When someone purchases life insurance, he or she must have an “insurable interest” in the insured. This means that the policyholder, i.e. the person who owns the policy and names the beneficiary or beneficiaries, will suffer financial loss if the insured dies unexpectedly. It is important to remember that this sort of relationship only needs to exist between the policyholder and the insured, not the beneficiary. Beneficiaries are not required to have any insurable interest in the insured (see our previous blog post). There are many situations in which an insurable interest exists, including:
- A spouse or family member
- A financially dependent ex-spouse
- An employer or business partner (if designated as “key personnel”)
- A creditor
In each of these examples, the policyholder is financially or emotionally “interested” in the well-being of the insured. If insurable interest were not a requirement for taking out life insurance, strangers could essentially gamble on the lives of others. A policyholder without substantial interest in the life of the insured would be incentivized to cause harm and profit from an early death benefit.
An insurable interest is a non-negotiable requirement for any form of any insurance, including life insurance. If there is an insufficient insurable interest between the policyholder and the insured, the policy is voided. The legal precedent for insurable interest was solidified in Warnock v. Davis, in which the Supreme Court of the United States asserted that a life insurance policy without insurable interest constitutes a “wager” against the life of the insured. (Warnock v. Davis, 104 U.S. 775)
Many state statutes also include provisions explicitly outlining what constitutes an “insurable interest.” For instance, California Insurance Code § 10110.1 defines insurable interest as “a reasonable expectation of pecuniary advantage through the continued life, health, or bodily safety” of the insured, “or a substantial interest engendered by love and affection in … individuals closely related by blood or law.”
Many investors try to find loopholes to avoid the need for an insurable interest in the insured. They do this by arranging with an individual to pay all the premiums on the individual’s policy on himself or herself with the understanding that, after a few years, the investor will obtain ownership of the policy. This evades the need for an insurable interest because insurable interests are evaluated at the time of the original purchase. Courts are not consistent in deciding whether these policies are legal.