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Insurable interest: what is it, and how does it work?

The concept of insurable interest drives the insurance industry. This term refers to a certain type of investment that protects the bearer from financial loss or hardship. It’s a major requirement of any insurance policy, which is designed to mitigate the risk of financial loss should something happen to the asset. Home insurance, auto insurance, and travel insurance are all examples of circumstances where insurance interest applies.

Who has insurable interest?

A business, person, or other entity is considered to have insurable interest when the loss or damage of a particular object would cause hardship. The concept of insurable interest can, therefore, apply in many situations where insurance is required to offset financial loss or damage.

The insurable interest doesn’t necessarily have to be in an inanimate object. For example, a business might have insurable interest in its upper management team and CEO, while a sports team would have an insurable interest in its star player.

Explanation of insurable interest

Insurance offers a way to protect against risk. It pools together funds from policyholders, all of whom are then protected against financial losses should they use their policy. Insurers cover loss from health care expenses, loss of life, property damage, theft, and automobile repairs.

Insurable interest applies to the policyholders who have a vested interest in not losing the object insured. To mitigate this risk, they purchase an insurance policy. There must not be any financial incentive to allow a loss. For example, a homeowner would have insurable interest in their own property and would take care not to destroy it intentionally.

Insurable interest examples

Here are a few real-world insurable interest examples, starting with the homeowner we’ve just mentioned above:

Homeowners insurance

With homeowners’ insurance, a policyholder would hold insurable interest in their own property. Losing the home would result in a devastating loss for the homeowner, who has a reasonable expectation that this asset will last for the long term. By contrast, an individual wouldn’t have the same insurable interest in their neighbour’s property. They wouldn’t suffer the same hardship or financial loss if a neighbour’s house was damaged, which is why homeowners can only purchase insurance on their own properties. This concept is called a ‘moral hazard’ in insurance underwriting, in which parties might have some incentive to allow a loss for greater financial gain.

Life insurance

The concept of insurable interest also applies to life insurance policies. For a policy to be legal and valid, it should be purchased with the intention that the person covered will live a reasonable lifespan. Pre-existing health conditions must be declared and factored into this value. Consequently, an individual couldn’t purchase a high-value policy for an elderly relative with terminal cancer. In other words, the value of the life insurance policy can’t be so high that it would create a moral hazard.

Business insurance

There are many areas where a business might have insurable interest. Losing a key employee could create financial hardship, as could the cost of damaged property. Business insurance policies take one or more of these areas into consideration. Property insurance for a business would cover equipment, inventory, furnishings, and signage. Losing any of these would increase hardship and financial loss. Liability insurance protects the business against damages, which would also cause hardship.

In some cases, insurable interest is very clear, such as when an item you paid for is stolen. In other cases, it might be vague. One example would be a mortgaged property. While you might have some insurable interest in the property, so does the bank. Bottom line: for insurance to be valid, it must be based on this underlying risk of loss or damage.

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