Friday, March 03, 2006

Back to Basics...

With all of our posts on Buy-Sell Agreements, Section 105 Plans, and Consumer Driven Healthcare, it’s easy to forget that there are still basic principles that undergird the insurance industry.
One such principle is that of “Moral Hazard,” another is “Insurable Interest.” I am moved to post about these two seemingly-simple concepts because of a conversation with a would-be client.
Seems that Mr Jones “owns” a home with his wife and their three grown, single sons. I use quotation marks to indicate that it really isn’t that simple:
Rob, his middle son, actually has the mortgage, and his name is the one on the title. His siblings and parents have agreed to help make the payments. There is no formal documentation … okay, except for the mortgage, there is no documentation. And that mortgage is for $205,000, with monthly payments over $2,000.
But wait, it gets better:
Rob has no actual income; he and his brothers just walked away from a failed landscaping business, en route to a new car business. Currently, they are all three “between jobs.” In fact, the only “steady income” is Dad’s $3,500 monthly check from Uncle Sam (don’t ask).
Which raises a few questions: how did Rob qualify for such a loan in the first place? What happens to Rob if any (or all) of his apparently none-too-responsible brothers decide to bail? What if Dad dies? Most of all, though, what has any of this to do with life insurance?
Well, turns out that they have all agreed that they need some, and apparently Dad drew the short straw. After an increasingly frustrating conversation (more than I really wanted to know, and yet not as much as I needed to know), it turned out that they all wanted $250,000 of coverage on each person.
Yes, I wondered that, as well.
The good news is that none of the five are tobacco users, or on any medications. Three, however, are substantially overweight, and Dad has a specific mental health condition.
Those are the facts, but what about the two principles to which I earlier alluded? Well, they come into play in a big way here:
Moral Hazard is defined as “the risk that coverage against a loss might increase the risk-taking behavior of the insured.” In other words, sometimes people are dishonest, or appear so. I work for my clients, but I represent the insurance carrier. I have an obligation to be careful about the risks I seek to place, even if that means that I sometimes have to walk away from a sale.
The second principle at work here is Insurable Interest. This means that in order to insure someone, one has to have some stake in that other person’s well-being. A husband obviously has a financial stake in his wife’s well-being, so he is said to have an “insurable interest.” My neighbor doesn’t have such a stake, so he has no such interest.
In this case, there was a lot of the first (moral hazard) and a lack of the second (insurable interest):
Rob owes the bank a lot of money (insurable interest), but lacks the means to pay for the insurance (moral hazard). His siblings (and parents) really have no demonstrable stake in Rob’s well-being: if he dies, it’s not like they’re on the note. Thus, they lack insurable interest.
Dad was upset to learn that I couldn’t help him. Of course, I wasn’t too thrilled, either: after all, no one pays me a commission to say “no.” I did run this by an underwriter first, of course, to confirm my suspicions. And I suggested to Dad that, if and/or when his progeny find gainful employment, and they confirm this informal agreement by means of a written contract, we could then revisit the situation.
But I’m not holding my breath.
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