A person who takes out insurance must have an insurable interest in the subject matter of the cover; otherwise the contract will be invalid. In some instances, it may be illegal.
What is an insurable interest? In broad terms, it means the person buying the cover must benefit from the safety and well-being of the thing insured or his freedom from liability in relation to it. Alternatively, he would be prejudiced by its damage or loss, or the existence of liability.
Historically, insurable interest has been required to prevent "moral hazard" (bad faith) and to distinguish insurance from other activities, such as gambling.
But with betting now made legally respectable and regulatory and tax authorities using a number of other factors to define what is and is not insurance, does the doctrine still serve a purpose?
This was the question raised by the English and Scottish Law Commissions in their 2008 issues paper. The responses they received showed strong support for retaining the principle of insurable interest. As a result, the Law Commissions now consider "any major reform would be disruptive, for no clear benefit".
Instead, they propose to clarify the law to provide "a single, easily identifiable statutory source for the imposition of the requirement and spell out the consequences of non-compliance, untangling over 200 years of legislation".
Their proposals are set out in a second joint consultation paper on insurance law reform, published on 20th December 2011.
The law on insurable interest is complex and often inconsistent. Even the Law Commissions admit they had trouble analysing it. A large chunk of the doctrine may even have been abolished by accident under the Gambling Act 2005, which made gambling contracts enforceable in law for the first time.
Other statutory remnants still apply, such as a requirement that the names of all interested parties be listed in a life policy, otherwise the policy is illegal (although group policies can be taken out for the benefit of members of a stated class). It is also a criminal offence to take out a contract of marine insurance without insurable interest.
In recent years, however, the English courts have been stretching the boundaries of insurable interest rather than hold a policy invalid on what is often seen as a technicality.
It has been long established that indemnity policies (such as most property cover, insurance on goods and liability insurance) require an insurable interest in the subject matter. Generally, this has to be shown at the time of the loss. Insurance policies without insurable interest are unenforceable because they are "wagers".
But uncertainty was introduced by the Gambling Act 2005, which made gambling contracts enforceable in law and, in doing so, arguably removed the requirement in English law for an insurable interest in indemnity insurance. Under the Marine Insurance (Gambling Policies) Act 1909, however, it is still a criminal offence to take out marine cover without insurable interest.
All indemnity policies are also subject to the indemnity principle, which dictates that the insured cannot recover more than he has actually lost.
One anomaly is valued policies - non-indemnity policies taken out on property that pay out a set amount regardless of actual loss. Requirements for insurable interest in a valued policy differ according to the subject matter but the law in this area is very unclear. If there were no need for insurable interest, such contracts would be very similar to credit derivatives.
This touches on another argument in favour of retaining insurable interest - it distinguishes indemnity insurance contracts from other risk transfer mechanisms, which are subject to separate regulatory and tax regimes.
Nowadays, however, authorities look at a range of features to identify what is and is not insurance. Insurable interest is no longer a deciding factor. More important, according to the Financial Services Authority, is the “assumption of risk” by the provider.
Proposals for indemnity insurance
Having considered these factors, the Law Commissions tentatively concluded in their 2008 issues paper that insurable interest in indemnity insurance was no longer necessary. In their view, the indemnity principle, which requires the policyholder to show actual loss, was sufficient safeguard against dishonesty.
But many respondents argued the principle was still important for three main reasons: it is the hallmark of insurance, it reinforces market discipline and it acts as a barrier to invalid claims. It was also said that insurable interest stressed to the world the clear difference between insurance and gambling.
Generally, many respondents felt that a major reform of the law on insurable interest was not a priority. The Law Commissions now agree:
"We accept that removing the requirement of insurable interest would be disruptive," they state in the consultation paper. "Without a compelling reason for such major reform, we should proceed with caution. On the other hand, the uncertainty and complexity generated by the patchwork of statutes and case law as to how and when a requirement is imposed is a defect in the current law that we think should be addressed."
For indemnity insurance, therefore, the paper does not propose to change the substance of the current law on what constitutes insurable interest. It does, however, suggest that the requirement for insurable interest for all types of insurance should be set out in a new statute.
"In indemnity insurance, to make a claim, the insured must show insurable interest at the time of the loss," the consultation paper states. But the need for interested parties to be named in the policy (dating back to the Marine Insurance Act 1788) would be abolished.
"We also propose that unless there is a real probability that a party would acquire some form of insurable interest at some stage, an insurance contract should be treated as void: the insurer may not sue for the premium, and the insured is entitled to a refund of premiums already paid. This is to guard against an insured being sold a policy that is, to all intents and purposes, worthless."
The Law Commissions ask for views on whether the statute should define insurable interest, or leave the matter to the courts, as it is now. If there is to be a definition, the paper suggests a non-exhaustive list of what constitutes insurable interest, but stresses that the concept should be left open-ended so that it can be developed further by the courts.
The proposed wording is: "an insured has an insurable interest if the insured has:
(1) a right in the property which is the subject matter of the insurance or a right arising out of a contract in respect of it; (2) a real probability either of an economic benefit from the preservation of the insured subject matter, or of an economic loss on its destruction, which would arise in the ordinary course of things; or (3) possession of the insured subject matter."
The paper also asks if insurers should be required to ask potential insureds about their insurable interest before the contract is made. The Law Commissions believe most insurers do this already for underwriting purposes.
In life insurance (and other non-indemnity insurance such as personal accident and critical illness) an insurable interest must be held when the policy is taken out.
The rule dates back to the Life Assurance Act 1774 when the legislature’s concern was to prevent a “mischievous kind of gaming” by stopping people from taking out insurance on the lives of distant family members or public figures.
Newspapers at the time were publishing the odds on celebrity survival (there are websites doing something similar today). There were even concerns that the practice might encourage murder.
Since then, case law has limited those who have an insurable interest arising out of “natural affection” to the person whose life is being insured and their spouse. The Civil Partnership Act 2004 extended this to civil partners.
Anyone else (such as an employer taking out key man insurance) has to show an interest arising out of a potential financial loss recognised by law – and the amount insured is limited to the value of that loss. In the case of an employee, this might only cover the contractual notice period. In group life schemes, it may also prevent the employer offering benefits to employees' families.
A further category is an interest established by statute (such as the Civil Partnership Act). In recent years the court has also recognised other types of interest held at the time of the contract which do not fit neatly into any of the other categories.
In practice, the restrictions on life insurance are frequently avoided by an individual taking out cover on his own life and assigning it to whom he likes.
In addition, many insurers will provide cover on the life of a cohabitee or fiancé and these contracts will be upheld by the Financial Ombudsman Service. The danger in stretching the rules, of course, is that an insurer's liquidator, administrator or reinsurer may not take the same view.
Proposals for life insurance
In the case of life insurance, the Law Commissions propose to restate the law of insurable interest, but with some modifications.
Specifically, the category of those who can insure the life of another on the basis of financial loss would be widened. Instead of having to show a potential financial loss recognised by law, the test would be based on a reasonable expectation of economic loss.
The consultation paper also asks for views on widening the categories of natural affection to include children under 18 (for small amounts) and cohabitants, and a specific insurable interest for the trustees of pension and other group schemes.
Under the proposals, parents would be able to insure the life of a child under 18. The paper asks whether the amount should be capped and, if so, what would be an appropriate amount.
Most cohabitants would be able to insure the life of their partner on the basis of a reasonable expectation of economic loss, for instance where they had taken out a joint mortgage or shared responsibility for a child.
The Law Commissions, however, suggest that, as an alternative to an insurable interest based on economic dependency, cohabitants should also be able to claim insurable interest based on natural affection, without having to show economic dependency.
For this test, the paper proposes a minimum period of 5 years during which the couple have lived together in the same household as spouses (husband, wife or civil partner).
The Law Commissions also propose that the trustees of pension or group schemes should have an unlimited insurable interest on the lives insured. At present, pension fund trustees often insure the lives of their members but the legal basis for doing so is unclear. The paper asks whether employers that sponsor group schemes offering employee benefits should have a similar insurable interest.
Lastly, the requirement that the names of all interested parties be listed in a life policy, otherwise the policy is illegal, would be abolished.
The consultation, which also covers late payment of insurance claims and reforming the law on fraudulent claims closes on 20th March 2012. The Commissions plan to make their final recommendations to Parliament in 2013.
Their third Consultation paper, due in 2012, will cover pre-contract nondisclosure and representations in business insurance and the law of warranties in business and consumer insurance.