Why do life assurance policies require insurable interest?

Why insurable interest is important

Insurable interest is the key element in the structure of a life assurance policy. It is fundamental to the policy’s very existence. If there is no insurable interest there is no life assurance policy.

What is insurable interest?

The doctrine of insurable interest states, broadly speaking, that in order to have a valid policy of insurance/assurance, the policyholder must:

• Gain a benefit from the continued existence of the item being insured; or
  
  
• Suffer a loss on its destruction.

This concept applies to all forms of assurance and insurance – not simply life assurance.

Why the concept is important

Without insurable interest a contract of insurance or life assurance is void.

The Life Assurance Act 1774

The Life Assurance Act 1774 is for regulating Insurances upon Lives, and for prohibiting all such Insurances except in cases where the Persons insuring shall have an Interest in the Life or Death of the Persons insured.

Statement

Whereas it hath been found by experience that the making insurances on lives or other events wherein the assured shall have no interest hath introduced a mischievous kind of gaming:

1. No Insurance to be made on the lives of persons having no interest, &c.

From and after the passing of this Act no insurance shall be made by any person or persons, bodies politick or corporate, on the life or lives of any person, or persons, or on any other event or events whatsoever, wherein the person or persons for whose use, benefit, or on whose account such policy or policies shall be made, shall have no interest, or by way of gaming or wagering; and every assurance made contrary to the true intent and meaning hereof shall be null and void to all intents and purposes whatsoever.

2. No policies on lives without inserting the persons names, &c.

And it shall not be lawful to make any policy or policies on the life or lives of any person or persons, or other event or events, without inserting in such policy or policies the person or persons name or names interested therein, or for whose use, benefit, or on whose account such policy is so made or underwrote.

3. How much may be recovered where the insured hath interest in lives

And in all cases where the insured hath interest in such life or lives, event or events, no greater sum shall be recovered or received from the insurer or insurers than the amount of value of the interest of the insured in such life or lives, or other event or events.

4. Not to extend to insurances on ships, goods, &c.

Provided always, that nothing herein contained shall extend or be construed to extend to insurances bona fide made by any person or persons on ships, goods, or merchandises, but every such insurance shall be as valid and effectual in the law as if this Act had not been made.

Meaning

The 1774 Act:

• Bans the making of insurances where there is no interest. Any policy issued in such circumstances is null and void (not voidable)
  
  
• Requires the names of those interested (the lives assured) to be noted in the policy document
  
  
• Limits the amount of any recovery to the value of the interest
  
  
• Provides  that the Act does not apply to insurances made on certain specified assets

The 1774 Act does not indicate what type of interest is required. However subsequent case law and statutes have established four categories

The four categories of insurable interest

1. Interest arising out of natural affection
   
   
2. Interest arising out of a potential financial loss which is recognised by law and can be shown at the time of the contract
   
   
3. Interest arising out of statutory provisions
   
   
4. Interest recognised by the courts that does not fit into any of the above categories

Interest Arising Out Of Natural Affection

Own life and life of spouse

Natural affection enables an individual to insure his/her own life, or the life of his/her spouse. The class is therefore extremely limited. Anyone who falls within these classes of natural affection will not need to prove that they have a pecuniary interest recognised by law in the life insured.

In cases of interest established by natural affection, there is no legal limit on the sum insured.

Other family relationships

Other family relationships do not - in the absence of potential financial loss, or statutory provision - give rise to a right to insure. In English law there is no general right for children and parents to insure each other's lives. There is no insurable interest based on natural affection between siblings, persons related by marriage or between cousins, nephews, nieces, uncles or aunts.

In Scots law, the obligation of aliment gives rise to an insurable interest in certain relationships where none exists in England or Wales.

English law

A child who is a minor could suffer a financial detriment on the death of a parent. However, there is no general statutory right under English law for children to receive maintenance from their parents. An insurance policy taken out by a child on a parent's life would require some sort of specific obligation on the parent (e.g. a maintenance order).

Likewise, a parent does not have an insurable interest in the life of a child. In England and Wales, children have no legal duty to maintain their parents and parents have no insurable interest in the life of their offspring on the grounds of natural affection.

The position in Scots law

In Scots law aliment is a maintenance obligation to "provide such support as is reasonable in the circumstances". The Family Law (Scotland) Act 1985 provides that the obligation of aliment is owed only by:

• Spouses and civil partners to each other;
  
  
• A father or mother to his or her child;
  
  
• A person  to a child who has been accepted by him or her as a child of his or her family

For the purposes of establishing insurable interest, a child will have an insurable interest in the life of their parents to the value of the obligation of aliment. The duty of aliment ceases when the child reaches 18 years of age, or 25 years of age if in education or training for a trade, profession or vocation. The insurable interest will exist only for as long as the obligation of aliment is owed. This applies equally to a child accepted as a child of the family.

A child owes no obligation of aliment to their parent; therefore, in Scotland as in England and Wales, a parent has no insurable interest in the life of their child.

As spouses and civil partners are presumed by law to have an unlimited insurable interest in the lives of each other, the obligation of aliment has no additional effect for establishing an insurable interest.

Cohabitants and fiancé(e)s

In the absence of any pecuniary and legal interest, there is no right to insure the life of a cohabitant. Nevertheless the Insurance Ombudsman has indicated that he would enforce such contracts.

Fiancé(e)s have no interest in each other's lives. However, the Insurance Ombudsman stated that he would allow an engaged couple to have an insurable interest in each other's lives on the grounds of natural affection.

Interest arising out of a potential financial loss which is recognised by law and can be shown at the time of the contract

Where there is no interest in the life insured based on the grounds of natural affection, the policyholder must show an interest in the duration of the life insured which is pecuniary and recognised by law at the time of the contract. However, unlike the category of natural affection, discussed above, case law and section 3 of the Life Assurance Act 1774 limit the sum payable to the economic value of that interest.

Examples of potential financial loss

• A creditor in the life of a debtor, to the amount of the loan.
  
  
• A joint debtor in the life of a joint debtor, to the amount of the debt. (e.g. cohabiting friends buying a house together who are declared to be jointly and severally liable for the mortgage will be able to insure each others' lives to the amount of the whole of the mortgage debt.)
  
  
• An employer  in the life of an employee, to the value of the period of notice. If the employee is a 'key person' it may also be possible to insure the costs of recruiting and training a replacement, and any loss of profits in the meantime.

The key elements are therefore that the interest must be pecuniary and recognised by law.

A mere expectancy or hope of future pecuniary benefit from the prolongation of the life insured or of the fulfilment by him of moral obligations owed to the assured, are insufficient to sustain an insurable interest.

Therefore, in order to establish a valid insurable interest in a life, the insured must demonstrate a right recognised by law to a pecuniary amount.

Interest arising out of statutory provisions

It is possible for an insurable interest in a life to be created (or the requirement waived) by statutory provisions.

Civil partners

The law for registered civil partners has been, in effect, brought into line with the presumption of natural affection that applies to married couples. The Civil Partnership Act 2004 gives a person an insurable interest in his or her civil partner and that interest is deemed to be unlimited.

Married Women's Property Act 1882

A policy of insurance taken out by a husband for the benefit of his wife or children, or by a wife for the benefit of her husband or children creates a statutory trust of the policy in the hands of the executors. The proceeds therefore do not fall within the estate of the deceased person who took the policy out and the benefit can be paid directly to the beneficiary.

This is relevant to insurable interest because it means that parents can take out a policy on their own lives and declare that the benefits are payable to the children.

Interest recognised by the courts that does not fit into any of the above categories

Interest recognised by the courts that does not fit into any of the above categories are “rare birds”.

In certain situations the Courts have held that insurable interest exists where the general principles discussed above would indicate otherwise.

1. Cases where the Court has defined the subject matter as a particular life of a particular person and where the insurance is to recover a sum on the death of that person. A legal and pecuniary interest in the life insured is necessary.
   
   
2. Cases “in which the Court has recognised interests which are not even strictly pecuniary”. These include cases where insurable interest is based on natural affection and, importantly, cases where it is not necessary to show a pecuniary or legal interest.

These situations generally require a decision by the Court. They generally involve group life policies.

Other requirements of the Life Assurance Act 1774

When must the interest exist?

Decided cases have established that the interest only has to exist at the inception of the contract and not at the time of loss.

Once the policy has been properly created, the policyholder does not need to continue to hold an insurable interest in the life insured. The contract is still legal if the policyholder has no insurable interest at the time of the death. It is, for example, possible to hold an insurance policy on the life of a divorced spouse.

(This has enabled life policies to be assigned, bought and sold on the Traded Endowment Policies ("TEPS") market.)

Naming interested persons

Section 2 of the 1774 Act requires the person or persons interested in a policy, or for whose benefit the policy is effected, to be named in the policy document. If the interested person is named, it can be established whether or not he or she has an insurable interest. The person interested will commonly be the policyholder.

(The Insurance Companies Amendment Act 1973 allows policies to be for the benefit of unnamed members of a stated class, provided that the members of that class can be identified at any given time. This permits "group life" policies to be offered.)

Amount of recovery

Under section 3 of the 1774 Act, the amount of any recovery is limited to the interest of the policyholder in the life insured.

The principle that insurers cannot recover a sum greater than their interest does not apply to policies where the interest is based on natural affection, - policies on one's own life or the life of a spouse. Here the amount of interest is unlimited.

Summary

The 1774 Life Assurance Act imposes a requirement for the policyholder to show an insurable interest in the life insured at the time the contract is taken out.

This interest can be created in the following circumstances:

1. Where the policyholder has a relationship of natural affection with the life insured; (In England and Wales this only covers the policyholder's own life or his spouse, not other family members. In Scotland, additionally, children to whom an obligation of aliment is owed have an interest in the lives of their parents.)
   
   
2. Where the policyholder will suffer a pecuniary loss recognised by law on the death of the life insured;
   
   
3. Where statute 'creates' interest; and
   
   
4. Where the policyholder suffers a loss under a policy on many lives which has been taken out for a substantial period of time.

The interest must exist at the time the policy is taken out. Where the insurable interest is created under categories 2, 3 and 4 above, the amount that can be insured is limited to the amount of interest the policyholder has in the life insured.

Where a policyholder cannot show insurable interest in the life insured, the policy is illegal and claims will not be paid under it.

Possible reform

The Law Commission of England & Wales and the Scottish Law Commission have been asked to simplify and update  the law relating to insurable interest. Draft legislation has been published but at the time of writing it remains draft.

https://www.lawcom.gov.uk/document/insurable-interest-consultation/
 

Natural affection

The current category of natural affection could be expended so that it covered more than "own life" and the life of a spouse.

The proposal is that insurable interest arising out of natural affection could be held to exist as follows:

1. Any individual - in his or her own life and in the life of his or her spouse or civil partner;
   
   
2. Any individual who is cared for and dependent on his or her parent or guardian - in the life of his or her parent or guardian;
   
   
3. Any parent - in the life of his or her adult child;
   
   
4. Any individual - in the life of his or her cohabitant

Where there is a relationship of natural affection between the policyholder and the life insured, then the policyholder should be permitted to insure that life for an unlimited amount.
 

Legal pecuniary loss

The category of insurable interest supported by a legal pecuniary loss should be amended so that the policyholder has a reasonable expectation of pecuniary or economic loss on the death of the life insured. Policyholders with an interest based on pecuniary or economic loss should be able to insure the life for the value that is equivalent to the reasonable expectation of the loss.

It is proposed that consent of the life insured should provide an alternative ground for establishing insurable interest. This would be available where the policyholder and the life to be insured do not fit within the categories of natural affection or a reasonable expectation of loss.

It is not known when these proposals would be implemented.