What is 'Insurable Interest'
An insurable interest is a stake in the value of an entity or event for which a person or entity purchases an insurance policy to mitigate the risk of loss. Insurable interest is a basic requirement for issuing an insurance policy that makes the entity or event legal, valid and protected against intentionally harmful acts. Entities or events not subject to financial loss do not have an insurable interest and cannot be purchase an insurance policy to cover them in the event of loss.
BREAKING DOWN 'Insurable Interest'
Insurance is a method of pooled risk exposure that protects policyholders from financial losses. Insurers have created many tools to cover losses related to various factors such as 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 insurance policies should compensate a policyholder for a covered loss, but losses should not reward or penalize holders. This suggests insurers should design policies to cover the value of the at-risk asset appropriately. Poorly conceived or designed policies create moral hazard, whereby parties have an incentive to allow or even affect a loss. If moral hazard is prominent, it increases the costs to insurance companies and drives premiums to unsustainable levels.
Identifying Insurable Interest
Homeowners insurance compensates a policyholder who suffers a major financial loss in the event that a fire or other destructive force destroys his or her home. The homeowner has insurable interest in the property; losing that home would create a catastrophic loss for the policyholder.
An individual cannot purchase homeowners insurance on a neighbor's house. There is no insurable interest in a neighboring property because another entity owns it. If a neighboring property is destroyed, but another property is unaffected, insurable loss has not occurred. Purchasing homeowners insurance for a neighbor’s house creates an incentive to cause damage to that house and collect the insurance proceeds — appropriate underwriting would not create such an incentive. This represents moral hazard.
Insurable interest is also necessary in life insurance although this has not always been the case. There are cases where people have purchased life insurance policies for 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 death. 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 the human life value of the insured; otherwise, the indemnity principle would be violated creating moral hazard.