What does 'insurable interest' mean in the context of insurance?

In the context of insurance, 'insurable interest' refers to the requirement that a policyholder must have a legitimate interest in the insured property or the life being insured. This concept is foundational to insurance because it helps to prevent moral hazard and ensures that the policyholder has a valid stake in the risk covered by the policy.

When an individual takes out an insurance policy, they must demonstrate that they would suffer a financial loss or hardship if the insured event were to occur. For example, a homeowner has insurable interest in their house because if it were to be damaged or destroyed, they would face a significant financial loss. Similarly, someone who takes out a life insurance policy on another person—such as a spouse or child—must have an insurable interest in that person's life; otherwise, it can lead to unethical situations, such as benefiting from someone's death without any personal stake.

Understanding insurable interest is critical because, without it, insurance would not function effectively as a risk management tool. This principle ensures that there is a genuine relationship between the insured and the insured property or life, thus maintaining the ethical integrity of the insurance process.