What is an 'Insurable Interest'
An insurable interest is a stake in the value of an entity or event for which an insurance policy is purchased to mitigate risk of loss. Insurable interest is a basic requirement for the issuance of an insurance policy, making it legal and valid and protecting against intentionally harmful acts. Entities not subject to financial loss from an event do not have an insurable interest and cannot purchase an insurance policy to cover that event.
BREAKING DOWN 'Insurable Interest'Insurance is a method of pooled risk exposure, and it protects policyholders from financial losses. A number of insurance tools have been created to cover losses related to automobile expenses, health care expenses, loss of income through disability, loss of life and damage to property.
Principle of Indemnity
The indemnification principle holds that a policyholder should be compensated for a covered loss, but that holders should be neither penalized nor rewarded by a loss. This suggests that policies should be designed to cover the value of the at-risk asset appropriately. Poorly conceived or poorly designed policies create moral hazard, in which parties have incentive to allow or even affect a loss. If moral hazard is too prominent, it would increase the costs to insurance companies, thereby driving up premiums to unsustainable levels.
Identifying Insurable Interest
Homeowners insurance compensates a policyholder who suffers a major financial loss in the event that his home is destroyed by a fire. The homeowner has insurable interest in the property; the loss of that home would create a catastrophic loss for the policyholder.
You cannot purchase homeowners insurance on a neighbor's house. There is no insurable interest in a neighboring property, because it is owned by another entity. If a neighboring property is destroyed, but your property is unaffected, then there has not been an insurable loss. Purchasing homeowners insurance for a neighbor’s house creates incentive to cause damage to that house and collect the insurance proceeds, whereas appropriate underwriting would not create such an incentive. That is an example of moral hazard.
Insurable interest is also necessary in life insurance, though this has not always been the case. There are anecdotes of people buying life insurance policies on elderly acquaintances strictly with the expectation of that person's imminent death. Life insurance regulations have evolved to require a relationship in which the policy owner will suffer a financial loss in the event of the insured's demise. This can include immediate family members, more distant blood relatives, romantic partners, creditors and business associates. The face value of life insurance policies must not exceed human life value of the insured, otherwise the indemnity principle would be violated, creating moral hazard.