The term Insurable interest refers to a person’s a financial investment or an economic stake in a piece of property. The concept of insurable interest is fundamental to commercial property insurance.
The Law of Insurable Interest
Property insurance is based on the “law of insurable interest”. This rule states that a person cannot receive payment for damage to insured property unless he or she has an insurable interest in the property when the damage occurs. In other words, a person must have sustained a financial loss as a result of the damage to the property.
Property insurance is intended to make an insured “whole” for a loss, not to profit from it. If the law of insurable interest did not exist, people could use insurance policies as a money-making tool.
A building owner has an insurable interest in the property. For example, Sam buys a warehouse to use in his business and pays $500,000 in cash. Sam’s insurable interest in the building is 100%. If the building is destroyed by a tornado ten days later, Sam will have lost his $500,000 investment.
A building owner loses his insurable interest in the property if the building is sold. For example, suppose that Sam has insured his warehouse under a commercial property policy. He sells the building to Steve. Two weeks after the sale the building is destroyed by a tornado. Sam hasn’t informed his insurer of the sale. Steve is out of the country when the damage occurs and isn’t aware of it.
Sam files a claim for the replacement value of the building and the insurer pays him for the loss. But Sam no longer has an interest in the building. He’s collected a windfall for a financial loss he did not sustain. When the insurer discovers Sam’s deception it demands that he return the money. It also reports Sam to the authorities, who prosecute him for insurance fraud.
Interest of Lenders
A lender has an insurable interest in property used as collateral for a loan. For example, Sarah borrows $25,000 from a bank to purchase a commercial refrigerator. The bank has the right to take possession of the refrigerator if Sarah defaults on the loan. If the appliance is destroyed by a fire or some other peril, the bank will lose the value of the collateral. To protect its financial interest in the refrigerator, the bank requires Sarah to insure the appliance under a commercial property policy.
A bank that provides a mortgage for the purchase of a building has an insurable interest in the building to the extent of the outstanding mortgage. The bank’s interest in the building declines over time as the borrower pays off the loan. The buyer has an insurable interest in the property to the extent of his or her equity in the property.
For example, Bob purchases a building for $1 million and insures it for that amount under a commercial property policy. The building is destroyed by a fire five years later. At the time the fire occurs, Bob has paid off half the loan so his insurable interest in the building is now $500,000. Bob’s insurer calculates the value of the building at $1 million. It sends a $1 million payment to the bank (the mortgagee). The bank retains $500,000 to cover the loan balance and forwards the balance to Bob.
Interest in Leased Property
A business may have an insurable interest in property it has leased if it is contractually liable for damage to the property. For example, Bill leases a laundry press that he uses in his dry cleaning business. Bill is liable under the lease agreement for the machine sustains during the term of the contract. Consequently, Bill has an insurable interest in the laundry press. If the machine is damaged by a covered peril , his property insurance should cover the loss.
Extent of Insurable Interest
Many property policies (including the ISO policy) address insurable interest in a policy condition entitled Loss Payment. It states that the insurer will not pay you more than your financial interest in covered property. This means that the insurer will calculate your loss payment based on your interest in the property at the time the loss occurred.
For example, suppose you buy a building that you insure under a commercial property policy. You sell half of your interest in the building to your friend Jim. Your insurer adds Jim to your policy as a named insured. Four months after the sale, the building burns to the ground. At the time the loss occurred, you and Jim each owned 50 percent of the building. Thus, your insurer compensates each of you for 50 percent of the value of the building.
Auto Physical Damage Coverage
The concept of insurable interest is relevant to physical damage coverage under a commercial auto policy. If you have insured an auto under comprehensive, specified causes of loss, or collision coverage and the auto is damaged, you must have an insurable interest in the vehicle at the time of the loss to receive a claim payment from your insurer.