Insurable interest is required when buying life insurance on someone else. Insurable interest means the policy owner will face financial hardship if the insured person dies.
Insurable interest ensures that life insurance is used for its intended purpose of providing financial protection for loved ones. In this article, you’ll learn who has insurable interest and how it’s determined.
What Is Insurable Interest?
If the loss of a specific person or asset can create financial hardship for you, you have an insurable interest in that person or asset.
As far as life insurance goes:
- Insurable interest is a relationship between the person applying for insurance and the person whose life is to be insured.
- The person applying for life insurance on someone else must have a financial interest in the continued well-being of the insured person.
John Smith and Jane Doolittle co-own a home in New York, and both contribute towards the mortgage and utility bills. If either John or Jane was to pass away, the surviving partner would face financial difficulties due to the loss of their joint income.
Therefore, John and Jane both benefit from the other person being alive. They each have insurable interest in the other.
Learn more about what it means to be the owner of a life insurance policy.
When Must Insurable Interest Exist?
To buy life insurance, 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.
Consider the examples below.
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.
Why Insurable Interest Matters
In the past, insurable interest wasn’t always required for buying life insurance on someone.
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, the local baker couldn’t buy life insurance on a British congressperson for no reason.
Insurance companies want to ensure there are no incentives to harm someone. Insurance companies can reduce any moral hazard by requiring insurable interest, the insured’s consent, and applying risk analysis.
Definition of moral hazard: When someone with an insurance policy is incentivized to cause loss or damage to collect on the insurance. Moral hazards can create problems by encouraging people and institutions to engage in behavior that ultimately harms themselves and others.
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How Is Insurable Interest Determined?
Before the insurance company approves life insurance coverage, they will do their due diligence to verify insurable interest. They may require a phone interview with the proposed insured or ask for documentation to prove insurable interest.
Examples of insurable interest documentation may include:
- Proof of financial dependence: If the policy owner is financially dependent on the insured individual, the life insurance company may require documentation such as tax returns, bank statements, or other financial records to establish the extent of the dependence.
- Business partnership agreement: If the policy owner is a business partner of the insured individual, the life insurance company may require a copy of the partnership agreement to establish the nature of the business relationship.
- Loan documents: If the policy owner has loaned money to the insured individual, the life insurance company may require loan documents to establish the financial relationship between the parties.
- Court order: If the policy owner has been awarded custody of a minor child, the life insurance company may require a copy of the court order to establish the policyholder’s legal obligation to provide for the child’s well-being.
Insurance companies also consider your human life value when approving coverage. This ensures that beneficiaries receive a death benefit that aligns with the financial benefits the insured person once provided. Essentially, they don’t want you to be worth more dead than alive.
Calculating human life value can be different from person to person and vary from insurer to insurer. In general, they look at how much income you make annually, how many years you have left until retirement, and your expected income growth rate based on inflation and cost-of-living adjustments.
Wondering about your life insurance limits? Find out how much life insurance you can get.
Insurable Interest Examples
Insurable interest is required for many insurance products, not just life insurance. To buy insurance, the policy owner must have a legitimate interest in preserving the insured object or the insured person’s life. These are some examples of insurable interest in different insurance contexts.
In some cases, having a blood relationship is sufficient for insurable interest, and financial proof is not required. Four family relationships qualify as sentimental interest:
- Parent to child
- Grandparent to grandchild
- Spouse to spouse
If your relationship with your older brother is strained and you’re concerned he may try to buy a life insurance policy on you without you knowing, don’t worry, it’s not possible. To buy life insurance on someone else you need the proposed insured’s consent.
In other words, your brother would need you to permit him to buy a policy on you. You’d be signing papers, talking with an insurance company representative on the phone, and, in most cases, getting a quick medical exam.
Examples of life insurance non-sentimental insurable interest:
- Business partners: Business partners have an insurable interest in each other’s lives, as the death of one partner could negatively impact the business’s financial stability.
- Key employees: A business owner may have an insurable interest in the life of a key employee whose death could significantly impact the company’s operations and financial health.
- Co-signed loan borrowers: If two individuals co-sign a loan, they both have an insurable interest in each other’s lives. The death of one borrower could leave the surviving borrower responsible for the full loan amount, causing financial strain.
- Caregivers: If an individual relies on another person for caregiving or support, they may have an insurable interest in the caregiver’s life. The caregiver’s death could lead to increased expenses related to hiring a professional caregiver or adjusting the individual’s living arrangements.
These are just a few examples of when insurable interest is used to buy life insurance on someone else. You always need the other person’s consent and participation in the application process, except parents buying life insurance on their minor child.
Insurable interest is needed in other forms of insurance as well.
- Homeowners: Homeowners have an insurable interest in their homes, as damage or destruction of the property could result in significant financial loss.
- Mortgage lenders: Mortgage lenders have an insurable interest in the properties they finance, as the borrower’s default or damage to the property could lead to financial losses.
- Landlords: Landlords have an insurable interest in their rental properties, as damage or destruction of the property could negatively affect their income and investment.
- Vehicle owners: Vehicle owners have an insurable interest in their cars, as damage or loss of the vehicle could lead to financial hardship.
- Auto loan lenders: Lenders who finance auto loans have an insurable interest in the vehicles they finance, as damage or loss of the vehicle could result in financial losses. It’s why many lenders require borrowers to purchase comprehensive and collision coverage as part of their auto insurance policy.
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Insurable interest is a fundamental principle in insurance. This requirement is in place for several reasons:
- Prevents gambling and speculation: Insurable interest ensures that insurance policies provide financial protection against genuine risks and losses rather than being used for speculative purposes or as a form of gambling.
- Aligns interests: Requiring insurable interest ensures that the policy owner and the insured share a common interest in preserving the insured property or life. This alignment of interests discourages fraudulent behavior and reduces moral hazards.
- Facilitates indemnification: In basic terms, insurable interest ensures that the person buying insurance cares about what or who they are insuring. It helps guarantee that, if a loss occurs, the money received is in line with the actual financial loss and not a profit.
- Legal requirement: In many jurisdictions, insurable interest is a legal requirement for an insurance contract to be valid. The absence of insurable interest can render an insurance policy void or unenforceable.
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