Under English law, it is a fundamental requirement that a contract of (re)insurance has an insurable interest. At its most basic, insurable interest requires that the (re)insured either benefits from the preservation of the (re)insured object or suffers a disadvantage should it be lost. Its purpose is to guard against moral hazard and to distinguish (re)insurance from other forms of risk transfer (such as derivatives) or gambling. However, this could be about to change!
Proposals for reform
In March 2015, following two earlier consultations (in 2008 and 2011), the Law Commission published an Issues Paper consulting on the reform (and, potentially, the abolition) of the doctrine of insurable interest. The updated and simplified proposals were well supported and, in April 2016, a draft bill was published giving effect to the proposals. Supporters for reform argue that the current law is archaic and has had the effect of hindering the (re)insurance market’s ability to offer particular types of products for which there is demand.
Whilst the outcome of the Law Commission’s consultation is still uncertain , one thing is clear – reforming insurable interest, or abolishing it altogether, could make it even more difficult to keep (re)insurance contracts distinct from other instruments (for example derivatives) or, indeed, the concept of gambling. This article examines why there is a need or demand to maintain a dividing line.
The draft bill
If enacted, the draft bill will repeal the Life Assurance Act 1774, the Marine Insurance (Gambling Policies) Act 1909 and the Marine Insurance Act 1788. That said, it should be noted that sections 4 – 15 of the Marine Insurance Act 1906 would be retained for contracts of marine insurance (which still require the insured to have an insurable interest).
The draft bill approaches insurable interest from two standpoints - “life-related” and “insurance other than life-related insurance”.
> A contract of life-related insurance is defined in section 1 of the draft bill as:
“… a contract of insurance under which the insured event is the death, injury, ill-health or incapacity of an individual, or the life of an individual continuing”.
The main change for life-related insurance is that clause 2(2) of the draft bill sets out a non-exhaustive list of insurable interests in a life-related context; it is much broader than the current position under the Acts or jurisprudence and it is intended to widen the types of policy that can be written.
> With non-life insurance, the position is more ambiguous – many would argue that there is no substantive change to the law as it currently stands. Under the draft bill, a policy will be void if the insured does not have an insurable interest (or a reasonable prospect of acquiring one) at the time the policy is taken out. The insured must also have an actual insurable interest at the time of the loss or insured event, in order for a claim to be payable. The indemnity principle operates to require some relationship between the loss and the insurance payment.
Clause 3(3) of the draft bill provides that:
“… the circumstances in which the insured has an insurable interest in a subject matter include, in particular, circumstances where the insured:
(1) has a right in it,
(2) has a right arising out of a contract in respect of it,
(3) has possession or custody of it, or
(4) will suffer economic loss if the insured event relating to it occurs.”
It is the fourth limb which prompts the most concern; many consider it is too widely drafted and there are calls from many quarters for it to be amended to reduce the risk of other types of risk transfer (e.g. pure parametric products) being treated as (re)insurance. Some members of the (re)insurance industry are already wary about the convergence of the (re)insurance and capital markets and the proposed reforms would facilitate the further erosion of boundaries between the two.
Parametric products: blurred lines
As part of this process of reform, the spotlight has been shone on the so-called ‘parametric products’, which include insurance-linked securities (ILS) such as industry loss warranties (ILWs) and catastrophe bonds (cat bonds). These increasingly popular (and in the case of cat bonds enduring) products provide for payment of a fixed sum triggered by the occurrence of a specific event (e.g. a natural catastrophe such as a hurricane in Florida), without the policyholder necessarily having to demonstrate a loss – they can be structured as (re)insurance or as derivative contracts.
Accompanying its issues paper and draft bill, the Law Commission has also published a consultation paper to discuss its understanding of parametric products and how the proposed insurable interest reforms might have an impact upon them.
The law as it stands adequately differentiates between a (re)insurance contract and a derivative contract; the former requires an insurable interest, the latter does not. However, the proposed reforms have the potential to blur the lines, particularly when it comes to derivative contracts – which could be re-characterised as (re)insurance contracts if the draft bill is enacted. The Law Commission has been consulting as to why it is so important to differentiate between (re)insurance and derivative parametric products. Is it not that they are just two sides of the same coin? It is true that derivatives and (re)insurance may behave in a similar way and have mirroring commercial outcomes, but there are important reasons to draw a distinction between the two and, in particular, for the insurable interest requirement to be retained for contracts of (re)insurance. As a result of previous consultations, the Law Commission’s Issues Paper identified the following four reasons for maintaining insurable interest:
> It is the hallmark of insurance: insurable interest serves to delineate the boundaries within which the insurance industry operates. This is extremely important from a legal, regulatory and tax/accounting standpoint as different regulatory and tax regimes apply to (re)insurance compared to other risk transfer products, or gambling.
> It reinforces market discipline: insurable interest is one of the factors which restrains the (re)insurance industry from trading – in this context, insurance might be contrasted with derivative trading, which has come under considerable scrutiny since the 2008 financial crisis.
> It acts as a barrier against invalid claims: requiring an insurable interest ensures that only one interested party can claim.
> It may have other specific uses: for example, it may help determine where the insurance is located – which is important for regulatory and tax purposes.
The post-Brexit landscape
The proposed reforms to insurable interest are just a small part of wider legislative reforms in the (re)insurance arena and, ultimately, the UK government’s objective which is to create a legal and regulatory framework that will attract ILS investment to the UK (The Bank of England and Financial Services Act 2016, Section 31 – which received Royal Assent on 4 May 2016). The government is responding to concerns that the UK needs to innovate and be flexible in order to maintain its competitive edge.
This is particularly imperative after Brexit.
Turning back to the detail, it remains to be seen whether the Law Commission will address the concerns that have been raised and amend the draft bill before it is enacted. If the distinction between (re)insurance and derivatives is to be maintained, the Law Commission must tread carefully when it comes to parametric products. There is most certainly a delicate balancing act to be performed between modernising the law of insurable interest (as part of the government’s wider objective to create a legal and regulatory regime that will attract ILS investment to the UK) and preserving a dividing line between (re)insurance, derivatives and gambling and the differing regulatory regimes that flow from these distinctions.