When an insurance company offers a policy to insure against an event, the insured is required to have an insurable interest, which refers to some loss that the insured will suffer if the event occurs. For a property insurance policy, the insurable interest must exist at the time of the event.
An insurable interest can take many different forms:
- The owner of the property has an insurable interest for the propertys value. (Fee Simple)
- A secured creditor has an insurable interest in property for the amount of the loan balance outstanding. An unsecured creditor has no insurable interest in the debtors property.
- A lessee has an insurable interest in the property during the rental period.
- The beneficiary of a trust has an insurable interest in trust property that they will eventually receive.
- A shareholder has an insurable interest in property held by the corporation to the extent of the shareholders percentage investment.
- A buyer of goods has an insurable interest as soon as the goods exist and are identified to the contract.
In the last case, it is important to identify the point at which goods are identified. For example, if a buyer has paid for 1,000 boxes of a product from the seller, and the sellers inventory includes 50,000 boxes of that type of product, there is no way to determine which boxes are for the buyer, so no insurable interest exists. Once the seller moves 1,000 boxes to the loading dock and places the buyers invoice on top of one of the boxes, however, the goods have been identified and can be insured by the buyer.
The coinsurance clause is a device used by insurance companies to prevent the insured from recovering in full on small losses when they haven't insured the property for its full value. The standard 80% clause in most policies requires the insured to have coverage of at least 80% of the fair market value of the property at the time of the loss. If coverage is smaller, the recovery is limited by the clause to a percentage of the loss equal to the face value of the policy divided by the required coverage. When a claim is filed, the amount to be paid will be the smallest of 3 amounts:
- Amount of the loss
- Face value of the policy
- Limit based on the coinsurance clause (Result)
o Ignore coinsurance % if total loss.
For example, assume the following facts apply to property:
Fair market value of property 500
Face value of policy 300
Coinsurance requirement 80%
Based on the coinsurance requirement, the insured must have at least $500 x 80% = $400 to recover in full on small losses. Since the actual coverage is only $300, the insurance company will only cover $300 / $400 = 75% of the loss:
$200 x $300 / $400 = $150
Notice the clause is designed to prevent the insured from recovering full on small losses. The clause is not needed for large ones. If, for example, the above property had been totally destroyed, the coinsurance limit would have been:
$500 x $300 / $400 = $375
The actual recovery, however, would have been only $300, since the insurance company will not pay more than the face value of the policy in any event.
When the insured has obtained coverage from more than one insurance company, the insurance companies will share the liability based on the pro rata clauses in both policies, which allocate the claim based on the relative policy limits. For instance, if the $300 of coverage in the example included $200 of coverage from insurance company A and $100 from insurance company B, company A pays 2/3 and company B 1/3 of the amount due to the insured. Of course, the total paid to the insured will still be based on the 3 limits (loss, face, coinsurance limit) discussed previously.
For example, in the case of the $200 loss that was limited to $150 based on the coinsurance clause, the payments are:
Company A: $150 x 2/3 = $100
Company B: $150 x 1/3 = $50
In the case of the $500 loss that was limited to $300 based on the policy value, the payments are:
Company A: $300 x 2/3 = $200
Company B: $300 x 1/3 = $100
Life insurance coverage also requires an insurable interest, which could be a close relative, dependent, or a creditor or business partner who would be affected by the death of the insured. One very important difference is that, in the case of a life insurance policy, the insurable interest must exist at the time the policy is first obtained, and doesnt need to be present at the time of death.
For example, if two partners in a business each take out life insurance on the other, and continue to make premium payments after dissolving the business and ending their relationship, the coverage will still be valid.
Any policy coverage assumes the insured will fill out their insurance application accurately and completely. If the insured lied on the application about a material risk factor, the insurance company may properly refuse to pay in most cases. Two exceptions related to life insurance:
- If the insured lied about their age, the insurance company must pay based on the coverage the premiums would have purchased using the correct age of the insured.
- If the policy contains an incontestability clause, the insurance company will not be able to refuse payment based on misstatements or omissions on the application after the time period specified in the clause has passed.