1.2 Insurable Interest, Indemnity, and Insurance Principles

Insurable Interest

Insurable interest means the policyowner must stand to suffer a genuine financial or emotional loss if the insured event occurs. Without it, a contract is an illegal wager and is void. In life insurance, the timing rule is critical and heavily tested:

Insurable interest must exist at the time the policy is issued (application), but it does NOT need to exist at the time of the insured's death.

This differs from property insurance, where insurable interest must exist at the time of loss. People are presumed to have unlimited insurable interest in their own lives. For another person, insurable interest arises from:

• Family/marital relationship - spouse, parent-child (love and affection).
• Financial relationship - a creditor in a debtor (up to the loan amount), business partners in each other, an employer in a key employee.

Trap: A person can buy a policy on their own life and name anyone as beneficiary - the beneficiary does not need insurable interest. The owner does.

Third-Party Ownership

A common exam pattern is third-party ownership, where the owner, the insured, and the beneficiary are three different parties. A wife (owner) may insure her husband (insured) and name their child (beneficiary). Here the owner must hold insurable interest in the insured at issue. Employer-owned coverage on a key employee works the same way: the employer's insurable interest is the financial loss it would suffer if the employee died. Modern federal rules also require the employee's written consent (notice and consent) for employer-owned life insurance to receive favorable tax treatment.

Principle of Indemnity and Related Doctrines

The principle of indemnity holds that a policy should restore the insured to the same financial condition that existed before the loss - no profit from a loss. Health insurance (medical expense) is largely a contract of indemnity, paying actual covered costs.

Life insurance is generally NOT a contract of indemnity - it is a valued contract (or "valued policy"), paying a stated face amount regardless of any measurable economic loss, because a human life cannot be precisely valued. The exam tests this contrast directly.

Supporting Principles

Adverse Selection and Reinsurance

Adverse selection is the tendency of higher-risk individuals to seek insurance more aggressively than standard risks. Underwriting, waiting periods, and exclusions exist to control it; if unchecked, claims exceed premiums and rates rise.

Reinsurance lets a primary insurer (the ceding company) transfer part of a risk to a reinsurer. The portion the insurer keeps is its retention; the amount passed on is the cession. Reinsurance protects against catastrophic accumulation and stabilizes results.

Worked example: An insurer issues a $5,000,000 policy but its retention limit is $1,000,000. It cedes $4,000,000 to a reinsurer. If the insured dies, the primary insurer pays the full $5,000,000 claim to the beneficiary, then recovers $4,000,000 from the reinsurer - the beneficiary deals only with the original insurer.

Stranger-Originated Life Insurance (STOLI)

Because insurable interest must exist at issue, schemes that arrange coverage for the benefit of investors with no insurable interest - stranger-originated life insurance (STOLI) - are prohibited in most states. An investor cannot persuade a senior to take out a large policy and immediately assign it to the investor for cash. The exam may describe such a fact pattern and ask why the contract is void: the answer is the lack of insurable interest, which makes the arrangement an illegal wagering contract rather than legitimate risk transfer.

When Insurable Interest Must Exist - and Stranger-Owned Traps

The timing rule separates life from property insurance. In life insurance, insurable interest must exist at the time of application/policy issue - it need not exist at the time of the insured's death. In property insurance, by contrast, insurable interest must exist at the time of loss.

A person always has unlimited insurable interest in their own life. Others must show a relationship - close family, a creditor (limited to the debt), or a business tie such as key person or buy-sell arrangements.

STOLI/IOLI and Wagering

Stranger-Originated Life Insurance (STOLI) schemes induce a person to buy a policy then transfer it to investors with no insurable interest - effectively a wager on a human life. These are illegal because they violate the insurable-interest doctrine that bars gambling on lives.

Worked distinction: life insurance pays a stated face amount rather than measuring actual loss, so it is not a pure indemnity contract - yet insurable interest still bars buying coverage on a stranger. Health and disability are closer to indemnity, limiting recovery to actual expense or income loss to prevent overinsurance.