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Insurance contracts can also be classified by how they calculate the amount they pay for a covered loss. This distinction is especially important for comparing life and health policies to property and casualty policies.
A valued contract pays a predetermined, stated amount when a covered loss occurs, regardless of the insured's actual financial loss. Life insurance and accidental death and dismemberment (AD&D) policies are valued contracts. For example, a $500,000 life insurance policy pays the full $500,000 death benefit regardless of the actual financial loss suffered by the beneficiaries.
An indemnity contract's goal is to restore the insured to their pre-loss financial position — no more and no less. Most property, casualty, and health insurance policies are indemnity contracts. For example, if a car sustains $5,000 in damage, the policy pays $5,000 to repair it. In a reimbursement-style health plan with a $500,000 maximum hospital benefit, a $25,000 hospital bill results in a $25,000 reimbursement. For disability income insurance, if a person normally earns $600 per week and the policy provides a $400 weekly benefit, the benefit replaces roughly two-thirds of the insured's lost income rather than the full amount.
Remember: Valued contracts pay a predetermined amount (like a $500,000 life insurance policy), while indemnity contracts pay based on actual loss (like a $25,000 hospital bill). Life insurance is ALWAYS a valued contract – you can't calculate the "actual loss" of a life.
| Feature | Valued Contracts | Indemnity Contracts |
|---|---|---|
| Payment basis | Predetermined, stated amount | Actual financial loss |
| Common types | Life insurance, AD&D policies | Property, casualty, and most health insurance |
| Benefit calculation | Fixed at policy issue | Calculated at time of loss |
| Purpose | Pay the stated face amount regardless of loss | Restore the insured to their pre-loss financial position, without profit |
Among all the special features we have discussed, the concept of insurable interest stands out as particularly crucial. It serves as the cornerstone that distinguishes legitimate insurance contracts from mere wagers. Understanding insurable interest is essential because it determines who can purchase insurance and what or whom can be insured. As such, it directly affects the validity of insurance contracts.
The simple rule is this: "You can only insure what you could lose money on." You CAN insure those things that would cost you money if they were damaged or lost, such as the following:
You CANNOT insure things that don't affect you financially, such as the following:
Time matters: for life insurance, you only need an insurable interest when you buy the policy. For property insurance, you need an insurable interest both when you buy the policy AND when you file a claim.
Ask yourself: "Would I lose money if this were damaged or lost?" If YES, you probably have insurable interest. If NO, you probably do not have an insurable interest.
Any person who purchases life insurance on their own life possesses an unrestricted or unlimited insurable interest in themself. Insurable interest also exists automatically in marital relationships, between parents and children, in a business situation between a business and a key employee, or in a debtor-creditor relationship. For example, it is assumed that spouses have an insurable interest in each other's lives, as there are financial and emotional benefits to the continuation of each life. An individual even possesses an insurable interest in a nephew or niece if either lived in the individual's household or was their guardian. A person does not have an insurable interest in the life of their mail carrier since there's no expectation of benefiting from the mail carrier's continued life.
For a person other than the insured to be the policy owner, they must have an insurable interest in the insured. Life insurance contracts originated without an insurable interest are known as stranger-originated life insurance (STOLI). They are formed without a legal purpose and are therefore not enforceable.
It's important to note that, for a life or health insurance contract, insurable interest is only required at the time of the application. Insurable interest doesn't need to continue throughout the duration of the policy, and it does not need to exist at the time of the claim. For example, two individuals are married and take out an insurance policy on each other's lives. There's no issue if the individuals later get divorced but keep the life insurance policies they own on each other. Although insurable interest no longer exists, the policies remain valid because insurable interest existed when the policies were bought. However, they would no longer be able to purchase additional insurance on the other's life since insurable interest no longer exists.
For property and casualty insurance, an insured must prove that they have a legitimate interest in preserving the property they seek to insure when the insurance is purchased and when a loss occurs. For example, Bob owns the house next door to Tiffany, who also owns her house. Bob can purchase a homeowners policy on his home, and Tiffany can buy a homeowners policy on her house. However, they're not allowed to purchase homeowners insurance on each other's property because each has only an insurable interest in their own home.