To be enforceable a contract must be entered into for a legal purpose. All contracts are assumed to have a legal purpose, except those that contemplate a course of action that would contravene a statute or some other rule of law. It is not sufficient, however, that the agreement refrain from an act specifically prohibited by law; it must not tend to encourage illegality, immorality, or other conduct contrary to public policy. There is an exception to this rule. An insurance contract issued by an insurer unlicensed to do business in that state is an illegal contract. However, the law that makes such a contract illegal was enacted to protect the citizens of the state. Consequently, the law permits the insured, but not the life insurance company, the option to either avoid the contract or enforce the contract.

Life insurance clearly does not require either party to perform an illegal act and, in that respect, qualifies as a perfectly valid contract. As a matter of fact, it is universally recognized as having a purpose highly beneficial to society and worthy of favorable legislative treatment. On the other hand, it has been acknowledged that without adequate safeguards, life insurance could lend itself to behavior that would be socially harmful and contrary to public policy. Specifically, it could provide the motivation for wagering, murder, and suicide.

Regarding the first of these dangers, remember that life insurance is an aleatory contract. This means that it offers the potential of a return out of all proportion to the investment in the contract. This characteristic quickly attracted elements of the population who hoped to enrich themselves through the operation of the laws of chance. In eighteenth-century England, life insurance became the means of satisfying a mania for gambling, which was discouraged but not prohibited. Speculative life insurance was likely to be taken out on anyone who was in the public eye. Persons accused of crimes punishable by death and those in disfavor with the royal court were favorite subjects for life insurance contracts. Prominent people became the object of speculative insurance as soon as press notices revealed them to be seriously ill, and the premium for new policies on such persons fluctuated from day to day in accordance with the reports or rumors of their condition. Newspapers of the day even carried premium quotations on the lives of persons known to be the object of speculative insurance, with the consequences described by a contemporary writer. "This inhuman sport affected the minds of men depressed by long sickness; for when such persons casting an eye over a newspaper for amusement, saw their lives had been insured in the Alley at 90 p.c., they despaired of all hopes, and thus their desolution [sic] was hastened."

The situation became so intolerable that in 1774 Parliament enacted a law stating that a person contracting for insurance had to have an insurable interest in the life of the person to be insured. The statute added an indemnity element; upon the death of the insured, it was illegal to recover a sum in excess of the monetary interest that the policyowner had in the life of the insured.

In this country an insurable interest has always been required in all jurisdictions, but with the exceptions noted later, no attempt has been made to apply the indemnity concept that existed for a time in England. As late as 1960, the requirement of insurable interest was not based upon statute but resulted from a judicial application of the public policy against enforcing wagering contracts. All states require that an insurable interest between the applicant-owner and the prospective insured exist at the contract�s inception.

The insurable interest requirement originated as a means of controlling wagering on human lives and still finds its greatest significance in that function, but it was also intended to reduce the threat of murder created by insuring one person�s life for the benefit of another. The thought was that if the class of persons who can legally insure the life of another is restricted to those who are closely related to the proposed insured by blood, or possess such a financial relationship that they stand to gain more by his or her continued life than by his or her death, the temptation to murder the insured would be greatly curtailed. A further safeguard is that a person whose life is to be insured by another must give his consent to the transaction. Presumably, a prospective insured will not permit his or her life to be insured in favor of a person whose integrity or motives are questionable.

The same reasoning underlies the rule, discussed later, that the beneficiary of a policy applied for or owned by the insured need not have an insurable interest in the insured. The law presumes that the insured, whose life is at stake, is capable of choosing beneficiaries who will not be motivated to commit murder to enjoy the insurance proceeds sooner.

The foregoing deterrents are supplemented not only by criminal penalties for murder but also by statutes and judicial rulings that prohibit the payment of insurance proceeds to a beneficiary who murders the insured. This restriction is based on a general rule of law that a wrongdoer is not permitted to profit by his or her wrongdoing. The insurance company is not relieved of its obligation to pay because the proceeds will be owed to contingent beneficiaries or to the insured�s estate, depending on the policy language and the law in the particular jurisdiction involved.

A final area in which there is the possibility of a conflict between life insurance and the public interest is the treatment of suicide. Suicide is contrary to many religious laws, and attempted suicide is ordinarily a penal offense. Thus suicide is contrary to public policy. Any contract that would encourage suicide or act as an inducement to commit suicide would, by the same token, be contrary to public policy.

Some of the early court decisions in this country indicated that death by suicide should not be covered by a life insurance policy. In a leading case, the United States Supreme Court expressed the view that "death intentionally caused by the act of the insured when in sound mind�the policy being silent as to suicide�is not to be deemed to have been within the contemplation of the parties . . . [A] different view would attribute to them a purpose to make a contract that could not be enforced without injury to the public. A contract, the tendency of which is to endanger the public interests or injuriously affect the public good, or which is subversive of sound morality, ought never to receive the sanction of a court of justice or be made the foundation of its judgment."

This view, which has since been rejected by the American courts but is still the law in England, was not universally entertained. To protect themselves against people who might apply for insurance with the deliberate intention of committing suicide, insurers adopted the precaution of inserting a clause in their policies that limited their liability to a return of premiums if the insured committed suicide within a specified period�usually one or 2 years�after the date of issue. It was felt that such a clause would properly protect the insurers� interests and after a preliminary period during which any abnormal impulse toward self-destruction should have passed away, would provide coverage against a peril to which all people are subject.

Such a clause was adjudged by the United States Supreme Court to conserve the public interest, and most of the states have enacted statutory restrictions on the insurer�s right to avoid liability because of suicide during a limited period after the life insurance policy is issued. Although most states permit suicide exclusions for 2 years or less, a few states limit the maximum length of the suicide exclusion clause to one year.

Exception to Suicide Exclusion. An exception to this philosophy is the Missouri statute that precludes the defense of suicide at any time unless it can be proved that the insured was contemplating suicide at the time he or she applied for the insurance. The Missouri statute provides as follows: "In all suits upon policies of insurance on life hereafter issued by any company doing business in this state, to a citizen of this state, it shall be no defense that the insured committed suicide, unless it shall be shown to the satisfaction of the court or jury trying the case, that the insured contemplated suicide at the time he made his application for the policy, and any stipulation in the policy to the contrary shall be void." This statute has been upheld by the United States Supreme Court as not being in conflict with the state constitution or the federal Constitution, but the court intimated that the statute was inconsistent with public policy and sound morality.

The insured�s state of mind at the time of the suicide can determine whether the death benefit is payable. New York, for example, prohibits exclusion of suicide while the insured is insane. Suppose the policy has a suicide clause, but the clause does not contain the phrase "while sane or insane." If the insured commits suicide while sane, the company will not be required to pay the death benefit. However, if the insured was insane at the time of the suicide, the insurer will be required to pay the death benefit. This rule is based on the theory that insanity is a disease that may infect all insureds, and the insurer has assumed that risk. Consequently, to avoid that risk suicide clauses usually specifically exclude liability for a suicide whether the insured was sane or insane. A sample suicide clause reads as follows:

Note there is no suicide exclusion clause in the policy, the death benefit is payable even if the insured commits suicide and intended to do so when the policy was purchased. Note also that the insured�s accidental death is not excluded even if it occurs as the result of insured�s sane or insane act.

A typical insurable interest statute is the following Pennsylvania law: "The term �insurable interest� is defined as meaning, in the case of persons related by blood or law, an interest engendered by love and affection, and in the case of other persons, a lawful economic interest in having the life of the insured continue, as distinguished from an interest which would arise only by the death of the insured." In its broadest sense, insurable interest is a "relation between the insured and the event insured against such that the occurrence of the event will cause substantial loss or harm of some kind to the insured." Note that the life insurance definition does not require a pecuniary interest; it is broad enough to recognize a sentimental interest based on love and affection. Some cases support the opinion that a relationship by blood or marriage alone constitutes an insurable interest. Among blood relationships, only parent and child, grandparent and grandchild, and siblings have been recognized as sufficiently close to establish an insurable interest. Among relationships based upon marital ties, only the relationship between husband and wife is sufficient to establish an insurable interest. Beyond these four narrow categories, it is the majority role that sentimental attachment based upon relationship alone is insufficient to establish an insurable interest. Note further that a pecuniary interest need not be capable of exact measurement. Nor need it be based on a legal right. It is sufficient that there be a reasonable expectation of some financial gain or advantage.

Before a discussion of the various relationships that can give rise to an insurable interest, it is necessary to explain when the interest must be present.

In property and casualty insurance, an insurable interest need not be present at the inception of the contract, but it must exist at the time of loss if there is to be any recovery under the contract. The requirements are reversed in the case of life insurance. In life insurance an insurable interest must exist at the inception of the contract but need not be present at the time of the insured�s death. This striking difference in the application of the requirement results from the fact that property insurance is based on the principle of indemnity, while a life insurance contract is not. To use property insurance terminology, a life insurance policy is a valued policy. It is a contract to pay a stated sum upon the occurrence of the event insured against. The stated sum may be unrelated to the dollar value of the loss. Since the beneficiary has a legal claim to a fixed sum of money upon the insured�s death, he or she need not prove that a loss was sustained by reason of the death.

One may concede that the insurable interest of one person in another person�s life should not be the measure of recovery and still argue that if the former�s interest has become wholly extinguished, his or her right to the face amount of the policy should likewise be extinguished. To permit a person whose interest in the life of the insured has been completely terminated to collect the proceeds at the insured�s death gives the appearance of speculation and offends many people�s sense of justice. However, the rule was adopted by the English courts at a time when surrender values were not available, and termination of a policy before maturity meant forfeiture of all accumulated values. For the courts to force a policyowner to lapse a policy and forfeit the entire investment element because an interest that was perfectly valid at the time the policy was issued had been extinguished would have been harsh. The courts were faced with the alternative of permitting the owner of the policy to collect the full face amount of the policy or nothing at all.

If the matter were being adjudicated today without regard to precedent, the courts would probably hold that extinguishment of insurable interest terminates a policy and the policyowner would be permitted to recover the cash value as of the date of extinguishment, together with premiums paid thereafter in mistaken reliance on the contract. As the matter now stands, an incipient insurable interest is all that is necessary to sustain the validity of a life insurance contract. Thus if a creditor procures insurance on the life of his or her debtor and the debt is subsequently extinguished, the creditor may keep the policy in force and collect the full amount of the policy when the insured dies. A policy procured by a partnership on the life of a partner is unaffected by the dissolution of the partnership and the transfer of the policy to a former member of the firm who no longer has an insurable interest. A corporation that procures a policy on the life of a valuable manager may collect the full amount of insurance, despite the fact that the manager had previously been discharged. A divorce does not deprive a spouse-beneficiary of the right to the proceeds of his or her former spouse�s life insurance, even though he or she no longer has an insurable interest in the former spouse�s life.

The foregoing rules are not followed in Texas. The Texas courts have traditionally required a continuing interest. That is, a person who takes out insurance on the life of another person must have an insurable interest in the insured at the maturity of the contract in order to receive the proceeds. Prior to 1953, Texas case law also required that any beneficiary or assignee in a policy procured by the insured have an insurable interest at all times. A later statute modified the requirement by stating that any beneficiary or assignee named by the insured will be deemed to have an insurable interest, but it left undisturbed the mandate of a continuing interest for the person who procures insurance on another�s life.

This discussion has made no reference to life insurance policies procured by the person whose life is to be insured since in such cases there is no question of a continuing interest. If the view is accepted that a person has an insurable interest in his or her own life, then certainly that insurable interest continues throughout his or her life.

In considering the relationships that give rise to an insurable interest, it is helpful to distinguish between the cases in which the applicant is applying for insurance on his or her own life and those where the applicant is seeking insurance on the life of another.

The question of insurable interest is not involved when a person, on his or her own initiative, applies for a policy on his or her own life. It is commonly said that a person has an unlimited insurable interest in his or her own life, but the expression is technically inaccurate since a person does not suffer a financial loss by his or her own death�or at least that person does not survive to claim indemnity for a loss. Hence it seems preferable to state that the issue of insurable interest is immaterial when a person applies for insurance on his or her own life. Regardless of how the status of the insured is characterized, the law considers the insurable interest requirement to have been met�for any amount of life insurance.

For underwriting purposes, however, insurers do not accept the view that the applicant has an unlimited insurable interest or that the question is immaterial. An applicant�s financial circumstances are carefully investigated, and the company limits the amount of insurance to that which can be justified by the applicant�s financial status and earning capacity.

The law is well settled that when a person procures a policy on his or her own life, it is not necessary that the beneficiary have an insurable interest in the insured�s life, either at the inception of the contract or at the time of the insured�s death. United States law is unanimous on that point, the rationale being that insureds should be permitted to dispose of their human life value with the same freedom that they can exercise in disposing of their other property at death. The temptation to murder is considered minimized by the insured�s judgment in choosing the objects of his or her bounty. As a matter of fact, the insured enjoys much greater latitude in disposing of his human life value, since insurance proceeds are not subject to restrictions on bequests to charitable organizations or claims of creditors (if properly set up). Some restrictions do exist in the community property and quasi-community property states, however.

Applications at Beneficiary�s Instigation. The courts take a different view of the situation when the policy is applied for at the beneficiary�s instigation. Such a transaction may arise out of a legitimate business relationship and have a useful purpose, or it may serve as a cloak for a wagering contract. When the application does not stem from a business or personal situation that would seem to justify the designation of the particular beneficiary as payee and the beneficiary agrees in advance to pay all premiums under the policy, the courts are inclined to regard the transaction as speculative in nature. For example, when a woman was induced to apply for insurance on her life in favor of the mortgagee of her husband�s land, her employer, and her sister-in-law, and the beneficiary in each case was paying all premiums, the contract was declared to be a wager.

The payment of premiums by the beneficiary is not conclusive proof of wagering, but it gives rise to a strong inference. Since the question of insurable interest is important only at the policy�s inception, it is immaterial whether later, because of a change of circumstances, the beneficiary assumes responsibility for premium payments in order to keep the policy in force.

In 1893 a North Carolina court ruled that a policy procured at a college�s instigation covering the life of a wealthy man (a prospective donor) was invalid because the college had no insurable interest in his life. This changed during the 1900s, however, and it became an acceptable practice for donors to encourage charities and other nonprofit institutions to apply for life insurance on their lives, with the donors providing a means of paying the premiums, often using trusts. It was widely believed that the various state statutes regarding insurable interest included the relationship between a charity or nonprofit organization and its donors.

However, the IRS issued a private letter ruling in 1991 to a New York taxpayer disallowing income tax, gift tax, and estate tax deductions related to an intended gift of life insurance to a charity. The basis of the denial was an IRS interpretation that the charity lacked an insurable interest in the life of the donor under New York law. In swift reaction to the IRS�s private letter ruling, New York and many other states amended their insurable interest statutes to acknowledge an insurable interest between charities and their prospective donors. Although there is disparity from one state to another, most of these revised statutes specifically recognize the relationship between donors and many classifications of nonprofit organizations as an insurable interest. As some tax authorities point out, a few of these statutes do not, however, explicitly express the donee organization�s right to apply for the life insurance policy directly. Some tax advantages may be lost if an existing policy is donated to the organization, rather than purchased by the donee organization.

In practice an insurer makes no distinction between applications submitted at the prospective insured�s initiative and those submitted at the prospective beneficiary�s instigation. In all cases, the insurer requires that the original beneficiary have an insurable interest of some sort as a precaution against wagering, homicide, or other moral peril. If the prospective beneficiary does not appear to have a legitimate insurable interest, the company will request an explanation of the relationship; if the explanation is unsatisfactory, it will almost certainly reject the application.

Once the policy is issued, however, the company has no right to withhold approval of a change of beneficiary on the grounds that the proposed beneficiary lacks an insurable interest�or on any other grounds, for that matter, except failure to comply with the prescribed procedure for effecting such a change. Of course, if the circumstances surrounding the request for a change of beneficiary indicate an attempt to evade the underwriting requirements of the company or the legal requirement of insurable interest, the insurer may be permitted to rescind the policy on the grounds of fraud or on the grounds that the entire transaction was a subterfuge for procurement of insurance by a person lacking an insurable interest in the insured.

Policy Assignments. The insured may make the policy payable to a third party by means of an assignment, and as a general rule, it is not necessary for the assignee to have an insurable interest. The position of the courts is that it is immaterial whether the insured designates the payee of the policy within the contract itself, as with a conventional beneficiary designation, or with a separate instrument�an assignment.

A very few states, however, require the assignee to have an insurable interest, at least under certain circumstances. All states require an insurable interest if the insured was induced by the assignee to take out the policy since that would be tantamount to the assignee�s applying for the insurance directly. If there is any indication at the time of application that an assignment is contemplated, the insurance company, as a matter of underwriting practice, will usually require evidence of the prospective assignee�s insurable interest.

Under the doctrine adopted by the majority of American courts, there is nothing to invalidate successive assignments of a life insurance policy once it is validly issued. None of the assignees need have an insurable interest, and the insured need not give his or her consent to the assignments. This rule is based on the doctrine that a life insurance policy is a form of personal property and should be freely transferable. If a life insurance contract could be sold only to persons having an insurable interest in the insured�s life, the market would be severely limited, and the owner of the policy would be handicapped in disposing of it.

Accelerated-Benefit Provisions. In recent years there were instances where persons suffering from full-blown AIDS sold their life insurance policies to viatical settlement companies (companies that keep the policies to collect the death benefit) in order to help them finance needed health care during the terminal stage of their illness. Such policy sales prompted some life insurers to introduce accelerated-benefit provisions for life insurance policies. The IRS has even set forth requirements for tax-free treatment of life insurance proceeds that are paid during the last 12 months of life for terminally ill insured persons under these accelerated-benefit provisions.

Some states have imposed insurance regulations on viatical settlement companies to discourage unregulated commercial trading of life insurance policies covering terminally ill individuals. There is a concern that desperate people with few options may be taken advantage of by unregulated persons wagering on life insurance policies.

It seems repugnant and contrary to public policy for existing life insurance policies to be sold on the auction block to the highest bidder. (Such a market actually developed in England before the development of cash values in life insurance policies.) If the buyers of these policies had an insurable interest in the insured�s life there would be less of a public policy concern.

A special set of rules is applicable when a policy is made payable to a creditor of the insured, whether the designation is as beneficiary or as assignee. Creditor situations will be discussed in the next section of this chapter.

Most policies are issued upon the application and at the initiative of the person to be insured. Hence the foregoing principles govern the typical situation. The rules applicable to the exceptional cases in which the applicant and the insured are not one and the same are set forth below.

In most jurisdictions consent of the person to be insured is usually essential to the validity of a life insurance contract taken out by a person other than the prospective insured. However, these jurisdictions usually make an exception for applications submitted by a spouse on the life of the other spouse or by a parent on the life of a child too young to apply for insurance in his or her own right. As a practical matter, the prospective insured�s signature needed on the application to affirm the accuracy of the information in it. Hence insurers always require the signature of the person whose life is to be insured, except when that person is a minor.

In all jurisdictions, a third-party applicant must have an insurable interest in the life of the person to be insured. This statement presupposes that the applicant will be the owner of the policy and the person to receive the proceeds upon maturity of the contract. A more accurate statement of the requirement�as it is prescribed in some states, at least�is that the person who procures the policy and is to receive the proceeds must have an insurable interest in the insured. The New York Insurance Law, for example, states the requirement in such terms and provides that if the proceeds are paid to a person not having an insurable interest in the insured at the time the contract was made, the insured�s personal representative may maintain an action to recover such proceeds from the person receiving them.

The insurable interest required may arise out of either a family or a business relationship. As explained earlier, if it arises out of a family relationship, it may be based on love and affection or on a legal or factual expectation of financial advantage from continuance of the life of the insured. Interests originating in business relationships are regarded as economic in nature.

Family Relationships. The doctrine that an emotional attachment constitutes a sufficient insurable interest, apart from financial considerations, has been expounded in various judicial opinions and incorporated into the statutes of some states. It seems that the doctrine serves both of the insurable interest requirement�s major objectives: to minimize wagering and to prevent murder.

In applying the doctrine, the closeness of relationship needed to satisfy the requirement is critical. The relationship of husband and wife is universally conceded to be close enough, although it is virtually always accompanied by an economic interest. The relationship of parent and child, based on both economic and familial ties, is generally regarded as sufficient to satisfy the law. A growing minority of courts have also recognized the relationships of sibling to sibling and grandparent and grandchild as sufficient. Blood relationships more remote than the above such as uncle and niece, uncle and nephew, and cousin of any degree, have generally been rejected as insufficient. Aside from that of husband and wife, no tie growing out of affinity alone�such as an interest of an individual in his or her father-in-law, mother-in-law, brother-in-law, stepfather, or stepchild�has been recognized as a sufficient insurable interest.

The courts that do not subscribe to the belief that a sentimental value alone will satisfy the insurable interest requirement still find a valid insurable interest in close family relationships, apparently on the assumption that a legal or factual expectation of pecuniary value exists in such cases. Thus the legal obligation of spouses to support each other gives them an insurable interest in each other�s life. A parent is entitled to the services of a minor child and hence has an insurable interest in the child�s life. A woman has an insurable interest in the life of her fiance, at least in states where the agreement to marry is a legal obligation.

An expectation of financial advantage from the continued life of a person which is not based on a legal obligation is referred to as a factual expectation. A factual expectation is generally not sufficient to support a contract of indemnity, such as those found in the property and casualty insurance branches, but it has long been regarded as sufficient in life insurance. In the earliest reported American decision involving life insurance, the Supreme Judicial Court of Massachusetts upheld a policy in favor of the insured�s sister on the grounds that the insured had been voluntarily supporting her and probably would have continued to do so had he lived. A foster child, though not legally adopted and hence without legal claim to support, has been held to have an insurable interest in the life of his foster father. A woman living with a man under the honest but mistaken belief that she was lawfully married to him was held to have had an insurable interest in his life because of her expectation (possibly misplaced) that he would have continued to support her. An illegitimate child is considered to have an insurable interest in the life of his or her putative father, who has contributed to the child�s support.

When an insurable interest is based on a family relationship, there is no legal limit to the amount of insurance that may be validated by it. This is based on the concept that a life insurance policy is not a contract of indemnity and hence does not purport to reimburse a beneficiary for a specific pecuniary loss. Insurance companies, however, have their own strict guides limiting the amount of insurance they will underwrite. It would be extremely difficult, if not impossible, to place a precise valuation on an interest based on love and affection. Interests arising out of a legal entitlement to support could perhaps be valued, but those based on a factual expectation could be measured only in the roughest terms. Interests based on business relationships can usually be valued and, in general, can support only an amount of insurance that bears a reasonable relationship to the value of the interest.

Business Relationships. A variety of business relationships create an insurable interest. One of the most common is a contractual arrangement calling for unique or distinctive personal services. There are numerous examples of such arrangements in the entertainment world. A theatrical producer has an insurable interest in the life of an actor who has contracted to perform over a definite period and who would be extremely difficult to replace in the role. Likewise, a film producer has an insurable interest in the lives of the principal performers, which escalates as the film gets into production and the death of a star would disrupt operations and require refilming all scenes in which the deceased appeared. Professional sport teams have an insurable interest in the lives of their players.

The examples above are based on contractual or legal obligations, but factual expectations may also support an insurable interest. The importance of the business manager has led to the recognition that a corporation or other form of business enterprise has an insurable interest in the life of a manager or some other official whose services and skills are vital to the prosperity of the enterprise, even though the person has not assumed a legal obligation to work for the firm for any specified period of time. A firm�s interest in its key officers and employees has been recognized by statute in many states and judicially sanctioned in the other states. Insurance taken out to protect such an interest is called keyperson insurance and is widely sold.

Another business relationship that gives rise to an insurable interest exists among partners in a partnership and stockholders in a closely held corporation. The consequences of the death of a general partner or active stockholder can be so detrimental that the parties involved frequently enter into an agreement for the disposition of the business interest of any individuals who might die while still active in the management of the firm. Specifically, the agreement binds the firm�s surviving members to purchase the deceased member�s interest at a specified price. It also obligates the deceased member�s estate to sell his or her interest to the surviving members. The agreements are usually financed by insurance on the lives of the individuals involved, and either the other members of the firm or the firm itself applies for the insurance on any particular individual. In such cases, the courts have recognized an insurable interest, based on the factual expectation of a loss if the business has to be liquidated, upon a general partner�s or stockholder�s death.

Perhaps the most common business or commercial transaction that produces an insurable interest is by lending money. Despite the fact that the obligation to repay a loan is not discharged by the death of a debtor�the obligation is enforceable against the deceased�s estate�a creditor is universally conceded to have an insurable interest in the life of the debtor. This rule is based on the recognition that the creditor may not be able to collect the sum of money due from the debtor�s estate because of insufficiency of assets. The creditor may protect his or her interest by taking out insurance on the debtor�s life or by requiring the debtor to designate the creditor as payee under a policy taken out by the debtor.

If the creditor takes out insurance on the debtor�s life and pays the premiums, he or she is permitted to retain the full amount of the proceeds, even though they exceed the amount of the debt, plus accumulated interest. In fact, the creditor can retain the full amount of the proceeds even if the debt has been completely extinguished. The only limitation imposed in most jurisdictions is that the amount of insurance must not be disproportionate to the amount of the debt as it existed at the time the policy was issued or as it was reasonably expected to be thereafter. The purpose of this requirement is to prevent using a debt as a cloak for a wagering transaction. In a leading case, for example, a policy for $3,000 taken out on the basis of a $70 debt was held to be a wager and hence invalid. Yet policies have been upheld when the amount of insurance was several times the debt. A Maryland court upheld a policy for $6,500 on a debt of $1,000, while a New York court validated a policy for $5,000 taken out to protect a debt of $2,823. These decisions are largely due to the notion that a creditor should be allowed to insure the debtor�s life for a sum estimated to be sufficient to reimburse the creditor at the debtor�s death for premiums paid on the policy, with interest thereon, plus the debt and accumulated interest. There is no clear rule on how much in excess of the debt can be taken out in life insurance on the debtor. The only guideline is that the amount of insurance must bear a reasonable relationship to the size of the debt.

If a debtor assigns an existing policy to the creditor as security for a loan, the creditor is permitted to retain only the amount of the creditor�s interest and must pay the excess, if any, to the insured�s estate or third-party beneficiary, as the case may be. The creditor�s interest is construed to comprise the unpaid portion of the loan, accumulated interest on the loan, and expenses connected with the loan, including any premiums paid on the policy. The same rule applies when the creditor is designated beneficiary if it is clear that the arrangement was intended to serve as security for the debt. In general, the creditor�s rights are the same when the debtor procures new insurance and assigns it as collateral, provided the debtor pays the premium.

Occasionally a policy is assigned to the creditor in satisfaction of the debt and not as security for it. In those instances, the creditor is allowed to keep all the proceeds, even though they greatly exceed the amount of the debt canceled. The validity of such an arrangement has been upheld even when the creditor has induced the debtor to procure the policy.

A life insurance contract not supported by an incipient insurable interest is a wagering contract and hence illegal. This does not mean, however, that the contract cannot be carried out according to its terms. The courts will not enforce an illegal contract, but they do not necessarily forbid the parties to observe the promises made under the illegal agreement.

If an insurance company feels that the applicant honestly believed that he or she had an insurable interest in the life of the person to be insured, it may honor its promise despite later evidence that there was no insurable interest. On the other hand, if the company feels that the applicant knew that no insurable interest existed and sought the insurance for speculative purposes, it may deny liability on the grounds of illegality. If the court sustains the company�s contention, there will be no obligation under the contract. Not only will the company be relieved of paying the face amount of the policy (if the insured has died), but in some states it will also not be obligated to return the premiums paid under the contract.

Several states have relaxed the rule against nonenforcement of illegal contracts to allow the applicant or personal representative to recover all premiums paid if he or she applied for insurance in the honest belief that he or she had an insurable interest. In all jurisdictions recovery of premiums is permitted if the insurer�s agent induced the applicant to apply for insurance by falsely leading the applicant to believe that he or she had a legitimate insurable interest.

Moreover, in cases involving wagering policies, the courts have not strictly applied the doctrine that a partial illegality taints the entire transaction and makes it void for all purposes. The rule is frequently modified when a person applies for insurance on his or her own life at the instigation of a third party who lacks an insurable interest in the applicant but who pays the premiums and is designated beneficiary. From a strict legal standpoint, such a contract is illegal. Nevertheless, the courts may direct the insurance company to pay the proceeds to the insured�s estate and nullify the interest of the offending beneficiary. Under such circumstances, however, the courts are practically unanimous in permitting the beneficiary to recover the premiums he or she paid on the policy out of the proceeds. The courts take the same attitude toward cases in which a policy is assigned to a third party who induced the insured to apply for the policy but has no insurable interest.