With the best of intentions (usually) people often try to arrange life insurance policies that lack on critical component with the insurance companies, insurable interest. Insurable interest quantifies the actual financial loss a beneficiary would incur upon the death of the insured.

This often strikes a nerve when I explain to a person that, no, you can’t take out an insurance policy on your mother with you as the beneficiary in the amount of $250,000 and explain to the insurance company that it is for burial. No, mom doesn’t own a house with a mortgage. No, she doesn’t have any debt. So, wonders the insurance company, after you bury your mom in the highest of fashion, what are your intentions for the other $240,000? This is seen as an attempt to over insure your mom and unless mortality experience has changed recently, there used to be a measurable difference in mortality rates between the adequately and the over insured.

The parent thing is probably the most frequent challenge to the insurable interest issue, but there are plenty of other examples. So, you want to take out $500,000 and make your friend the beneficiary. The company wants to know why the friend should be the beneficiary of half a million dollars and your answer is because you can afford to buy it and you think it would be nice to do.

First, let’s dispel with the old fashioned notion that if you can afford it you should be able to buy it. Insurance companies are not in the business of creating wealth where there was none. They are in the business of replacing losses. Now, if you owe your friend $500,000 and want to take out a policy so that if you die they still get paid, that is legitimate insurable interest. There is a loss to your friend upon your death. By the way, don’t try that avenue unless you can actually prove there is a loan.

Bottom line. Think it through ahead of time. Just like financial justification would preclude someone making $10,000 a year from owning $1,000,000 worth of life insurance, companies look at insurable interest to make sure they’re not selling policies that create wealth rather than replace losses.