The main purpose of buying insurance is to compensate for losses—the insured's losses. To allow someone to be compensated for a loss that does not affect them financially would create a moral hazard. For what purpose would anyone take out such insurance unless they hoped to profit from it, and if someone hoped to profit from it, they may cause the loss, since the loss isn't their loss. Indeed, if the loss doesn't happen, they may make it happen, since they are continually losing the premium money. A morale hazard also exists, because even if they don't cause the loss, they have no incentive to prevent the loss. Thus, the insured must have an insurable interest in the thing being insured. A good example of the moral hazard created when there is no insurable interest is the story of the blue-eyed six.
In the late 1800's, in Lebanon County, Pennsylvania, there was an old man who looked like he was going to die very soon. So 6 men, who were unrelated to the old man and had no financial stake in his death, decided to make money by taking out a life insurance policy on him, which they could do at that time. But the old man lived a lot longer that they had expected—and the premiums were expensive. So they murdered him to collect the life insurance sooner. Subsequently, they were caught and hanged, but if the principle of insurable interest were operating in those days, the old man would have lived longer than he did.
Without an insurable interest, buying insurance would be gambling—paying premiums in the hope of making a profit, which is not only against public policy, but also against the purpose of insurance, which is to compensate you for your losses. In property insurance, the lack of an insurable interest would also violate the principle of indemnity, where the insured is only compensated for his loss—and no more.
Property and Liability Insurance
Obviously, ownership gives the owner an insurable interest in that property. However, there are other factors that can also give rise to an insurable interest.
Secured creditors have an insurable interest in the property used as security for the property. For instance, almost all mortgage lenders require that the secured realty be insured, with the mortgagee (the lender) named as beneficiary.
Legal liability will also create an insurable interest. Bailment commonly creates a legal liability for the bailee, and, thus, creates an insurable interest in the property for the bailee. For instance, an auto repair shop can have insurance on the vehicles on its lot for possible damage or theft, even though the shop does not own them.
A contractual right can also create an insurable interest, such as the right to purchase property at some future date.
Because property and liability insurance are contracts of indemnity that only covers losses, the insurable interest must exist at the time of the loss. For instance, if you sold a house that would have still been covered by insurance if you hadn't sold it, and it was destroyed by fire, then your insurance company does not have to pay for the fire based on your policy, because you no longer have an insurable interest in the property. Paying you for the fire would violate the principle of indemnity, because you would not only collect the insurance, but would also still be legally entitled to the proceeds of the sale, allowing you to profit from the fire. Your insurance will not cover the new owner, because, if the house is destroyed by a fire after you have sold it, then the loss is not yours, but the new owner's.
Obviously, you have an insurable interest in your own life, and you can purchase any amount of life insurance up to the limits imposed by the insurance company. Any beneficiary can be named, and they do not need to have an insurable interest in you.
However, for anyone to purchase life insurance on someone else's life, they must have an insurable interest, which is usually satisfied if they are closely related, and, especially, if the beneficiary would suffer financial loss from the insured's death. So, for instance, spouses can insure each other. However, life insurance cannot be purchased on someone who is more remotely related or unrelated, unless the beneficiary would suffer a financial loss from the death. A business partner, for instance, may buy life insurance on the other partners, so that if one of them dies, the beneficiary can purchase that partner's stake in the business. Or a company may buy life insurance for its top salespeople, since it can experience a financial loss if any of them dies. Or a movie producer may buy life insurance for its top stars, because of the financial loss that will probably occur if any of the stars die before the movie is finished. Even a creditor can buy a policy for its debtors.
However, when the insurable interest is based on a possible financial loss, and the beneficiary of the policy is also the owner of the policy, then the value of the life insurance policy is limited to the extent of the possible financial loss. Otherwise, there would be moral hazard, since the owner of the policy would profit from the insured's demise.
Because life insurance is a valued policy insurance that pays a specified sum to the beneficiary at the time of the insured's death, the beneficiary does not have to prove a loss to collect the insurance. So, unlike property insurance, an insurable interest must exist at the time of the purchase of the life insurance—not afterward, or even when death occurs, as long the premiums are paid. This characteristic of life insurance is what allowed the existence of viatical settlements in the late 1980's and 90's, in which people with AIDS sold their life insurance policies to investors for immediate money. Nowadays, life insurance policies are being sold by older people to life settlement providers, who, in turn, sell them to hedge funds or investment banks. The banks pay the premiums, pool the policies and securitize the policies into what has become known as death bonds.