If you have assets, like a home or a car, it’s important that you have insurance just in case anything were to ever happen. Although states require owners to cover these items, having an insurance policy is always a smart move. Why?
Because it can protect you financially if something were to happen to the asset. For example, if your house burned down, you would need to find a new place to live or rebuild the property, which can be prohibitively expensive for the uninsured.
When buying an type of insurance policy, however, there is one term you may come across – insurable interest. This term is the foundation of all insurance types, whether you’re protecting your home, auto, or life. In this article, we will break down the definition of insurable interest and the different ways that it can come into effect.
What is an Insurable Interest?
By definition, an insurable interest is an investment by a person or entity to cover the loss or damage of a specific asset. To have an insurable interest, you have to prove that you will suffer financially should the asset be damaged, stolen, or destroyed.
One of the most common examples of an insurable interest is your car. If a thief were to steal your vehicle, you would have a hard time getting around, and replacing it would be costly. To prove that you are the one who suffers, all you have to do is show your name on the title.
In cases where you are paying off an auto loan, you and the bank both have an insurable interest on the car. Since you are the one who signed the loan paperwork, you can prove that damage or loss of the vehicle will cause financial harm.
Here are a few other examples of insurable interest and how they relate to different policy types.
As a homeowner, your house represents a significant financial responsibility. If it were to get damaged or destroyed, the cost of rebuilding or relocating would be substantial. As the owner (or loan holder), you have a provable insurable interest in the property.
Companies that own commercial property also have an interest in the buildings since damage or loss would create undue financial stress, particularly regarding all of the potential assets inside.
When it comes to homeowners or property insurance, most insurers will cover the loss of any assets contained within. For example, electronics, furniture, and other items can be included within the appraisal since they may be damaged along with the property itself.
There was a time when you could buy a life insurance policy on someone, even if you didn’t know them personally. Fortunately, in recent decades, rules have been amended to correct this oversight.
To prove insurable interest on a person, you have to illustrate how their death will impact you financially. Some relationships are automatically covered, such as parents, children, and other immediate family members.
You could get a policy on someone who isn’t related to you. This as long as you can show evidence that you will suffer financially if they die. For example, let’s say that you live with a legal guardian who isn’t related to you. If they pass, you could face significant hardships, particularly if the person pays for items like rent or utilities.
Another example of insurable interest is when a company or organization takes out a policy on a critical member. Sports teams may insure a star player, while a business might have an insurance policy on the CEO or top-level executives. Since the loss or injury of these individuals could cause financial harm to the organization, it has an insurable interest.
Indemnification and Moral Hazards
As we mentioned, there was a time when you could buy a life insurance policy on someone you barely knew. This rule was changed because these plans could theoretically reward someone for harming someone else. For example, if you took out a policy on a person who was dying, you could earn a large cash benefit. This is even if their loss wouldn’t affect you financially.
In this instance, there is a “moral hazard.” This term means that there is an incentive for causing a loss since the benefits would be greater than the damage. The technical name for this is the indemnification principle. The idea is that insurance companies should pay out policies without rewarding or penalizing policyholders.
Just as you can’t buy life insurance on someone you barely know, you can’t insure a property you don’t own. Since the loss won’t affect you personally, there would be an incentive to damage that property. Which is a way to collect the insurance money.
How to Fix This
To alleviate this problem, insurance companies need to have comprehensive underwriting for each policy. If a plan’s wording is too vague, it could create a moral hazard, even if that was not intended.
One of the critical elements of the indemnification principle is that the insurance benefit should not be higher than the value of the insurable interest. For example, let’s say that your house is appraised at $500,000. If you took out a homeowner’s policy with a $1 million benefit, you could earn money with a larger loss.
This principle is also why life insurance policies use income tables to put a cap on the size of the death benefit. This is also why individuals with a terminal illness are typically denied coverage. Even if they can get a final expense policy, the payout is relatively small. There is also a two-year waiting period. Otherwise, there could become a moral hazard.
Contact NextGen Life Insurance Today
Understanding how insurable interest can apply to life insurance can help you make the right decision for your needs. However, the best way to find the best policy is to compare rates and details across different companies. At NextGen Life Insurance, we make it easy to get coverage. Get a free life insurance quote from us today.