The significance of insurable interest in underwriting

Relationships between the policyholder, the life insured and the beneficiary will dictate whether an insurable interest exists or not at the time the policy is issued.

The basic principle of insurance is to protect against loss rather than create an opportunity for speculative gain. If you want to buy a life insurance policy on someone else's life, you must have an interest in that person remaining alive, or expect financial loss from that person's death. This is called an insurable interest.

Preventing moral hazard

Buying insurance on the life of a stranger would create a moral hazard wherein the person owning the insurance policy stands to profit from the death of the insured. An example of such an abuse of insurance occurred in Pennsylvania in the late 1800s. Six men obtained an insurance policy on an elderly man. Frustrated by the high costs and impatient for the payoff, the men murdered the old man, a crime for which they were hanged.

No longer gambling

The early use of insurance as a form of gambling, for example life insurance on the lives of kings, led to the banning of life insurance in France, Holland and Sweden during the 16th and 17th centuries.The principle of insurable interest as a requirement for purchasing insurance distanced insurance from gambling, thereby leading to better reputation and greater acceptance of the insurance industry.The UK was the first to pass legislation that did not allow insurance contracts if no insurable interest could be proven. The Life Assurance Act 1774 rendered these kinds of contracts illegal, and the Marine Insurance Act 1906 rendered them void.

Modern principles

Today, the basic principles are as follows:
• Each individual has an unlimited insurable interest in his/her own life, and can select anyone as a beneficiary.
• Parent and child, husband and wife, brother and sister have an insurable interest in each other because of blood or marriage.
• Creditor-debtor relationships give rise to an insurable interest. The creditor can be the beneficiary for the amount of the outstanding loan.
• Business relationships give rise to an insurable interest. An employee may insure the life of an employer, and an employer may insure the life of an employee.

An insurable interest must be present when the insurance policy is taken, but not necessarily when a claim occurs. For example, because a woman has an insurable interest in the life of her fiancé, she purchases an insurance policy on his life. Even if the relationship ends, as long as she continues to pay the premiums, she will be able to collect the death benefit under the policy.

Identifying irregularities

Irregularities can often only be identified at claim stage. Questioning insurable interest at underwriting stage is not only in the company's best interest but also often in the best interest of the life assured.

In a recent case, a client obtained key man cover for one of his employees. The life assureds’ accidental death led to a claim, at which point it was discovered that cover had been taken out through several companies and that the ‘key man’ was actually a recently contracted, low-income worker. It was later found that his death was less than accidental.

Issues to consider

Insurance companies have a duty to exercise reasonable care in determining whether insurable interest exists and whether the consent of the insured has been obtained.

The reasons for cover should make sense, and cover should also be in direct proportion to the anticipated loss, being amended as needs change.