On 14 January the English and Scottish Law Commissions published an issues paper addressing the requirement for insurable interest in certain insurance contracts. The paper sets out the Commissions’ preliminary thinking on reforming the law in this area and seeks views on their proposals. The proposals are designed to clarify the law, restrict the requirement for an insurable interest and ensure that it applies in a more rational way. If they are implemented, the proposals may increase the range of cases in which risks and commitments may be insured. The intention is that risk transfer contracts that are not currently regulated as insurance should be unaffected.
The law of insurable interest
The English and Scottish Law Commissions’ issues paper on insurable interest is the latest in a series of issues papers addressing proposals for the reform of insurance contract law. The Commissions acknowledge that the law on insurable interest is complex and provide a helpful analysis of how it currently stands.
In summary, for an insurance policy to be valid the policyholder must have a sufficient interest in the subject matter of the insurance. This means, in effect, that a policyholder must gain a benefit from preserving the subject matter of the insurance or suffer a disadvantage should it be lost.
Sometimes the requirement for an insurable interest in insurance contracts can restrict the range of products that an insurer may underwrite. This is most likely to be the case for life products. There are also concerns that the distinction between an insurance contract and other contracts involving risk transfer, such as derivatives, may turn on the existence of an insurable interest.
In England and Wales non-indemnity, or ‘valued’, policies such as life, accident and critical illness require an insurable interest at inception. The Commissions consider these rules to be very restrictive in their application. For instance, although people can take out insurance on their own or their spouses’ lives, they cannot take it out on their parents or children. Group insurance schemes covering employee benefits also cause problems, which are sometimes solved by assigning policies to those who want to benefit from them.
Non-life, non-indemnity insurance is quite rare in England. Examples include policies that pay out a fixed sum if a property is destroyed by fire or on the departure of a key employee. However, the Commissions feel the law in this area is particularly unclear.
The situation is also complicated for indemnity insurance (including, for instance, liability insurance). Indemnity insurance generally assumes that payment to or indemnification of the insured will be contingent on proof of loss and thus of some indirect stake in the subject matter. However this is a distinct concept from a strict insurable interest.
Before the Gambling Act 2005, the law required anyone taking out property insurance to have a legal or equitable interest in the property or a right to it under a contract. In the absence of such an interest, the insurance contract became unenforceable and policyholders could not have claims paid under it. However, it appears that this requirement was removed by the Gambling Act 2005, so it seems that under English law, contracts of indemnity insurance without insurable interest are now enforceable.
The Commissions feel that the uncertainties surrounding the law, and how it should be applied, may reduce insurers’ confidence in offering new products and thus expanding the market.
Recommendations for non-indemnity insurance
The Commissions suggest retaining the requirement for an insurable interest in non-indemnity insurance. They feel that it serves a useful purpose in preventing, for instance, speculative insurance on the life of celebrities. It should, however, be applied in a more flexible way and the categories of interest should be enlarged to:
- cover a wider range of cases where the interest is supported by ‘natural affection’. In such cases the policyholder should be able to insure the life in question for an unlimited amount; and
- recognise an insurable interest where the policyholder has a ‘reasonable expectation of pecuniary or economic loss’ on the death of the insured. This would extend the current limited test, which requires a more strictly defined pecuniary interest recognised by law.
Implementation of these proposals could give a boost to the life insurance market. A policyholder could buy cover to meet reasonable future expenses that might arise on a death, such as interest payments on a debt and on the loss of business suffered following the departure, illness or death of a key employee.
The Commissions propose that requiring the insured to consent to the insurance should provide an alternative ground for establishing insurable interest. Views are sought over whether special rules are necessary for the group life insurance.
Where the requirement for an insurable interest is not met
The Commissions have also anticipated some issues that may arise when the requirements on insurable interest are not met.
- They recommend that a contract of non-indemnity life insurance without insurable interest should be void, not illegal. This would allow the policyholder to recover any premiums paid.
- They seek views over whether there is a need to reform the law to cover the lapse of an insurable interest (eg on divorce) or the assignment of a policy taken out by someone other than the insured (should the consent of the insured be required?).
Recommendations for indemnity insurance
The Commissions feel that case law and the Gambling Act 2005 have probably already removed the requirement for insurable interest in indemnity insurance. It would be difficult to justify re-introducing it.
In arriving at this conclusion the Commissions have considered whether this would make it more difficult to distinguish between effecting insurance contracts (which is a regulated activity) and creating credit derivatives (which is not). They conclude that this difficulty would not arise because:
- under a credit derivative the payment obligation is not conditional (as it is in an insurance contract) on the payee’s sustaining a loss or having a risk of loss; and
- the Financial Services Authority’s guidance on identifying a contract of insurance accepts that the existence of an insurable interest is not a key issue.
Some insurance policies combine standard indemnity insurance with life or personal accident benefits. Typical travel policies are an example: they may repay medical expenditure incurred abroad (indemnity element) as well as paying lump sums for loss of limbs or disablement. The Commissions recommend that they should be treated as severable. In other words, lack of insurable interest should affect only the non-indemnity insurance element of the policy.
The Commissions ask a number of additional questions to help them with their further research and policy formulation. These are identified in chapter eight of the paper and include the following.
- Are there other categories of non-indemnity insurance that are not covered by the rules on insurable interest suggested by the Commissions and that need to be provided for?
- Are there other categories of indemnity insurance that require specific rules? They may relate, for instance, to payments due ‘in honour’ only or to insurance taken out by a householder on contents belonging to other people. In such cases the point may be taken that the policyholder has not suffered any true loss and that the indemnity principle does not, therefore, apply.
- To what extent are non-life, non-indemnity products offered on the market and do concerns arise over whether they amount to derivatives rather than insurance?
- Should insurers be required to check when granting cover either that there is an insurable interest (when it is required by law) or that there is a sufficient interest to give rise to a liability under indemnity insurance?
Responding to the discussion paper
The Commissions have asked for responses to their paper by 11 April 2008. There will be a further opportunity to comment when more detailed proposals are formulated, but this is probably the best stage at which to influence the Commissions’ thinking on the issues of principle.