1.2 Insurable Interest, Indemnity, and Adverse Selection

Insurable Interest

Insurable interest exists when the policyowner would suffer a real financial or emotional loss if the insured event occurred. Its purpose is to keep insurance from becoming a wager on a stranger's death or health and to remove any motive to cause the loss.

The most-tested timing rule:

Because life and health require it only at application, a policy stays valid even if the relationship later ends. A wife who buys coverage on her husband and then divorces him keeps a valid contract; insurable interest is judged at issue.

Who Has Insurable Interest in a Life

A person always has unlimited insurable interest in their own life. For coverage on someone else, a financial stake or close relationship is required:

• Spouses — in each other (close family relationship).
• Parents — in minor children, and adult children in dependent parents.
• Business partners — in one another for buy-sell funding.
• Employers — in a key employee whose loss would harm the firm.
• Creditors — in a debtor, but only up to the outstanding debt.

Worked limit: A bank lends a borrower $80,000. The bank may insure the borrower's life as a creditor, but its insurable interest is capped at the roughly $80,000 it stands to lose. A $1,000,000 policy by the bank on that borrower would exceed insurable interest and be unenforceable for the excess.

The Principle of Indemnity

The principle of indemnity holds that insurance should restore the insured to the same financial position held before the loss, no better and no worse. Profiting from a loss would create moral hazard.

Life insurance is the classic exception. Because human life cannot be objectively valued, a life policy is a valued contract that pays the agreed face amount regardless of any economic measure of the life lost. Health insurance, by contrast, is largely reimbursement-based: it pays actual covered expenses, not a windfall.

Coinsurance and Cost Sharing

To keep reimbursement honest and discourage overuse, health plans impose cost sharing. Coinsurance is the percentage of covered costs the insured pays after the deductible.

Worked coinsurance example: A plan has a $1,000 deductible and 80/20 coinsurance with a $5,000 out-of-pocket maximum. The insured incurs $11,000 in covered charges.

• Insured pays the first $1,000 (deductible). Remaining covered amount: $10,000.
• Of that $10,000, the insured's 20% share is $2,000; the plan pays 80% = $8,000.
• Insured's running total: $1,000 + $2,000 = $3,000, which is below the $5,000 cap, so no cap relief applies.

The insured pays $3,000 and the insurer pays $8,000. This shared structure embodies indemnity: the insured is restored, but retains enough stake to avoid wasteful claims.

Adverse Selection

Adverse selection is the tendency of people with higher-than-average expected losses to seek out, apply for, or keep insurance more aggressively than average risks. A person who feels ill is far likelier to buy generous health coverage; a skydiver is more motivated to load up on life insurance.

Left unchecked, adverse selection skews the pool toward bad risks, drives up claims, and forces rate increases that push good risks out, a spiral sometimes called a death spiral. Insurers fight back with the same tools the exam tests:

• Underwriting classifies and prices or declines applicants.
• Exclusions and waiting periods (such as the life suicide clause or pre-existing-condition limits) blunt selection.
• Guaranteed issue tradeoffs accept selection in exchange for higher rates or limited benefits.

Adverse selection is selection by the applicant; underwriting is selection by the insurer that restores balance.

Indemnity, Tax Limits, and Forced Distributions

The indemnity idea also shapes the tax rules that keep insurance from becoming a pure investment shelter. Two numeric guardrails recur on the exam.

MEC 7-pay test: A life policy becomes a Modified Endowment Contract (MEC) if cumulative premiums in the first seven years exceed the sum of seven level annual net premiums needed to make it paid-up. A policy funded with $20,000 per year when the 7-pay limit is $12,000 per year breaches the test. Lifetime distributions then become last-in-first-out (LIFO) taxable gains first, often with a 10% penalty before age 59 1/2.

Required Minimum Distributions (RMDs): Qualified annuities and retirement accounts must begin paying out by the required beginning age (currently 73). An RMD is the prior year-end balance divided by an IRS life-expectancy factor; missing it triggers an excise penalty.

The theme: tax law caps how much a person may shelter, mirroring indemnity's rule that insurance restores rather than enriches.