We tend to think of life insurance in terms of protecting other people who rely on us financially.
You might already have a policy to protect your family if anything happens to you.
But, while this is a tremendously important purpose of life insurance, it is not the only purpose.
In some instances, you need life insurance not to protect others, but to protect yourself against the financial impact that someone else’s death would have on you.
Buying life insurance on another person can be a prudent – and sometimes essential – financial decision.
But you can’t buy life insurance on just anyone.
Because the purpose of life insurance is to protect against the risk of the insured person’s death, there must be an actual risk that is being addressed.
The parties to a policy must have some sort of financial connection that the policy is insuring.
Parties to a Life Insurance Policy
Every life insurance policy has three indispensable parties (four if you count the insurance company).
First, there must be the “insured,” the person whose death results in a payment from the insurance company. The insured typically must apply for the policy and go through life insurance underwriting for final approval. However, there is also accelerated underwriting available that does not require a medical exam.
Next, there is the policyholder, AKA policy owner, the person who “owns” the policy and is responsible for paying the life insurance premiums. The policyholder does not have to be the insured, although they often are.
And, finally, there is the “beneficiary.” A life insurance beneficiary is the person who receives money from the insurance company if the insured dies. A beneficiary can be a person or an entity, such as a business or non-profit organization.
There can, of course, be some overlap. If you take out a policy that would pay your spouse if you die, you are the insured and the policyholder. Or, if your spouse purchases the policy, you are still the insured, but your spouse is both policyholder and beneficiary.
A life insurance policy can be set up in different ways, but the bottom line is that the person buying the policy must have a financial stake in the person to be insured. In insurance lingo, this is referred to as an “insurable interest” or “insurable risk.”
Every state requires that, for a life insurance policy to be legal, it must protect against a legitimate financial risk.
Stated otherwise, you must demonstrate that the insured’s death would have an actual financial impact on your circumstances and that you therefore have an “insurable interest.”
Insurable interests can come in a variety of forms, but some financial interest must be present.
For immediate family, insurable risks are fairly obvious. If an insured contributes to household income, the potential loss of income is a risk that can be protected by life insurance.
A surviving spouse might need life insurance proceeds to pay off household debt or provide for large future expenditures like the kids’ college education.
Basically, if the policyholder relies on the insured’s earning capacity, an insurable interest is undoubtedly present.
Lost income, though, is by no means the only insurable interest among family members.
The financial value provided to a family by a stay-at-home spouse is an insurable interest. After all, if the spouse dies, the surviving spouse would have to shoulder the increased burden – either sacrificing work-hours for housework and childcare or paying someone else to do it.
Even considering life insurance for children, it’s not hard to identify an insurable interest. In the tragic event of a child’s death, the parents are responsible for final medical bills and funeral expenses, for example. And a child’s death is likely to lead to substantial missed hours at work while the parents grieve.
An insurable interest can also be present between relatives who do not live in the same household.
If grandparents watch the kids while the parents work, the value of the childcare is an insurable interest.
Likewise, if you help with the cost of your elderly parents’ or grandparents’ long-term care, they have an insurable interest in you.
Or, if you co-sign a relative’s vehicle loan, you have an insurable interest because you are responsible for the loan payment if the relative dies.
Even after a divorce, ex-spouses may still have insurable interests in one another.
If a former spouse pays alimony or child support, the risk of losing the payments is insurable. For this reason, divorce decrees often require life insurance payable to a former spouse who receives support payments.
Divorce decrees requiring a former spouse to pay marital debts also create an insurable interest. Because third-party creditors are not bound by a divorce decree, if an ex-spouse dies, the creditors will look to the surviving co-debtor for payment.
Insurable Interests for Businesses
Insurable interests do not require a familial relationship between the policyholder and the insured.
Businesses often purchase key person life insurance policies on their employees to offset the financial impact an employee’s death would have on operations. “Key-man” policies insure against the potential impact of a vital employee’s death.
A law firm, for instance, might rely on a “rainmaker” partner to bring in high-profile clients. The rainmaker’s death would lead to significant loss of income to the firm.
Businesses have an insurable interest in even relatively low-level employees due to the cost of recruiting and training replacements. It’s not uncommon for businesses to purchase life insurance on nearly all employees, varying coverage amounts according to the anticipated financial impact each employee’s death would cause.
Partnerships and other closely-held businesses can use life insurance to ensure sufficient liquidity to buy out a deceased partner’s stake in the business.
Buy-sell agreements funded by life insurance (i.e. contracts between the owners of a business governing transfer of ownership interests) typically require the business to purchase life insurance on each of the owners in an amount sufficient to purchase that owner’s interest upon death.
A buy-sell agreement both guaranties fair compensation to departed partners’ heirs and prevents spouses and children with no connection to the business from acquiring managerial control.
Policies required by buy-sell agreements can be purchased by the business itself or the other partners. Either way, there is an insurable interest.
A not so well known reason for buying life insurance on someone else is for infinite banking. This may be the best reason for buying life insurance on someone else.
Let me explain…
In a past article on why I have multiple life insurance policies, I laid out my reasons for putting the majority of my savings into whole life insurance.
The benefits of whole life insurance are many and some people wanting to get whole life insurance are denied coverage.
The good news is that if you choose to use life insurance as a personal bank, you can buy life insurance on someone else and practice infinite banking with that policy. You can read more in our pros and cons of infinite banking article.
Other Insurable Interests
If neither a familial or business relationship is present, an insurable interest depends on some other financial arrangement between the policyholder and the insured.
If you co-signed a loan for a friend or jointly purchased a vacation condo and are both liable for mortgage payments, you have an insurable interest. Conversely, a creditor has an insurable interest in the person who owes a debt.
A bank might purchase life insurance on a business owner to whom it extends a sizeable line of credit to ensure that the money is repaid if the business owner dies. For example, lenders of small business loans often require the use of life insurance policies on borrowers as collateral.
Change in Circumstances
Notably, insurable interests are evaluated as of the time of application. A change in circumstances will not void an otherwise valid policy.
So, if you take out a policy on someone with whom you co-signed a loan, the policy is still valid after the loan is paid back and the insurable interest is no longer present. It might make sense to cancel the policy and stop paying the life insurance premiums since the risk is gone, but you wouldn’t have to.
So, to reiterate…
In a nutshell, if someone else’s death would affect you financially, you have an insurable interest in that person’s life. But, importantly, the impact must be financial. An emotional loss alone is not enough.
The death of your favorite actor or your local bartender might take an emotional toll, but, absent some financial connection, you can’t take out a life insurance policy on them.
Can I get life insurance on someone else without them knowing it?
Short answer: NO
Long answer: You cannot take a life insurance policy out on anyone. The insured’s consent is just as critical to a life insurance policy as an insurable interest.
During the underwriting process, the insurance company investigates the insured, including gathering data about the insured’s health history. To do this, the company needs the insured’s permission.
Thus, even if someone else’s death would have a huge financial impact on you,
you can’t buy life insurance without that person’s consent and approval.
Most life insurance companies also require a medical examination of an insured before issuing a policy. This allows the company to evaluate the level of risk it is undertaking.
All things being equal, life insurance premiums are higher for someone who is overweight with high blood-pressure and a family history of early death than for someone in good health whose grandparents lived into their nineties.
For our purposes, a medical exam adds another layer to the consent requirement. You can’t take out a policy on someone who isn’t willing to be at least minimally investigated by the insurer.
You should consider no exam life insurance for someone else that needs coverage but does not want to go through the entire underwriting process.
The key takeaway to remember…
Neither consent nor an insurable interest alone is sufficient. You need both. And there are important reasons for these requirements.
Why Require an Insurable Interest and Consent?
As cynical as it seems to say, the primary reason life insurance policies require an insurable interest and the insured’s consent is to discourage malevolent schemes. For example, the recent case of the UK man who murdered his wife to collect the $2.5 million death benefit. (1)
Sadly, unscrupulous people have purchased life insurance on someone else and then caused harm to the other person. The law wants to remove this temptation and prevent opportunistic purchases. After all, policyholders are less likely to have bad intentions toward an insured they depend upon and who has consented to the policy.
This line of thinking is also why life insurance coverage also has to be proportional to the level of financial interest the purchaser has in the insured. This is referred to as financial justification.
If you cannot justify to the insurance company the amount of coverage you are applying for you will either be denied or offered a lesser amount.
For instance, if you lend a friend $50,000, and you want a life insurance policy to make sure the loan gets repaid, you won’t be able to buy a million-dollar policy.
On the other hand, if your spouse is the primary breadwinner, and the family relies on his or her income for living expenses, to pay the mortgage, and for the kids’ eventual higher education, you will be able to buy a policy with much higher coverage.
Null and Void
In addition to the statutory requirements, most life insurance policies have contractual terms intended to curb abuse. Policies generally won’t pay out if the policyholder or beneficiary contributed to the insured’s death, and pretty much any insurance policy is void if it is procured through fraud.
So, forged consent or a phony insurable interest will nullify a policy, even if it is initially issued (and both acts can lead to criminal charges).
So, in summary…
To a greater or lesser degree, everyone relies on someone else financially. And we all have someone whose death would have a substantial financial impact.
Buying life insurance on someone else who you depend on allows you to control these risks and soften the financial blow.
You see, when you buy life insurance on someone else, you can make sure the coverage level is suitable, the appropriate beneficiary is designated, and the premiums are always paid.
If you need to insure against the financial risk of someone else’s death, a pro client guide at I&E can help you decide what coverage is right for your situation.