Legal basis of insurance: insurable interest
Another characteristic of a contract of insurance is the existence of an insurable interest.
This is not a general rule of law but is in fact a statutory requirement, imposed by the ‘Life Insurance Act’ 1774 (which is not confined to life insurance) and the ‘Marine Insurance Acts’ of 1746 and 1778, codified in the Marine Insurance Act 1906 (not in fact confined to marine insurance).
The 1906 Act defines insurable interest as where a person stands “in any legal or equitable relation to the adventure or to any insurable property at risk therein, in consequence of which he may benefit by the safety or due arrival of insurable property, or may be prejudiced by its loss, or damage thereto, or by the detention thereof, or may incur liability in respect thereof”. In other words, a person who may suffer financial loss from an event has an insurable interest in the property or interest which is insured against that event. The event must create upon the insured a commercial loss or liability, or it must affect a right of the insured which is recognised and protected by the courts.
A person will therefore have an insurable interest in property in its possession but cannot have an insurable interest in its debtor’s property unless a lien or similar right attaches to it. Neither can a person have an insurable interest against an event if it does not seek directly to protect the right to which it is legally entitled. Thus a parent company has an insurable interest in the shares of its subsidiary but not in the underlying assets or profits of that company.
A contract without insurable interest is null and void for all purposes, though in practice void contracts are often performed as if they had full legal effect.
The requirement for an insurable interest is a feature of English and Scottish law that is not present in all territories; even common law ones such as the Isle of Man. Its application to modern commercial law has been questioned, and it is under review (GIM1010). One effect of the need for an insurable interest is to hinder the establishment of a secondary market in insurance or reinsurance risks. Arbitrage possibilities are strictly limited and there can be no effective forward trading of insurance risks in the capital markets. This is one factor behind the existence of a pronounced insurance (or underwriting) cycle, see GIM1240. The absence of derivative instruments also makes the cycle hard to manage.