What is Insurable Interest in Life Insurance?

The image shows an older couple learning about insurable interests on the internet together.

How much cash is your policy worth?

There are many factors that enter into the purchase of a life insurance policy. Beneficiaries must be named, the policy owner must also name the insured, and the policy owner’s budget must be flexible enough to accommodate the premiums that must be paid. 

But some people overlook another factor that has to be present in every life insurance application. In order for any life policy to be valid, it must be able to show that the beneficiary has an insurable interest on the insured person. Here we examine this factor in more detail.

What is an insurable interest?

Conceptually speaking, an insurable interest can be defined as the amount of hardship that someone will face if they lose something or someone that they have insured. It can be a financial hardship or other kinds of hardship, depending upon what or who was insured. 

In the general insurance industry in the United States today, insurable interest refers to the amount of financial need that the beneficiary on a life insurance policy will have when the insured passes away or the property is lost or damaged. This can also be called insurance interest. 

A simple way to think of it is for someone to ask him or herself the question, “is there a reasonable interest in insuring this person’s life? If the answer to this question is yes, then an insurable interest exists. In this case, interest is equal to need or motivation. There can be an insurable interest requirement by any members of the insured’s family, including stepchildren, stepparents, biological relatives and others. 

Insurable interest also happens in business relationships. For example, a business can have an insurable interest on a key employee without which it could not make a profit. There are a variety of situations where one party can have an insurable interest on another party, and a variety of reasons why this type of interest can exist.

Insurable interest also applies to property insurance. The policy owner and beneficiary have to have an insurable interest on the property, meaning that if the property is destroyed or damaged, then the policy owner and/or beneficiary will suffer a financial loss. 

Insurable interest: Example 1 

Fred has two small children and a wife who does not work. Fred is the sole source of financial support for the entire family. His wife and kids obviously have an insurable interest as Fred is the primary breadwinner. Without him, they would have no means of financial support. 

A life insurance broker pointing at a notepad, explaining insurable interest to an older couple.

The amount of insurable interest they have will depend upon several factors, such as the amounts of debt and savings that the family has, whether his wife remarries quickly or is able to find a job that can support her and their kids. But their financial dependency and relational status immediately qualify them to be beneficiaries. 

Insurable interest: Example 2

Another scenario is where the insured owes material debts to someone. The lender therefore has an insurable interest on his or her debtor and could probably take out a life insurance policy on the debtor with no hassles from the insurance company. This is especially true if the debtor is accruing additional debt. 

Buy-sell agreements are also founded upon insurable interest. If three business partners each own a third of a small business, then each partner will take out life insurance policies on the other two partners so that if one partner dies, then the life insurance payouts from the life policies will provide the two surviving partners with enough cash to buy the dead partner’s share of the business.

In general, the underwriting departments of most life insurance companies will accord insurable interest to any immediate family member of an insured, including spouses and former spouses, children and grandchildren, aging parents, special needs adult children, fiancées and siblings. Most insurance carriers will require a bit of explanation regarding why more distant relatives might have a financial interest, but the majority of the time they will accept any reasonable explanation as to why this is the case.

Why is it necessary to have an insurable interest?

The concept of insurable interest was created by the life insurance industry and integrated into modern law as a way to protect insurers from having to pay out death benefits on frivolous policies and prevent insurance fraud. 

For example, someone may know a neighbor of theirs who works at a dangerous job, such as construction or law enforcement. Insurance companies would not allow this person to purchase life insurance on his or her neighbor, because the prospective policy owner is simply seeking a quick payday from the insurance proceeds that are triggered by the neighbor’s death should it occur. The prospective policy owner will not suffer any kind of financial loss as a result of the insured’s death. 

Life insurance is designed to fund legitimate needs for beneficiaries, and insurers do not want to underwrite policies that are purchased with the intention of making an easy profit. Frivolous policies like this are considered to be a moral hazard. 

It should be noted that insuring another adult will always require that person’s permission. No insurer will accept a policy application without the prospective insured’s written consent. This is a safeguard that protects the insurance company when it comes to insuring the lives of others. 

Do I have to have an insurable interest before I can buy a life insurance policy?

All prospective policy owners must have an insurable interest in the insured, even if they are the insured. The insurance industry considers a policyholder who is also the insured to have an insurable interest on his or her own life, and the insured is free to name any beneficiary or beneficiaries that he or she chooses. But insurers will summarily reject any policy application that does not demonstrate an insurable interest in any capacity.

What's your life insurance policy worth?

However, not everyone is required to be able to prove insurable interest. If Fred from the example above buys a life insurance policy and names his wife as the beneficiary, then the insurance company will simply assume that an insurable interest exists because they are married. Other cases can require a more detailed explanation of why the beneficiary will need the money, such as if the beneficiary is charged with paying for all of the leftover medical bills and funeral expenses of the insured.

But again, most insurers will accept just about any reasonable explanation of why an insurable interest exists. Some explanations just require more documentation than others.

It should also be noted that insurable interest does not apply to an annuity. Since there is no risk of loss in most cases, these vehicles are exempt from this requirement. 

When do I have to be able to show insurable interest?

Insurable interest must be established at the time that the insurance policy is taken out. It only has to be proven in that single “snapshot” of time when the application is submitted. Therefore, if a policyholder names his or her spouse as the beneficiary and then gets divorced, then the ex-spouse will remain on the policy until the policyholder names a new beneficiary to replace him or her. Insurable interest does not have to be proven on an ongoing basis; it must only be shown when applying for life insurance coverage.

Life settlements and insurable interest

A life settlement transaction is one of the most obvious cases where insurable interest is necessary. This is where a life settlement company buys a life insurance policy from an insured that no longer wants or needs the coverage, or else needs cash now to pay bills or fund other financial goals. The settlement company has a clear insurable interest in the insured, because it is depending upon the death of the insured to recoup the costs of buying and paying for the insured’s policy and also to make a profit.

Get an instant life insurance valuation

No life insurance contract that cannot clearly show insurable interest can be valid. The insurance laws are very clear on this point. Fortunately, this is not all that difficult to prove in most cases. The more esoteric the reason for the interest, the more detailed the explanation to the insurer will have to be. Consult your financial advisor for more information on insurable interest and how it could affect you.

Want to find out how much you could sell your policy for? Try our free life settlement calculator.

Author:
Chris Granwehr is the Founder of Dawn Life Settlements and a former senior manager with Mason Finance, an industry-leading life settlement provider in California. He's a member of the Life Insurance Settlement Association, and he has a passion for empowering customers financially through a faster, easier life settlement system.