Insurable interest is required for insurance policies to confirm that the person taking out the insurance is likely to suffer if something happens to the insured person or item. This requirement eliminates moral hazard and ensures that the policyholder has a financial loss if the insured object or person is damaged or destroyed. Lenders also have insurable interest, and personal insurance is more complicated, with life insurance policies taken out on behalf of dependents or spouses.
If someone suffers a loss if an object or person is damaged or destroyed, they are said to have an “insurable interest”. Insurance companies require people to have an insurable interest before a policy is issued, confirming that the person taking out the insurance is likely to suffer if something happens to the insured person or item. Put simply: you can insure your car because if something happens to it, you will suffer a financial loss, but you cannot insure your neighbor’s car, because if something happens to it, you will not be financially affected, although your neighbor may ask for rides, and you may feel sympathy for your neighbor’s plight.
Insurable interest requirements have not always existed in the insurance industry, which has created some complicated situations. Some people have bought insurance as a form of speculation, effectively betting on the continued existence of an object or person. Perhaps most glaringly, people have taken out life insurance policies on unrelated individuals, and there are some reports that when these individuals failed to die in a timely manner, policyholders helped them out. As a result, insurance companies began requiring people to hold an insurable interest, to eliminate moral hazard.
For property insurance, establishing insurable interest is easy. If someone owns a home, car, business, or other type of property and the property is damaged, destroyed, or rendered unusable, they suffer a financial loss, because the property needs to be repaired or replaced. Further losses may be incurred indirectly; for example, if someone is unable to go to work because their car has been stolen, they lose their salary and may be at risk of losing their job.
Likewise, lenders are also considered to have insurable interest. Banks that issue home loans, for example, often require people to carry insurance so that, in the event the home is destroyed, the bank can file an insurance claim to collect the loan balance. To collect the insurance, you must hold a lien on the property.
Personal insurance is a little more complicated. Life insurance policies can be taken out on behalf of dependents, on the assumption that the loss of a parent causes financial loss (among other types of losses which unfortunately are not insurable). Conversely, a parent might take out dependent life insurance for a dependent with the argument that the loss of a child could cause emotional and financial damage. Spousal life insurance is also not uncommon. However, people do not automatically have an insurable interest in everyone they are related to; a niece may not be allowed to take out life insurance on an uncle, for example, although the uncle may choose to name the niece as the beneficiary of his life insurance policy.
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