The Insurable Interest Doctrine: What is it?  And What Does It Mean?   Evan B. Sorensen, Esq. 

 The Insurable Interest Doctrine: What is it? And What Does It Mean? Evan B. Sorensen, Esq. Kenne J. Zielinski, Esq. Tressler LLP
The Insurable Interest Doctrine | 1 The Insurable Interest Doctrine: What is it? And What Does It Mean? While one cannot define an insurable interest with complete certainty or precision, in general it exists when the policy holder derives pecuniary benefit or advantage by the preservation or continued existence of the property or will sustain pecuniary loss from its destruction.1 In other words, the insurable interest doctrine requires a person or entity which holds an insurance policy to have some significant interest in the property insured by the policy.2 Traditionally, the insurable interest requirement has been very broadly read and interpreted with almost any interest being found to create an “insurable” interest. This article will explore the origins of the insurable interest doctrine following its migration from England to the United States, examine why the doctrine is important in the commercial coverage context, examine current trends and issues in determining the insurability of commercial interests, and finally discuss whether inter‐related but unnamed entities could potentially have an insurable interest. I. Common Law and the Origins of the Insurable Interest Doctrine: Insurance law has long required that policyholders possess an insurable interest in the property which they seek to insure.3 Essentially, the insurable interest requirement typically functions as a safeguard to an insurer allowing the insurer to justify nonpayment after a covered occurrence has taken place. If the insurer can successfully prove the insured lacked an insurable interest in the property, a court will hold the insurance contract is void on grounds of public policy. So one may ask, where did the insurable interest requirement originate? And on what grounds is an insurance contract void if an insured lacks an insurable interest? Although the insurable interest doctrine has long been a commonplace in American law, its true origins date back to the 18th century in England. In 1746, the English Parliament outlawed gambling contracts on marine insurance.4 And subsequently in 1774, Parliament extended this gambling prohibition to life insurance contracts as well.5 Accordingly, the original purpose of the doctrine was Parliament’s attempt to curtail the use of insurance contracts as a vehicle to gamble on ships and lives. To achieve Parliament’s purpose, the Acts sought to void contracts which lacked an insurable interest.6 While the Acts of 1746 and 1774 prevented the use of insurance contracts as a means of wagering on ships and lives, the two laws fell short in 1
See, e.g., Delk v. Markel Am. Ins. Co., 81 P.3d 629, 636 (Okla. 2003). 2
While this article focuses on insurable interests in the property context, the breadth of the insurable interest doctrine extends well beyond the property arena. For example, the insurable interest doctrine thrives in the life insurance arena as well. 3
See, e.g., Connecticut Mut. Life Ins. Co. v. Schaefer, 94 U.S. 457 (1876). 4
Act of 1746, 19 Geo. 2, c. 37 § 1 (Eng.). 5
Act of 1774, 14 Geo. 3, c. 48, § 1 (Eng.). 6
Id. The Insurable Interest Doctrine | 2 precisely defining an insurable interest—so the task was left to the King’s Bench to articulate.7 As such, English case law defined the contours of an insurable interest and spawned the debate as to whether an insurable interest must encompass a legal interest in the property or does merely a factual expectation of possession of the property suffice? Interestingly enough, American courts still debate this question which the English Courts articulated over two centuries ago. In Le Cras v. Hughes,8 a British captain and his crew overtook a Spanish ship during a war with Spain. Pursuant to the English Prize Act, under certain circumstances a crew of a ship could acquire title to the captured ship and goods contained therein upon return to England.9 As such, the captain insured the ship and attempted to sail it back to England.10 However, a storm ensued and the ship and the spoils therein were lost at sea.11 Thereafter when the captain filed a claim to collect on the insurance policy, the insurance company denied the claim because legal title had yet to vest in the captain—the insurance company argued it was merely an expectancy, not an interest.12 The King’s Bench agreed to the extent that the captain’s interest did not rise to the level of a legal expectancy because the ship might have been awarded to the Royal Navy.13 However, Lord Mansfield explained that while the captain lacked a legal interest he did find the captain possessed an interest under the factual expectancy theory—i.e., it was commonplace that whenever a capture was made the Royal Crown made a grant since the Revolution.14 In particular Lord Mansfield stated “[w]herever a capture has been made, since the Revolution, by sea or land, the Crown has made a grant: there is no instance to the contrary.”15 Lord Mansfield indicated that while an interest was required, no particular interest was required.16 As such, the captain’s factual expectancy interest was sufficient.17 By comparison, some years later in Lucena v. Craufurd, a case similar to Les Cras v. Hughes, the court articulated the legal interest test.18 In Lucena, His Majesty’s ships captured several other ships. The Royal Commissioners thereafter insured the ships prior to sailing back 7
See Id. 8
Le Cras v. Hughes, (1782) 99 Eng.Rep. 549 (KB). Id. 10
Id. 11
Id. 12
Id. 13
Id. 14
Id. at 551. 15
Id. 16
Id. at 552. 17
Id. 18
Lucena v. Craufurd, (1805) 127 Eng. Rep. 630 (H.L.). 9
The Insurable Interest Doctrine | 3 to London.19 During the course of the journey a loss occurred and the commissioners sought to make a claim under the policies stating the interest was vested in the King.20 A disagreement with the insurance company ensued. Upon reaching the court, Lord Eldon delineated a narrowed ideal of what constituted an insurable interest.21 He struggled with the precept of the factual expectancy test. In that decision Lord Eldon explained: "In order to distinguish that intermediate thing between a strict right, or a right derived under a contract, and a mere expectation or hope, which has been termed an insurable interest, it has been said in many cases to be that which amounts to a moral certainty. I have in vain endeavoured however to find a fit definition of that which is between a certainty and an expectation; nor am I able to point out what is an interest unless it be a right in the property, or a right derivable out of some contract about the property, which in either case may be lost upon some contingency affecting the possession or enjoyment of the party." and "That expectation [of the insured in the case], though founded upon the highest probability, was not an interest, and it was equally not interest, whatever might have been the chances in favour of the expectation . . . If moral certainty be a ground of insurable interest, there are hundreds, perhaps thousands, who would be entitled to insure. First the dock company, then the dock master, then the warehouse‐keeper, then the porter, and then every other person who to a moral certainty would have anything to do with the property, and of course get something by it."22 Therein Lord Eldon articulated the perceived shortcomings of the factual expectancy test.23 If the commissioners—or anyone for that matter—could insure a ship prior to possessing a recognized property right in it, then wagering would once again be a problem—the very issue Parliament sought to prevent. In doing so, Lord Eldon set the stage for a debate that would confront courts for centuries in the context of insurable interest law—a debate that still resonates with courts today. Thus, the question is simply this: “In determining whether an insured has an insurable interest in the property which the insured seeks to insure, does the court require the insured to possess a legal interest or does a mere factual expectancy suffice?” 19
Id. 20
Id. Id. at 648–52. 22
Id. 23
Interestingly, in a divided opinion, the court remanded the matter for trial requiring the Royal Commissioners to demonstrate an expectancy coupled with an interest, i.e., somewhat of a hybrid between the legal interest theory and factual expectancy theory—for the sake of the reader’s curiosity, the Royal Commissioners eventually prevailed. 21
The Insurable Interest Doctrine | 4 And so the foundation of American insurable interest law was set. While the insurable interest doctrine confronted American courts prior to 1876, the United States Supreme Court stated in Connecticut Mutual Life Insurance Company v. Schaefer the “[t]he essential thing is, that the policy shall be obtained in good faith, and not for the purpose of speculating upon the hazard of a life [or property] in which the insured has no interest.”24 In other words, an insured must have an insurable interest in the property before the inured can recover on a policy insuring against damages to the property.25 However, the question remains as to whether a legal interest is required or merely a factual expectancy? Modern American Jurisprudence generally takes one of the two approaches.26 A. The Factual Expectancy Theory: In brief, the factual expectancy theory does not require an insured to own traditional forms of property interests to create an insurable interest.27 As such this theory looks beyond formal property rights and seeks to determine the insured’s real world expectation in a piece of property. Accordingly, pursuant to this theory, it may be difficult to anticipate if an insurable interest exists and subsequently difficult for a court to apply because of the fluidity of one’s expectations. B. The Legal Right Theory: Whereas the factual expectancy theory requires an evaluation of a subjective expectation, the legal right theory considers only objective legal rules in determining the existence of a property right and therefore an insurable interest. Accordingly, the objective legal right theory is more easily applied simply because either a property right exists or it doesn’t. C. The Modern American Majority & The Factual Expectancy Theory: As previously discussed, American jurisprudence is divided between the factual expectancy theory and the legal right theory. It appears the majority of 24
Conn. Mut. Life Ins. Co. v. Schaefer, 94 U.S. 457, 460 (1876) (while the U.S. Supreme Court was speaking in the context of life insurance, the principal holds true in the property context as well). 25
See Davis v. Phoenix Ins. Co., 111 Cal. 409, 43 P. 1115, 1116–1117 (Cal. 1896). 26
See ROBERT PINZUR, A Search for Consistency, 46 Ins. Coun. J. 109 (1979); see also WILLIAM R. VANCE, THE LAW OF INSURANCE 157–58 (3d. ed., Anderson, 1951); EDWIN W. PATTERSON, ESSENTIALS OF INSURANCE LAW 109 (2d ed. 1957). 27
See, e.g., Cal. Ins. Code § 281 (“Every interest in property, or any relation thereto, or liability in respecte thereof, of such a nature that a contemplated peril might directly damnify the insured, is an insurable interest”). The Insurable Interest Doctrine | 5 II. American courts tend to favor the “factual expectations end of the spectrum.”28 However, courts remain divided on the issue.29 Why the Insurable Interest Doctrine is Important in Commercial Coverage A. Major Issues: An insurer must consider many issues when dealing with insurable interests in the commercial coverage context. Some of the issues include but are not limited to the following: (1) the size of the potential loss/amounts of coverage (2) the duty of the insurer to provide contractual benefits and (3) compensating the correct party. In reality, given the low threshold to trigger an insurable interest, these three issues are really the paramount considerations for a carrier. The first thing that must be determined is whether the claim is being asserted by a proper insured. Often the solution may be simple, that the claim be refilled under the correct insured, however, when the policy is in the name of an entity, such as a management company, and there is no enumerated interests held by any other party, then the easy solution may be impossible. In our experience, the most difficult situation arises when a series of otherwise distinct companies share the same ownership, but the policy is held only in the name of one of the entities, without explicitly benefiting the ownership. We will deal with this situation in great detail below, but this situation is the most likely one to cross the average desk. B. The Insurable Interest Doctrine Asks the Following Questions: 28
See JEFFREY W. STEMPEL, INSURANCE COVERAGE LITIGATION §1.05 n44 (3rd ed. 2005) (citing COUCH ON INSURANCE § 41:11; ROBERT H. JERRY II, UnDERSTANDING INSURANCE LAW §§ 40–47 (3d ed. 2002); See, e.g., Lumbermens [sic] Mut. Ins. Co. v. Edmister, 412 F.2d 351 (8th Cir. 1969) (former owner remaining in possession may have insurable interest); Reid v. Hardware Mut. Ins. Co. of the Carolinas, Inc., 252 S.C. 339, 166 S.E.2d 317 (S.C. 1969) (mortgagor who has sold premises retains insurable interest in property); Baughman v. Niagara Fire Ins. Co., 163 Minn. 300, 204 N.W. 321 (Minn. 1925) ( mortgagee in possession but whose grantee had assumed mortgage debt retained insurable interest); Smith v. Eagle Star Ins. Co., 370 S.W.2d 448 (Tex. 1963) (policyholder in possession of state‐owned property has insurable interest); Tublitz v. Glen Falls Ins. Co., 179 N.J. Super. 275, 431 A.2d 201 (Law. Div. 1981) (building owner with plans and contract for demolition retains insurable interest in building). “Although these cases do not reject legal interest analysis or find insurability upon ‘mere’ expectations, they illustrate the modern American preference for deciding insurable interest questions on fact‐oriented grounds”). 29
See, e.g., Delk v. Markel Am. Ins. Co., 81 P.3d 629, 636 (Okla. 2003). The Insurable Interest Doctrine | 6 The insurable interest doctrine asks the following questions: (1) What is the policyholder’s stake in the subject of the property? (2) How attenuated is that interest to the probable cause and effect of loss? (3) How strong is that interest? (4) What is the reasonable range of value for the interest? and (5) Would permitting the policyholder to recover encourage wagering, fraud, moral hazard, or some other evil?30 At the end of the analysis are the public policy considerations. In fact, the public policy behind the insurable interest doctrine helps to explain the rationale behind these questions. C. Public Policy Underpinnings: As previously mentioned, essentially the purpose of the insurable interest doctrine is an attempt to control wagering, fraud, and moral hazards. While wagering and fraud are more easily definable, one may appropriately inquire as to what may constitute a moral hazard?31 A moral hazard is a “hazard that has its inception in mental attitudes.”32 This includes mental attitudes such as dishonesty, carelessness, and insanity or in concrete terms “the risk that an insured will destroy property or allow it to be destroyed (usu. by burning) in order to collect the insurance proceeds.”33 Alternatively, a moral hazard is “dishonesty or character defects that increase frequency or severity of loss.”34 The insurable interest doctrine seeks to safeguard against the aforementioned evils. Otherwise, in the absence of this bulwark, an insurance contract would simply be a mechanism for gambling or a device whereby the insured could unjustly profit from the destruction of insured’s property by the insured himself. Consider this, if the policyholder has a “tenuous connection, or no connection at all, to the property, an insurance contract could amount to a mere gambling agreement . . . .” or “a policyholder’s lack of some interest in the insured property and the availability of insurance to cover loss to the property may tempt an insured to destroy the property in order to make a profit from 30
See JEFFREY W. STEMPEL, INSURANCE COVERAGE LITIGATION §1.05 (3rd ed. 2005). 31
BLACK’S LAW DICTIONARY 1610 (8th ed. 2004) (defining wager as “[m]oney or other consideration risked on an uncertain event; a bet or gamble); Id. at 685 (defining fraud as “[a] knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment”). 32
Id. at 736. 33
Id. 34
See GEORGE E. REJDA, PRINCIPLES OF RISK MANAGEMENT AND INSURANCE 5–6 (9th ed. 2005). The Insurable Interest Doctrine | 7 III. the insurance proceeds.”35 In light of the foregoing, in the absence of the insurable interest requirement, the legislative concern is apparent. That is, insurance law must have some procedure whereby these types of evils are avoided. Accordingly, these are the types of scenarios the doctrine seeks to prevent and thereby simultaneously illustrates the rationale for its existence thereto in terms of public policy. Current Trends and Issues in Determining the Insurability of Commercial Interests A. The Lack of An Ownership Interest Does Not Necessarily Translate Into a Lack of an Insurable Interest In light of the factual expectancy test, the lack of an ownership interest in property does not preclude an insured from having an insurable interest. Rather, the factual expectancy theory has considerably broadened the spectrum of what constitutes an insurable interest. Whereas the strict legal interest theory is confined by objective legal principles, the factual expectancy theory is fluid and dynamic providing the court discretion in determining whether an insurable interest exists. For example, many courts have stated that an insurable interest may simply arise from “possession, enjoyment, or profits of the property.”36 In fact in one case, the District of Columbia Court of Appeals found an insurable interest where the insured had neither a legal or equitable interest in the property. The court found that although occupancy alone is insufficient for an insurable interest in the property, an insurable interest can arise when “a tenant is closely tied to the unique traits of a particular property…”37 In other words, if the tenant “stands to benefit See PETER J. KALIS, THOMAS M. REITER, and JAMES R. SEGERDAHL, INSURANCE COVERAGE LITIGATION § 13.03 (3rd ed. 2005) (citing 4 JOHN A. APPLEMAN & JEAN APPLEMAN, INSURANCE LAW AND PRACTICE § 2121 (1969); see also Constantine v. Home Ins. Co., 427 F.2d 1338 (6th Cir. 1970); Kentucky Cent. Life Ins. Co. v. McNabb, 825 F. Supp 269 (D. Kan. 1993); Luchansky v. Farmers Fire Ins. Co., 515 A.2d 598, 599 (Pa. Super. 1980) (quoting 4 APPLEMAN, INSURANCE LAW AND PRACTICE § 2123 (1969))). 36
See, e.g., Studio Frames Ltd. v. The Standard Fire Ins. Co., 483 F.3d 239, 245 (4th Cir. 2007); JAM Inc. v. Nautilus Ins. Co., 128 S.W.3d 879, 887 (Mo. App. 2004) (quoting DeWitt v. Am. Family Mut. Ins. Co., 667 S.W.2d 700, 705 (Mo. banc 1984)) (noting an insurable interest is not dependent upon the insured having legal title to the property, but “may be derived from possession, enjoyment, or profits of the property, security or lien resting upon it, or it may be other certain benefits growing out of or dependent upon it). 37
Technical Land, Inc. v. Firemen’s Ins. Co. of Washington, D.C., 756 A.2d 439, 447 (D.C. 2000). 35
The Insurable Interest Doctrine | 8 economically from a unique property or to suffer loss from its destruction[,]” the court may find an insurable interest.38 In a more recent case, Teague‐Strebeck Motors, Inc. v. Chrysler Ins. Co., 985 P.2d 1183, 1193 (N.M. Ct. App. 1999), the court found an insurable interest for a contingent property interest. In Teague, the parties contracted for the purchase and sale of the property at issue; however, the sale was subject to the bankruptcy court’s approval. Prior to the court’s approval, the property was destroyed. The court found that the purchaser had an insurable interest because the purchase was likely to be approved, and thus the likelihood of moral hazard was low. The court declared that the test for determining whether there is an insurable interest when there is a purchase agreement is an objective test based on the likelihood of completion of the transaction.39 In reaching its decision the court acknowledged that its ruling “probably extend[ed] the notion of an insurable interest as far as it has been extended in any jurisdiction.”40 41 42 As more states adopt the factual expectancy test, what constitutes an insurable interest has continued to expand. And presumably this is good public policy from the insured’s perspective. Whereas the strict legal theory appears to inure to the benefit of the insurer, the factual expectancy theory benefits the insured because its dynamism allows the court to find an insurable interest should the insurer raise the defense claiming the insured lacks an insurable interest. B. California Law, Inter Alia, Does Not Require An Insured to Own Traditional Forms of Property Interests to Create an Insurable Interest in Property California Insurance Code § 281 states “[e]very interest in property, or any relation thereto, or liability in respect thereof, of such a nature that a contemplated peril might directly damnify the insured is an insurable interest” (emphasis added). As such, California law speaks not to the strict legal interest theory but rather to the factual expectancy theory because it merely requires “any relation” to an interest in property. Pursuant to California law, a strict 38
Id. at 445 (emphasis added). 39
Id. at 1195. 40
Id. 41
The Teague court still recognized the necessity of properly measuring the extent of the insurable interest. Id. 42
However, courts still draw limits when the expectation of an ownership interest is too contingent. See Gossett v. Farmers Ins. Co. of Wash., 948 P.2d 1264, 1272 (Wash. 1997) (finding that insureds’ possession of a house they hoped to purchase did not give rise to an insurable interest). The Insurable Interest Doctrine | 9 C. property right is not prerequisite to for an insured to have an insurable interest.43 For example in Ann Burns v. California Fair Plan, the California appellate court noted “whether an interest is founded upon a legal title, an equitable title, a lien, or such other lawful interest therein as will produce a direct and certain pecuniary loss to the insurer by its destruction, [an insured] has an insurable interest therein.”44 As previously discussed, many other states embrace the factual expectancy theory—another example being Indiana. In United Farm Bureau Mut. Ins. Co. v. Blanton, the Indiana appellate court stated “[i]t is not essential that [an insured] hold[s] a security interest in or title to the property.” As such, the Indiana appellate court was thereby referring to the more relaxed factual expectancy test similar to the one espoused by California, inter alia.45 Generally, An Insured Must Have An Insurable Interest in the Property Both When The Policy Takes Effect And at the Time of the Loss Generally an insured must have an insurable interest in the property both at inception and at the time the loss is effectuated.46 In Dimmitt v. Progressive Cas. Ins. Co., the Missouri Supreme Court articulated “the insured must have an insurable interest in the property both at the time the insurance contract is made and at the time the loss is sustained.”47 This appears to be the majority rule concerning this issue.48 43
See also 36 O.S. 2001 § 3605 B. defines an insurable interest as “any actual, lawful, and substantial economic interest in the safety or preservation of the subject of the insurance free from loss, destruction, or pecuniary damage or impairment.” 44
Ann Burns v. California Fair Plan, 152 Cal. App. 4th 646, 651 (Cal. Ct. App. 2007) (citation omitted). 45
United Farm Bureau Mut. Ins. Co. v. Blanton, 457 N.E.2d 609, 611 (Ind. Ct. App. 1985); see also COLO. REV. STAT. § 10‐1‐102 (defining an insurable interest as “every interest in property or any relation thereto, or liability in respect thereof, of such a nature that a contemplated peril might directly damnify the insured”). 46
See also, CALIFORNIA INSURANCE CODE § 286 (stating “an interest in the property insured must exist when the insurance takes effect, and when the loss occurs, but need not exist in the meantime”); see also Shotmeyer v. New Jersey Title Ins. Co., 195 N.J. 72, 85 (N.J. 2008) (stating even if individuals were named insureds, they would not be entitled to recover because they did not have an insurable interest at the time of loss). 47
Dimmitt v. Progressive Cas. Ins. Co., 92 S.W.3d 789, 792 (Mo. banc 2003) (citation omitted); see also Kingston v. Great Southwest Fire Ins. Co., 578 P.2d 1278 (Utah 1978); International Serv. Ins. Co. v. Gonzales, 194 Cal. Rptr. 341 (Cal. Ct. App. 1987). 48
See JEFFREY W. STEMPEL, INSURANCE COVERAGE LITIGATION §1.05 (3rd ed. 2005). The Insurable Interest Doctrine | 10 However, this rule has been relaxed in particular forms of property insurance situations.49 “Among these are (1) open marine policies, which may cover return cargo purchased in the future; (2) floater policies that cover after‐
acquired goods; (3) builder’s risk polices that increase in value pro rata with construction progress; (4) future reinsurance; and (5) lost but then re‐acquired property in which the policyholder lacked [an] insurable interest during some time of the policy period.”50 Accordingly, one should keep this in mind should a policy deal with one of these situations. D. Recovery Is Generally Limited to the Value of the Insured’s Interest “If an insured’s interest ‘extends to the whole of the subject matter of the property,’ the insured may recover up to the value of the property, subject to the policy limitation.”51 Alternatively stated, “if the interest of the insured is less than the whole of the property, ‘[the insured’s] right is limited, not by the value of the property, but by the value of [the insured’s] interest . . . .”52 This delineates the general rule concerning this issue. Nonetheless, this general proposition is not an absolute. In some circumstances recovery may exceed the value of insured’s interest. In Delk v. Markel American Insurance Company, the Oklahoma Supreme Court recognized the general proposition that a cotenant’s insurable interest is limited to the cotenant’s interest in the property. However, the court explained “that under some circumstances a cotenant’s insurable interest may properly be so limited, but we regard Oklahoma’s factual expectation approach to insurable interest as authorizing under proper circumstances recovery by a cotenant of more than the cotenant’s fractional interest in the insured property.”53 The Delk court stated where one cotenant has been given the responsibility of maintaining and protecting the property for the benefit of the other co‐owners, that cotenant has been given managerial authority to take “any measure which a reasonably prudent person in that position would take, including purchasing insurance for the benefit of all owners.”54 By purchasing insurance, the managing cotenant clearly possesses a substantial economic interest in the continued existence of the property both as an individual and as 49
Id. 50
Id. at n64 (citation omitted). 51
Ann Burns, 152 Cal. App. at 653 (quoting Davis v. Phoenix Ins. Co., 111 Cal. 409, 415 (Cal. 1896). 52
Id. 53
Delk v. Markel Am. Ins. Co., 81 P.3d 629, 637–38 (Okla. 2003). 54
Id. The Insurable Interest Doctrine | 11 the representative agent.55 The court then highlighted that “‘the measure of an insurable interest in property is the extent to which in insured might be damnified by the loss.’”56 And further explained that “indemnification is measured by the extent to which the insured has been economically impacted.”57 As such, the court held that recovery by the managing cotenant of anything less than the full value of the property up to the policy limits will not constitute full indemnity.58 The court thereby held recovery may exceed the cotenant’s fractional ownership interest.59 Accordingly, this case illustrates a clear exception to the general proposition that recovery is limited to the value of the insured’s interest. E. The UCC Created Specific Requirements to the Solve Problem of Determining Insurable Interest Based on Title Prior to the UCC, the problem often arose as to which party bore the risk of a loss in a contract for the sale of goods. The party determined to have title to the goods was the party who could insure the goods and therefore the party who bore the risk of loss. However, determining which party held title was often a complicated endeavor. Therefore, the UCC sought to separate the concept of title from risk of loss and insurable interest.60 The UCC provides that a buyer of goods has an insurable interest in the goods when the goods are identified in the contract. The seller of the goods retains an insurable interest in the goods as long as he or she has title to the goods or a security interest in the goods. In other words, title is not a pre‐
requisite for an insurable interest. Specifically, UCC§ 2‐501 states: (1) The buyer obtains a special property and an insurable interest in goods by identification of existing goods as goods to which the contract refers even though the goods so identified are non‐conforming and he 55
Id. at 639. 56
Id. (citing OKLA. STAT. tit. 36 §3605 (2001)). 57
Id. 58
Id. 59
Id. 60
See In Re Quality Processing, Inc., 9 F.3d 1360, 1364 (8th Cir. 1993) (stating that “[t]he concept of identification of goods to a contract has a limited purpose under the UCC — to provide buyers of goods with a statutory indicium of insurable interest that is commercially preferable to the common law’s dependence upon passage of title”). The Insurable Interest Doctrine | 12 has an option to return or reject them. Such identification can be made at any time and in any manner explicitly agreed to by the parties. … (2) The seller retains an insurable interest in goods so long as title to or any security interest in the goods remains in him and where the identification is by the seller alone he may until default or insolvency or notification to the buyer that the identification is final substitute other goods for those identified. Thus, the UCC creates a definitive yet broader test to determine insurable interest as it relates to goods. While the UCC is not binding law, most states have adopted it in some form.61 The UCC’s provision for creating an insurable interest was more significant in the era where the legal interest doctrine prevailed because it created an insurable interest without legal title. While the factual expectancy test adopted by most states today could very well find an insurable interest without the terms stated in the UCC, the UCC brings more predictability to the insurable interest determination as it relates to goods. Moreover, in some situations it can have the effect of allowing a broader category of insurable interests. For example, in Gonsalves v. Montgomery, No. C 06‐2747 SBA (N.D. Cal September 20, 2006), the plaintiff and defendants entered into a contract for the sale and purchase of a boat. The plaintiff filed an action in order to recover the boat from the defendants pursuant to California Commercial Code § 2502 which provides that a buyer may recover goods that have not been shipped under certain conditions. One condition relevant to the plaintiff’s recovery pursuant to the statute was that he had an insurable interest in the goods.62 Pursuant to California’s UCC provision, for goods that are not in existence at the time of contract, the buyer can obtain an insurable interest “…when the goods are 61
See e.g. California Commercial Code § 2501 (setting forth insurable an interest provision identical to UCC 2‐501). 62
Cal. Com. Code § 2502(2). The Insurable Interest Doctrine | 13 shipped, marked or otherwise designated by the seller as goods to which the contract refers.63 The Court found that although the boat was largely unfinished and title had not passed, the buyer had an insurable interest in the boat solely because it was “in existence” and properly identified. This result is contrary to the result that would have been reached under the legal interest test. However, whether a different result in a similar situation would have been reached under the modern factual expectancy test is less apparent. California’s factual expectancy test states that “[e]very interest in property, or any relation thereto, or liability in respect thereof, of such a nature that a contemplated peril might directly damnify the insured is an insurable interest.” Cal. Ins. Code § 281. In Gonsalves, the plaintiff sought to purchase the boat for personal use. Thus, it does not seem likely that the purchase of goods for personal recreation use would have damnified him in any economic manner. However, the UCC finds an insurable interest without such an inquiry.64 Regardless of the outcome under the factual expectancy test, the purpose of the UCC is to create a clear test for insurable interest in preference to reliance on the passage of title. IV. Inter‐Related But Unnamed Entities and Insurable Interests A. The General Rule Generally, courts will make every effort to find that an insurable interest exists. For example, in Dimmitt v. Progressive Casualty Insurance Company, the Missouri Supreme Court stated “Missouri courts ‘make every effort to find an insurable interest and to sustain coverage’ . . . .”65 In Dimmitt, the Missouri Supreme Court explained “in general, a person has an insurable interest in the 63
Cal. Com. Code § 2501(b). 64
In actuality the plaintiff in Gonsalves had already paid a substantial portion of the purchase price which would convey an insurable interest in a portion of the boat under California’s factual expectancy test. However, it is mentioned for illustrative purposes. 65
Dimmitt v. Progressive Cas. Ins. Co., 92 S.W.3d 789, 792 (Mo. banc 2003) (quoting G.M. Battery & Boat Co. v. LKN Corp., 747 S.W.2d 624, 626 (Mo. banc 1988)); see generally Davis v Phoenix Ins. Co., 111 Cal. 409, 43 P. 1115, 1116–17 (Cal. 1896). Moreover, it is important to note that Dimmitt is not an inter‐
related entity case, but it is merely used here for illustrative purposes of the general rule. The Insurable Interest Doctrine | 14 subject matter insured where [the insured] has such a relation or concern in such subject matter that [the insured] will derive a pecuniary benefit or advantage from its preservation, or will suffer pecuniary loss or damage from its destruction, termination, or injury by happening of the event insured against.”66 Moreover, the Missouri Supreme Court further explained “an insurable interest may be ‘entirely disconnected from any title, lien, or possession,’ and may derive solely ‘from possession, enjoyment, or profits from the property’ as well as ‘other certain benefits growing out of or dependent upon it.”67 In other words, the court went to great lengths in explaining how Missouri courts, inter alia, are careful in finding an insurable interest. Relying on the reasoning of Dimmit, the Missouri Court of Appeals found in Jam Inc. v. Nautilus Ins. Co., 128 S.W.3d 879 (Mo.App.W.D. 2004), that the shareholder of a corporation has an insurable interest in property owned by the corporation. Specifically, the court stated that its holding was “… consistent with the definition of ‘insurable interest,’ in that a shareholder has such a relation or concern in corporate property that the shareholder will derive pecuniary benefit from its preservation, or will suffer pecuniary loss from its destruction.”68 69 Again, this general rule parallels and is therefore congruent with the factual expectancy test. That is, a court will look beyond the strictures of a traditional property interest to find an insurable interest. As discussed earlier, by doing so a court is presumably seeking to protect the insured. Whereas the insurable interest doctrine seeks to prevent wagering, fraud, and moral hazards thereby inuring to the benefit of the insurer—i,e, providing the insurer a contractual defense—the factual expectancy test softens the requirements of the strict legal interest test thereby inuring to the benefit of the insured—i.e, a court may find an insurable interest even in the absence of a concrete property interest. In other words, one might say these two principles are a check and balance to one another. 66
Id. (quoting G.M. Battery & Boat Co., 747 S.W.2d at 626 (citations omitted)). 67
Id. (quoting DeWitt v. Am. Fam. Mut. Ins. Co., 667 S.W.2d 700, 704–05 (Mo. banc 1984). 68
Id. at 888. 69
See also McQuay v. Penn‐America Ins. Co., Do. No. 02‐5112 (10th Cir. Nov. 10, 2003) (finding that a member of the LLC had insurable interest in a tavern owned by the LLC because he had an equitable interest in one third of the LLC and an economic interest in the tavern’s continuing existence because he was entitled to a share of the profits). The Insurable Interest Doctrine | 15 B. Cf. Shotmeyer v. New Jersey Realty Title Insurance Company, 195 N.J. 72 (N.J. 2008): i. Procedural Posture: In Shotmeyer, respondents, i.e., a general partnership, a limited partnership, and their partners sued appellant, i.e., a title insurer, alleging breach of contract and other counts relating to its refusal to pay a claim.70 The trial court granted the insurer summary judgment and respondents appealed.71 The New Jersey Superior Court Appellate Division reversed the trial court’s decision in favor of respondents.72 Thereafter the appellant sought review by the New Jersey Supreme Court.73 ii. Case Overview: A general partnership (“GP”), through its two individual partners, bought land and obtained title insurance.74 Ten years later the GP conveyed the land to a limited partnership (“LP”), which was coincidentally controlled by the same individuals. The LP never obtained new insurance. Over a decade later when the partners discovered a title defect, they sued the title insurer under the policy bought by the GP.75 At the trial court level, the court held the partners did not hold an insurable interest in the land because the insured, i.e., the GP, no longer held title to the land which was transferred to a new and separate legal entity, the LP.76 At the appellate level, the New Jersey Superior Court Appellate Division reversed holding that the GP and LP were merely alter egos of one another and as such the corporate form of the partnerships had to be disregarded in the interests of justice.77 The New Jersey Supreme Court disagreed and thereby reinstated the trial court’s judgment.78 The New Jersey Supreme Court held the GP’s title insurance policy lapsed when it was voluntarily conveyed to the LP, a separate and distinct limited 70
Shotmeyer v. New Jersey Title Insurance Company, 195 N.J. 72, 78 (N.J. 2008) 71
Id. 72
Id. 73
Id. 74
Id. at 77. 75
Id. 76
Id. 77
Id. 78
Id. The Insurable Interest Doctrine | 16 partnership formed by the same individuals.79 The court explained “[a] title insurance policy is a contract that protects a landowner against loss caused by defective title to the land.”80 A purchaser makes a single premium payment at the time of purchase which coverage then continues indefinitely until the insured “divests title or alters title in a way that terminates coverage.”81 The court then explained that pursuant to Title 42 “[p]roperty acquired by a partnership is the property of the partnership and not the individual partners.”82 The GP purchased the property and not the individual partners because the deed was acquired by two named individuals “. . . Partners trading as Beaver Run Farms, a General Partnership.”83 Moreover, the title insurance policy named the GP as the insured.84 Similarly, the later conveyance involved a transfer of the property from the GP to the LP.85 And by statute, the property therefore belonged to the LP, not the individual partners.86 The court also explained “a partnership is an entity distinct from its partners.”87 As such, because the property had been transferred to a separate and distinct entity, the title insurance policy lapsed.88 Thereby neither the GP nor the individual partners held an ownership or insurable interest at the time of loss.89 C. The Implications of the Shotmeyer Decision and Other Exceptions to the General Rule The Shotmeyer case highlights the need for special care when transferring assets between inter‐related but unnamed entities. Namely, particular attention must be given to insurance policies—and subsequently the legal consequences thereto—in the context of real property transfers, inter alia. In the absence of an insurable interest, an insurance contract will simply be void 79
Id. at 85. 80
Id. at 82 (citations omitted). 81
Id. 82
Id. at 83–84 (citing N.J. STAT. ANN. § 42:1A–12(a)(2)). 83
Id. 84
Id. 85
Id. 86
Id. (citing N.J. STAT. ANN. § 42:1A–12(b)(1) (stating “[p]roperty is acquired in the name of the partnership by a transfer to the partnership in its name). 87
Id. at 85 (citing N.J. STAT. ANN. § 42:1A–9(a)). 88
Id. 89
Id. Please note the New Jersey Supreme Court addressed additional issues such as continuation of insurance after conveyance of title and waiver arguments; however, for the sake of brevity, this article does not discuss these additional issues. The Insurable Interest Doctrine | 17 on grounds of public policy and therefore may create unintended consequences for the unwary.90 Even so, the court’s finding in Shotmeyer is hardly surprising in view of the fact that there is a long line of cases holding that there is no insurable interest where property has been transferred from an individual or entity to a related but distinct legal entity. For example, Shotmeyer’s reasoning relies on Gebhardt Family Investment, L.L.C, et al v. Nations Title Insurance of New York, Inc.91 In Gebhardt, respondents Joseph and Faye Gebhardt and Gebhardt Family Investment, L.L.C., sued appellant, their title company, for breach of contract for failing to resolve a cloud on the title of their property.92 The title insurance policy at issue named Joseph and Faye Gebhardt as the insureds.93 In 1995, the Gebhardts reported a claim to their title insurer, Nations Title Insurance.94 However, before resolution of the claim, the Gebhardts conveyed title to their property to Gebhardt Family Investment, L.L.C. (“the LLC”).95 The Gebhardts created the LLC for estate planning purposes and were its only members.96 The warranty deed stated that the LLC paid $160,000 consideration for the property.97 The appellate court affirmed the lower court ruling which found that the LLC was not insured under the policy because it obtained the property by way of purchase rather than by operation of law; and therefore, the Gebhardts’ coverage terminated when they conveyed the property to a separate entity.98 99 90
See also, Beckon, Inc. v. AMCO Ins. Co., 2008 LEXIS No. 4:07CV2074‐DJS at *7 (D. Mo. August 22, 2008) (noting that a lack of both legal and equitable title amounts to a mere expectation and “‘although amounting to a moral certainty that one will have an interest in the property, [it] does not give rise to an insurable interest’”) (quoting Wisecup v. Am. Ins. Co. of Newark, 186 Mo. App. 310 (Mo. App. 1914)). 91
Gebhardt Family Investment, L.L.C, et al v. Nations Title Insurance of New York, Inc., 132 Md. App. 457, 752 A.2d 1222 (2000) 92
Id. at 1224. 93
Id. at 1223. 94
Id. 95
Id. 96
Id. 97
Id. 98
Id. at 1224. 99
The court relied on the Virginia Limited Liability Company Act, Code §§ 13.1‐1002 through 13.1‐1073 which stated that “…the transfer of property from a member to the limited liability company is more than a change in the form of ownership; it is a transfer from one entity or person to another.” Id. at 1225. The Insurable Interest Doctrine | 18 Specifically, the Court rejected the argument that the Gebhardts still retained an interest in the property because they were the sole members of the LLC.100 101 102 Cases subsequent to Stromeyer have followed the principles expounded in Stromeyer and previous court decisions. For example, in Carney‐Dunphy v. Title Co. of Jersey & Chicago Title Ins. Co., 2009 U.S. Dist. LEXIS 55418 at *24‐25 (D. N.J. June 30, 2009), the United States District Court for the District of New Jersey relying on Stromeyer found that the plaintiff was not entitled to coverage under the title insurance policy because the policy lapsed when the property at issue was voluntarily conveyed from the plaintiff’s mother to a family trust.103 More recently, in Kwok v. Transnation Title Ins. Co., the California Court of Appeal found that the voluntary conveyance of an LLC’s property to its members’ trust terminated the applicable insurance coverage.104 In Kwok, Patrick and Maria Kwok formed an LLC of which they were the sole members. The LLC purchased real property and obtained title insurance in its name. Subsequent to the purchase, the LLC conveyed the property to Mr. and Mrs. Kwok as trustees of their revocable trust. Thereafter, the LLC dissolved. The court stated that the insurance “…coverage did not continue because title to the property did not devolve to appellants as members of the LLC on dissolution of the LLC, but rather was transferred by deed from the named insured to appellants as trustees of their family trust, a totally separate legal entity.105 Therefore, the coverage terminated despite the fact that the entities were comprised of the same members. In addition to Stromeyer, these cases also suggest that special attention must be paid when transferring assets to an inter‐related entity that is not named on the insurance policy. Courts have consistently found that parties 100
Id. at 1225. 101
See also e.g., Fairway Development Co. v. Title Insurance, 621 F.Supp. 120 (N.D. OH 1985) (finding that change in partnership personnel causing dissolution of first partnership extinguished title insurance of new partnership which consisted of only two of the former partners); Point of Rocks Ranch, LLC v. Sun Valley Title Ins. Co., 146 P.3d 677 (ID 2006) (holding that parties’ conveyance of land to their limited liability company extinguished their interest in property and was a “voluntary” transfer and not by operation of law). 102
But see, Heyden v. Safeco title Ins. Co., 175 Wis. 2d 508, 517‐18 (Dist. 1, 1993) (finding that the sole shareholder of a corporation had an insurable interest under the title policy). 103
Plaintiff would have been a successor to her mother’s interest under the title policy. 104
Kwok v. Transnation Title Ins. Co., 170 Cal.App.4th 1562 (Cal.App.2d 2009). 105
Id. at 1567. The Insurable Interest Doctrine | 19 taking advantage of the limited liability found in a limited liability company or limited partnership are subject to the potential pitfalls that arise when conveying property to a legally distinct entity. Courts are reluctant to so‐called pierce the corporate veil in these situations to find an insurable interest and that the unnamed entity is a party to the contract. However, such persons or entities can avoid the pitfalls of the Stromeyers and others like them by taking preventative measures upon transferring property. For example, the grantee could obtain a new insurance policy upon receiving the transfer or the grantor could amend its existing insurance policy to add the unnamed entity as an additional insured.106 Moreover, recent statutory enactments in some states suggest that some of the unintended consequences of transferring property from one related entity to another can be avoided for legal entities that have converted to an LLC or other legal entity.107 Many states have enacted conversion statutes which provide that a converted entity remains the same entity that existed before the conversion.108 For example, California Corporations Code § 17540.9(a) states in reference to an entity that converts into an LLC that “[a]n entity that converts into another entity pursuant to this chapter is for all purposes the same entity that existed before the conversion.” It also states under § 17540.9(b)(1) that upon a conversion taking effect “[a]ll the rights and property, whether real, personal, or mixed, of the converting entity or converting limited liability company are vested in the converted entity or converted limited liability company.”109 110 These statutes suggest that a legal entity such as a general partnership or limited partnership 106
Another preventative measure is found by obtaining a “Fairway Endorsement.” In Fairway Development Co. v. Title Insurance, 621 F.Supp. 120 (N.D. OH 1985), the court found that a change in partnership personnel caused the dissolution of the first partnership thereby extinguishing the title insurance of the new partnership which consisted of the remaining two partners. A “Fairway Endorsement” provides that coverage issued to a partnership will not be based on admission, substitution, or withdrawal of any individual or entity as a member of the partnership or change in any member’s interest in the partnership. The same endorsement could be utilized for an LLC. However, it should be noted that the Fairway decision was decided under the aggregate theory of partnership which caused a new partnership to form upon any change in partners. Under current law, Ohio and many other states follow the entity theory of partnership which upholds the original partnership as an entity upon any change of partners. See Ohio Rev. Code 1776. 107
See John C. Murray, Legal and Title‐Insurance Issues in Limited Liability Real‐Estate Transactions (2008), http://www.firstam.com/ekcms/uploadedFiles/firstam_com/References/Reference_Articles/John_C_M
urray_Reference/Limited_Liability_Companies/Limited%20Liability%20Companies%20‐
%20%20Article%20V.pdf 108
Id. 109
See also Illinois’ Limited Liability Company Act, 805 ILCS 180/37‐15, Del Code Ann. Tit. 6, § 18‐214(f). 110
See also Cal. Corp. Code § 15911.09 (stating same for conversion into limited partnership). The Insurable Interest Doctrine | 20 that converts into an LLC will retain all coverage and rights under an applicable insurance policy because any property transfer will be by “operation of law” rather than “voluntary” conveyance. D. The Uncertainty of Factual Expectancy Theory Whereas the insurable interest doctrine can adequately be described as the bulwark against evils such as wagering, fraud, and moral hazards, the factual expectancy theory may aptly be described as the insured’s safeguard against an unwarranted claim by an insurer that the insured lacked an insurable interest. And this appears to be good public policy for the reasons set forth above. However, the factual expectancy presents and insurer, the insured, and the court with a sense of ambiguity in precisely determining when an insurable interest exists. That is, the enforceability of an insurance contract depends upon how the court chooses to define an insurable interest. Whereas, the strict legal theory rests upon objective legal principles, the factual expectancy theory incorporates subjective values into the equation. For example, California defines an insurable interest as “[e]very interest in property, or any relation thereto, or liability in respect thereof, of such a nature that a contemplated peril might directly damnify the insured is an insurable interest” (emphasis added).111 It would be difficult to define with any precision what “any relation thereto” means. What quantum of a connection would suffice? Would the Shotmeyer case have been decided differently in California? Would the individual partners’ connection to both the general and limited partnerships suffice? In light of this uncertainty, each case will ultimately have to be decided upon its own facts pursuant to the factual expectancy theory.112 Accordingly, when dealing with inter‐related but unnamed entities, inter alia, the wise would carefully consider and address these types of issues at the outset. 111
See CALIFORNIA INSURANCE CODE § 281. 112
By comparison, the strict legal theory would, in most instances, provide a bright‐line rule. The Insurable Interest Doctrine | 21