In commercial property insurance, insurable interest means a financial interest or economic stake in a piece of property. When a person has an insurable interest in property, he or she will sustain a financial loss if the property is damaged or destroyed. That person also benefits financially when the property is preserved.
The owner of a piece of property has an insurable interest in it. The owner will lose all or a portion of the property's value if the property is damaged or destroyed.
For example, Sam pays $500,000 in cash for a warehouse to use in his business. Five years later, the building has appreciated to $600,000. Should the building be destroyed by a fire, Sam would sustain a financial loss of $600,000. Thus, Sam's insurable interest in the building is $600,000.
Law of Insurable Interest
Property insurance is based on a rule called the law of insurable interest. This rule is based on the idea that a person cannot receive payment for damage to insured property if he or she has no insurable interest in it when the damage occurs. The rule is designed to protect society against fraud, dishonesty, and speculation. The following example demonstrates why this is important.
Bill owns a commercial building that he insures under a commercial property policy. Six months after purchasing the policy, Bill sells the building to Steve. Bill does not inform his insurance company of the sale.
Two weeks later the building is destroyed by a tornado. Steve is out of the country when the damage takes place and doesn't know it has occurred.
Bill files a claim for the replacement value of the building under his property policy. Unaware that Bill no longer has an interest in the building, his insurer pays him for the loss.
Bill has collected a windfall from his insurance policy. He has received payment for a financial loss he did not sustain. When the damage occurred, Bill had no insurable interest in the building.
Insurance is intended to make an insured "whole" for a loss, not to profit from it. Thus, insurance differs from gambling. Gambling can provide a gain but insurance cannot. By requiring insureds to have an insurable interest in covered property, insurance companies make sure that property policies cannot be used for gambling.
Interest of Lenders
A lender has an insurable interest in property used as collateral for a loan. Suppose that Sarah obtains a $25,000 loan 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 refrigerator is destroyed by a fire or some other peril, the bank will lose the value of the collateral. The bank can protect its financial interest in the refrigerator by requiring Sarah to insure the appliance under a commercial property policy.
When a person obtains a mortgage from a bank to buy a building, the bank (mortgagee) 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 (mortgagor) has an insurable interest in the property to the extent of his or her equity in the property.
Suppose that Bob purchases a building for $1 million. Bob insures the building for $1 million under a commercial property policy. Five years later, the building is destroyed by a fire. At the time of the fire, Bob owes the bank $500,000. Bob's insurer determines that the value of the building is $1 million. It sends the $1 million payment to the bank. The bank retains $500,000 and forwards the remainder to Bob.
Extent of Insurable Interest
The amount you can recover for a property loss depends on your insurable interest in the property when the loss occurred. If your interest in the property has changed since the policy was written, your insurer will calculate your loss payment based on your interest in the property at the time of the loss.
For example, suppose you buy a building that you insure under a commercial property policy. Four months later you sell half of your interest in the building to your friend, Jim. Two months after the sale the building burns to the ground. You file a claim under your property policy seeking recovery for the total insured value of the building. Your insurer discovers that you owned only 50% of the building when the loss occurred. Your insurer compensates you for only 50% of the value of the building.
Auto Physical Damage Coverage
The rules regarding insurable interest apply to physical damage coverage under a commercial auto policy. To obtain recovery for loss or damage to a covered auto under Comprehensive, Specified Causes of Loss, or Collision coverage, you must have an insurable interest in the damaged auto at the time the loss occurs.