Insurance law's hapless busybody: a case against the insurable interest requirement.

• Author: Loshin, Jacob

NOTE CONTENTS INTRODUCTION I. THE TRADITIONAL ACCOUNT OF THE INSURABLE INTEREST DOCTRINE II. CONCEPTUAL COMPLICATIONS III. HOW THE INSURABLE INTEREST DOCTRINE FALLS A. Perverse Incentives B. Potential Exploitation C. General Inefficiency IV. POSSIBLE SOLUTIONS A. Clearer Doctrine B. Insurer Tort Liability C. Third-Party Standing V. A RADICAL SUGGESTION CONCLUSION INTRODUCTION

In the Russian classic Dead Souls, (1) a businessman invents a clever scheme to turn a legal quirk to his own advantage. The government taxes the gentry for every serf owned, but the government infrequently conducts the official census that counts taxable serfs. The businessman seeks to purchase dead serfs who remain on the tax rolls--reducing the owners' tax liabilities while enhancing the businessman's social standing on account of his newly acquired serfs. In defense of this distasteful-but-legal bargain, the businessman assures us, "You see, it's my practice never to depart from the letter of the law.... The law, sir--I'm speechless when confronted with the law." (2) Truth being only slightly less strange than fiction, many observers have recently criticized the practice of corporations purchasing life insurance on their employees (3) and hedge funds purchasing the policies of wealthy seniors. (4) Detractors have labeled these practices "dead peasant" insurance, (5) and they have lamented the presence of "investors willing to bet on when [someone] will die." (6) Indeed, these practices evoke a discomfort akin to the purchase of dead serfs. And yet, just like the purchase of dead serfs, these practices are enabled and encouraged by the "letter of the law." That law is the "insurable interest" doctrine.

Some may find this charge puzzling, for the doctrine has long been thought to protect against the kinds of "dead peasant" practices decried above. The insurable interest doctrine requires that the person who holds an insurance policy have some significant interest in the continued existence of the person or property insured by the policy. In other words, one cannot purchase a life insurance policy on a stranger or a property insurance policy on the stranger's property. This insurable interest requirement dates back to nineteenth-century England, and it remains a well-entrenched principle of modern insurance law. Insurance policies that compensate beneficiaries upon the death of a person or destruction of property that the beneficiary does not have an interest in preserving give beneficiaries an incentive to murder the insured person or destroy the insured property. This incentive is a form of "moral hazard, "(7) and the purpose of the insurable interest doctrine is to eliminate such moral hazard by invalidating insurance policies thought likely to inflame it--policies that lack an "insurable interest."

This Note takes issue with the conventional view of the insurable interest doctrine and argues that the doctrine tends to undermine the very aim it purports to advance. Moreover, the doctrine encourages unfairness and inefficiency in the insurance market. These perverse consequences suggest that the doctrine may do more harm than good and that we ought to give serious consideration to abandoning it.

This conclusion runs against the grain of much insurance law scholarship. Many scholars share the view that "the history of insurance furnishes many illustrations of the abuse of freedom of contract." (8) In this view, "the legal system [stands] as a traffic policeman actively adjusting the rules in order to regulate" the insurance market. (9) Yet, this Note tells a different story by illustrating how insurance companies can abuse the legal rules that aim to regulate them, and how a return to freedom of contract--that is, a return to the discipline of the market--offers the more promising approach. When they act as "traffic policemen," judges create ex ante uncertainty about the enforceability of insurance contracts, and insurance companies can exploit this uncertainty to the detriment of policyholders and third parties.

This Note traces the unintended consequences of such uncertainty along three different dimensions. First, the potential that an insurance contract may be voided for lack of insurable interest creates perverse incentives that undermine the doctrine's own purpose of reducing moral hazard, causing the doctrine to fail on its own terms. When an insurance policy is invalidated for lack of insurable interest, the insurance company is relieved of its obligation to pay under the policy. The prospect of invalidation reduces the expected costs of a policy to an insurer and thereby encourages insurers to issue more such policies. Meanwhile, doctrinal uncertainty permits insurers to maintain the appearance of good faith for policies that are not clearly invalid when issued. Taken together, these dynamics create perverse incentives that work to subsidize moral hazard rather than to discourage it.

Second, uncertainty about the doctrine's application creates an opportunity for insurers to exploit policyholders, thus impeding the goal of fairness in the insurance market. Here, uncertainty about the ultimate validity of an insurance policy with a questionable insurable interest permits insurers to issue policies that appear valid to policyholders, but that may nevertheless be deemed invalid by courts. The potential for invalidation decreases the value of the policy to the policyholder but increases the value to the insurer. Yet unsophisticated insurance purchasers may not anticipate that the insurable interest doctrine could ultimately render their insurance policies worthless.

Third, the imperfect relationship between the legal standard of "insurable interest" and the actual presence of moral hazard suggests that the doctrine may end up invalidating unobjectionable and mutually beneficial insurance contracts, thus impeding the goal of economic efficiency in the insurance market. Not all policies deemed to lack an insurable interest create an intolerable level of moral hazard. Hence, to the extent that "insurable interest" is an imperfect proxy for the existence of such moral hazard, the doctrine prohibits efficiency--enhancing activity without the offsetting benefit of reducing moral hazard.

The insurable interest doctrine, and its underlying "traffic policeman" approach, thus frustrate important goals along three key dimensions of insurance law--the doctrine's own purported goal of reducing moral hazard, the additional goal of fairness to insurance policyholders, and the general goal of economic efficiency in the insurance market. In light of these flaws, I suggest that the best way to fix the age-old doctrine may be simply to cast it aside. (10) Rather than acting as traffic policemen, courts should leave the policing to insurance companies themselves. Market pressures give insurance companies significant incentives to reduce intolerable moral hazard on their own, and they are better able to do so than courts. Eliminating the insurable interest doctrine would make insurers bear the cost of moral hazard rather than subsidizing the cost and thereby encouraging it.

Part I of this Note explains the history and traditional rationale for the insurable interest doctrine. Part II then introduces two complications to this rationale--first, the doctrine's inherent ambiguity, and second, the doctrine's inexact connection to the traditional concern of "moral hazard." Part III argues against the insurable interest doctrine, illustrating how the complications discussed in Part II generate perverse incentives, insurer exploitation, and general inefficiency. Part IV discusses three potential modifications to the insurable interest doctrine and argues that none of these modifications offers a fully satisfying solution. Finally, Part V explains why the insurable interest doctrine is unnecessary and suggests that abandoning the doctrine may be the best solution.

1. THE TRADITIONAL ACCOUNT OF THE INSURABLE INTEREST DOCTRINE

   The law has long required that insurance policyholders have an "insurable interest" in the life or property they insure. Indeed, scholars have maintained that insurable interest "is the very warp and woof of the enforcibility [sic] of insurance contracts." (11) Insurable interest usually functions as a defense employed by the insurer, justifying nonpayment after a particular insured event has come to pass. The insurer argues that the beneficiary of an insurance contract lacks the requisite insurable interest in the insured person or property. If a judge finds that the contract lacks an insurable interest, the judge will hold it void as against public policy. Deemed unenforceable, the contract no longer obliges the insurer to pay the promised amount to the beneficiary.

   Although this doctrine of insurable interest remains well-entrenched in American statutory and common law, its origins and subsequent evolution tell a more complicated story. Under English common law, insurance contracts were enforceable even if they lacked an insurable interest. (12) This state of affairs persisted until 1746, when Parliament passed a statute outlawing "wagering" contracts on marine insurance. (13) The statute declared that "no assurance ... shall be made by any person ... on any ship ... by way of gaming or wagering ... and ... every such assurance shall be null and void to all intents and purposes." (14) A subsequent Act in 1774 extended this prohibition from marine insurance to life insurance: "Whereas ... the making insurances on lives ... wherein the assured shall have no interest, hath introduced a mischievous kind of gaming: ... no insurance shall be made by any person ... on the life ... of any person ... wherein the person ... for whose ... benefit ... such policy ... shall be made, shall have no interest ...." (15)

   As the statutes' language reveals, the chief original purpose behind the insurable interest requirement was to prevent...