules in place that ensure the person insured with life insurance is not worth more dead than alive.
There are three main obstacles in place to prevent encouraging illegality, immorality, or misconduct:
- Insurable Interest
- Suicide Clause
- Financial Justification
What Is Insurable Interest?
In order to own life insurance on another person, you are required to have insurable interest.
Insurable interest is a relationship between the person applying for insurance and the person whose life is to be insured. With this relationship, there must be a reasonable advantage to the applicant in the continuation of the insured’s life.
An example may help this make more sense.
John Smith and Jane Doolittle own a home together in New York. Both John and Jane benefit from one another financially since each help pay the mortgage and utlity bills. If John died, Jane would suffer financially. If Jane died, John would suffer financially. John has an insurable interest in Jane. Jane has an insurable interest in John. They both benefit more with the other person being alive.
But insurable interest wasn’t always required.
In 18th century England, it was common for newspapers of the day to print life insurance quotes on prominent people who became ill. It became a gambling sensation. People would buy policies on these people taking a chance that they could make some money if that person died. The situation became so out of control that Parliament enacted a new law: you can’t buy life insurance without insurable interest. In other words, no longer could the local baker buy a life insurance policy on a British congressman just because.
Insurable interest was put into place to prevent wagering on human lives and reduce the threat of murder.
Common types of relationships that support an insurable interest:
- Close family member
- Financial dependency
- Business partnership
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In some cases, having a blood relationship is sufficient enough for insurable interest and financial proof is not required. There are only four family relationships deemed close enough to establish this sentimental interest:
- Parent to child
- Grandparent to grandchild
- Spouse to spouse
If you don’t have a great relationship with your older brother and you are now concerned he may be able to buy a life insurance policy on you without you knowing—don’t worry—to buy life insurance on someone else you need the proposed insured’s consent. In other words, your brother would need you to give him permission to buy a policy on you which means you would be signing papers, talking with an insurance company representative on the phone, and, in most cases, getting a quick medical exam done.
» Learn more: Can I Buy Life Insurance on Someone Else?
An interesting thing of note in regards to insurable interest and life insurance, is that insurable interest only needs to be present at the starting point of the policy but is not required to be present at the insured’s death.
Here are a couple examples:
Joe Johnson bought life insurance on his wife Karen. Their spousal relationship is clear insurable interest. Ten years later, Joe and Karen divorce. Unless Joe terminates the policy or changes ownership over to Karen, when Karen dies, Joe will still receive the death benefit even though there is no longer overt insurable interest.
Susan Swanson is the sole owner of a small business and buys key person life insurance on Chris Smith, who has been the company’s leading salesperson for several years. Ten years later, Chris decides to retire due to health reasons. Susan continues to pay the life insurance premiums until Chris dies. Although Susan no longer has an insurable interest in Chris, she is still entitled to the death benefit.
Do I need insurable interest if I own my own policy?
There is no law that states you cannot name whomever you wish as your policy’s beneficiary if you own the policy yourself. The rationale is that lawmakers assume you have the mental wherewithal to not choose a beneficiary that may wish you harm.
However, in practice, insurance companies do require that beneficiaries have reasonable insurable interest at the start of the policy as a precaution against wagering, homicide, or other mortal peril. When evaluating a life insurance application, if the prospective beneficiary does not appear to have a legitimate insurable interest, the insurance company will request an explanation of the relationship. They then can decide to approve or reject the application.
Once a policy is approved and placed inforce, however, the insurance company no longer has the right to disapprove if you decide to make a beneficiary change.
Life insurance companies put these rules in place to ensure a person is not worth more dead than alive.
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What Is a Suicide Clause?
Suicide is against many religious laws and attempted suicide is often considered a penal offense, therefore, suicide is contrary to public policy.
To protect against people who might apply for life insurance with the deliberate intention of killing themselves to provide their beneficiaries with a sum of money, insurance companies implemented a suicide clause.
Definition of a suicide clause: if the insured person commits suicide, while sane or insane, within a specified period—usually two years—the insurance company would not be obligated to pay the death benefit and instead would just return the premiums paid.
What Is Financial Justification?
Life insurance companies require financial justification for large policies since life insurance is designed to replace wealth—not increase it. Again, insurance companies put these rules in place to ensure a person is not worth more dead than alive.
An insurance company takes into consideration your age, current income, net worth, and any other assets or income streams you have access to in order to determine your insurability limit. This insurability limit is the total amount of insurance that can be inforce on one person at any given time.
For example, if your insurability limit is $1,000,000 and your spouse owns a $750,000 policy on you, your sister cannot purchase another $750,000 policy on you because then the insurance on you would be over your maximum insurability limit.
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The general rule of thumb to determine insurability limits is to multiply your income by a certain number based on your age.
If you’re age 40 or younger, your life can be insured for up to 25 times your current annual income. After age 40, that multiplier gets reduced by five in increments of ten years. That means that from ages 41-50, you can get 20 times your income in coverage; ages 51-60, you can get 15 times your income; and 10 times your income until age 70.
Most people will not max out their life insurance coverage. If you’re curious as to how much life insurance you may need, try out our life insurance needs calculator.
Life insurance is meant to protect families, not cause harm. These three obstacles are put into place to ensure a life insurance policy is purchased with good intentions. You can start the process now by getting running a term quote to see how little it may cost to financially protect your family.
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