Insurable interest

You cannot insure your neighbour's house. Not because the insurer would lose money on it, but because a policy on something you have no stake in is not insurance at all — it is a bet on somebody else's misfortune, and it gives you a reason to want the misfortune to happen.

Insurable interest is the rule that closes that door. The workbook gives it twice, from two angles:

• as a requirement of an insurable risk: the individual seeking insurance will face financial loss in the event of loss or destruction of the subject matter. The loss should be monetary in nature and not merely emotional or related to feelings, and the interest must be lawful.
• as a fundamental principle: the insurer will cover the risk only if the insured has an insurable interest, and the test is that the insured should be better off if the risk does not materialise but will be adversely affected if it does.

Where it exists automatically. Family members — direct dependents and relationships of blood and marriage — have insurable interest in each other. No proof is called for.

Where it must be proved. In other blood relationships — the workbook names aunts and uncles, cousins, nieces and nephews — insurable interest does not exist unless there is proof of financial dependence.

Where it exists commercially. A business owner has insurable interest in his own inventory, but not in the inventory of a competitor. A lender has insurable interest in the borrower to the extent of the amount outstanding. Employers have insurable interest in their key employees — which is the whole basis of keyman insurance, a policy the company buys, pays for and is the beneficiary of.

How it sits among the other requirements. Insurable interest is one of seven conditions the workbook lists for a risk to be insurable, alongside a large number of exposure units, loss that is accidental and unintentional, loss that is determinable and measurable, no prospect of gain or profit, a calculable chance of loss, and an economically feasible premium.

That sixth condition is its companion. A risk must be a pure risk — full or partial loss only. Speculative risk is not insurable: the workbook's example is that investing in the stock market may result in loss but may also result in gain, and so is not insurable. The same logic produces the principle of indemnity: insurance restores the financial situation to where it was before the event; the intent is not to make a profit.

A Pune-based textile trader, Mr Joshi, wants four policies. Which of them can be written?

Now a fifth. Mr Joshi has lent Rs 35,00,000 to a supplier. He may insure that supplier's life — but only to the extent of the amount outstanding. As the loan amortises to Rs 12,00,000, the insurable interest falls with it. Cover of Rs 35,00,000 against a Rs 12,00,000 exposure would turn a loss into a Rs 23,00,000 profit on the supplier's death, which is exactly what the principle of indemnity forbids.

And a sixth. He asks to insure against not making a profit on this season's stock. Refused: that is a speculative risk, not a pure one. The workbook's reasoning is behavioural — if it were possible to insure against not selling the goods, there would be very little incentive to try to sell them.

Chapter 1 (Basics of Insurance), section 1.2.1(b) as a requirement of an insurable risk and again as section 1.3.2 as one of the two fundamental principles alongside utmost good faith. Expect a "which of these can be insured" question built from the workbook's own list — competitor's inventory, nephew, lender, employer — and a definitional question distinguishing pure risk from speculative risk.

• The loss must be monetary. Emotional attachment is not insurable interest, however genuine.
• Aunts, uncles, cousins, nieces and nephews need proof of financial dependence. Spouse, children and parents do not.
• A lender's interest is capped at the amount outstanding, and it shrinks as the loan is repaid.
• Speculative risk is uninsurable. A stock market loss can be hedged, never insured.
• Insurable interest is not the same as utmost good faith. The first is about a stake in the subject matter; the second is about disclosure. They are the two fundamental principles, not one.
• The interest must be lawful — an interest in contraband is no interest at all.
• Insurable interest is about eligibility to insure, not about how much the claim will be. That is indemnity.