'Insurable Interest' and the Scope of First-Party Coverage

At the core of the court's analysis was this concern: “Andersen's theory would permit an insured to allege an insurable interest in a class of property so broad as to be impossible to define and certainly not susceptible to a predictable level of risk. ' the interest cannot be read as broadly as Andersen argues, allowing the insured to reap a windfall recovery for a loss so clearly unanticipated in the calculation of the premium.” Arthur Andersen, 416 N.J. Super. at 352 (internal citation omitted). As this decision properly recognizes, insurance is governed by actuarial principles, and the premiums paid by the insured are calculated based on the amount of coverage and degree of risk. Where the risk is an indirect economic one that cannot be quantified or even identified in advance of the loss event, it is one that cannot be rated by the insurer, and therefore cannot be properly viewed as part of what the insurer contemplated it was insuring at the time the policy was placed. The principle ' that one must consider whether the insurer could have had a reasonable basis on which to evaluate the risk now being claimed ' provides a helpful guide in the sometimes murky area of insurable interest. Indeed, it is a useful benchmark more generally and can help to identify and weed out both over-reaching claims by insureds and overly aggressive contract interpretation by insurers, so that both the insurer and insured get the benefit of their actual bargain.

Catherine A. Mondell is a partner and Seth C. Harrington is an associate in the Boston office of Ropes & Gray LLP. Mondell is a member of this newsletter's Board of Editors.

An insurable interest is a necessary component of any valid claim under an insurance contract and is traditionally viewed as a protection against moral hazard. Although an insurable interest is necessary for a valid claim, it does not, in and of itself, confer any right to coverage under a policy of insurance. Put another way, an “insurable interest” ' that is, an interest that is susceptible to being insured ' does not mean that one has an insured interest.

Notwithstanding this, the concept of “insurable interest” is often misused in an attempt to expand the scope of what is insured under first-party property policies. This article reviews the fundamental underpinnings of the concept of insurable interest, and certain recent cases that have grappled with the scope of insurable interest and have articulated a more meaningful application of the concept to claims under first-party property policies.

The Basis for an Insurable Interest Requirement

Generally speaking, the absence of an insurable interest prior to inception of a policy of insurance renders the contract void and unenforceable. 44 Am Jur. 2d Insurance ' 933 (2010). There may be instances in which an insurable interest develops after inception (as when a new building is acquired and added to an existing policy). But, in all events the absence of an insurable interest prior to the time of loss precludes any valid claim for insurance recovery.

The requirement that an insured have an existing “insurable interest” prior to the date of loss ensures that a relationship between the insured and the covered property exists independent of the policy of insurance and independent of the circumstances giving rise to the loss. 4f-109f Appleman on Insurance ' 2125 (1st ed.); 44 C.J.S. Insurance ' 322 (2010). Traditionally, courts have cited to and relied upon this insurable interest requirement to enforce a public interest against the use of insurance for “illegitimate purposes” such as “gambling or wagering, to protect against societal waste, and to avoid the danger that persons will intentionally destroy lives or property to receive insurance benefits.” 44 Am. Jur. 2d Insurance ' 934 (2010).

Defining the Permissible Scope of Insurable Interest

Given that “insurable interest” sets the outer boundaries of what it is permissible to insure, the concept is necessarily a broad one. On the other hand, to give meaning to the requirement and avoid the moral hazard issues outlined above, the concept of an insurable interest is one that cannot be stretched indefinitely.

Balancing these considerations, state legislators in various jurisdictions have attempted to define “insurable interest.” For example, a New York fire insurance statute provides that an insurable interest includes “any lawful and substantial economic interest in the safety or preservation of property from loss, destruction or pecuniary damage.” N.Y. Ins. Law ' 3401 (McKinney 2010). A number of states have adopted nearly identical provisions defining “insurable interest” in the context of property insurance by reference to a substantial economic interest of the insured in the relevant property. See Ariz. Rev. Stat. Ann. ' 20-1105 (2010); Fla. Stat. Ann. ' 627.405 (West 2010); La. Rev. Stat. Ann. ' 22:2328 (2009); Miss. Code Ann. ' 83-34-15 (2010); 36 Okla. Stat. Ann. tit. 36, ' 3605 (West 2010); S.C. Code Ann. ' 38-75-350 (2009); Utah Code Ann. 1953 ' 31A-21-104 (West 2010).

Courts too have wrestled with the question of the scope of insurable interest. Generally, American courts have not required the insured to hold legal or equitable title to the property, instead extending the insured's “interest” to other types of direct, cognizable interests in the subject property. Thus, courts generally recognize an insurable interest where one has an established responsibility to pay for replacement or repair of the property in question. E.g., Prince v. Royal Indem. Co. , 541 F.2d 646 (7th Cir. 1976). Contractual rights in the property, such as an assignment of a mortgage payment relative to the insured property, Hyman v. Sun Insurance Co. , 70 N.J. Super. 96 (App. Div. 1961), may also constitute sufficient “insurable interest.” In certain instances, courts have found that having an established right of use (such as by easement) is adequate to establish “insurable interest.” E.g., Miller v. New Jersey Ins. Underwriting Ass'n , 82 N.J. 594 (1980). In the absence of such a contractual or direct, cognizable interest, courts have refused to find an “insurable interest.” E.g., G. Simons & Co. S.A. v. New Bar of N. Am., No . No. 98CIV5162GBD, 2005 WL 1137348, at *4-5 (S.D.N.Y. May 13, 2005) (an exporter of goods has no insurable interest in goods that it has shipped, even if the exporter expects profits upon sale); Belton v. Cincinnati Ins. Co. , 602 S.E.2d 389, 391-92 (S.C. 2004) (an option to buy a building does not alone satisfy the insurable interest test); Judge v. Travelers Ins. Co. , 692 N.Y.S.2d 288, 290 (App. Div. 1999) (duties to manage a property that one previously owned does not constitute an insurable interest).

Picking up on the logic of these decisions, Colorado legislators have adopted a definition which parallels that of New York in referencing an economic interest, but also explicitly includes a requirement that the insured's interest be “of such a nature that a contemplated peril might directly damnify the insured.” Colo. Rev. Stat. Ann. ' 10-1-102 (West 2010) (emphasis added). Such a definition effectively codifies case law and reduces room for debate about the scope of what constitutes an insurable interest.

Nevertheless, the application of such statutory and court-generated definitions to the facts of a particular claim often leaves significant room for debate. The need to allow for flexibility and the focus on policy considerations often mean that the application of concepts such as “insurable interest” to a particular context has historically been a fact-intensive process. A review of certain cases arising from the 9/11 terrorist attack shows this to be true, although a recent decision out of the New Jersey court of appeals suggests a new framework for assessing claims of insurable interest that could provide greater certainty in this area.

Insurable Interest and the WTC Cases

Following the Sept. 11, 2001 terrorist attack, many companies suffered significant financial losses and looked to their first-party property insurers for potential recovery. See, e.g., The New Reality of Risk: Terrorist Attack Creates Major Property Concerns, Property Coverage, Oct. 5, 2010, available at www.marsh.cl/archivos_show.cfm?id=180 (discussing potential theories of recovery). Certain of these companies asserted that they were entitled to claim an “insurable interest” in certain portions of the World Trade Center complex, although they did not have an ownership or leasehold interest in those portions of the property.

In Citigroup, Inc. v. Industrial Risk Insurers , 336 F. Supp. 2d 282 (S.D.N.Y. 2004) aff'd 421 F.3d 81 (2d Cir. 2005), the question presented was whether 7WTCLP, the building manager for the 7 World Trade Center building in which Citigroup had leased property, had an insurable interest in removable fixtures and betterments within Citigroup's space. Plaintiff Citigroup alleged that it was an additional insured and loss payee under a policy insuring 7WTCLP's property. Citigroup further argued that 7WTCLP had an insurable interest in the removable fixtures and betterments of Citigroup's space, citing specific terms of the lease between it and 7WTCLP which, under certain circumstances, gave 7WTCLP certain contractual rights with respect to Citigroup's property. The trial court reviewed the terms of the lease and rejected Citigroup's arguments, holding that a hypothetical “expectancy of economic advantage” on the part of 7WTCLP under circumstances that were not present at the time of loss (e.g., Citigroup's abandonment of the property) was insufficient to establish an insurable interest. Id. at 288-89. The court concluded that because 7WTCLP did not own, have custody of, use or have an obligation to replace Citigroup's property under the terms of the lease, 7WTCLP did not have an “insurable interest” in that property. Id. at 288. As a result, the policy held by 7WTCLP could not be read to insure such property, and neither 7WTCLP nor Citigroup could recover under it. Id. The Second Circuit affirmed this decision, embracing the trial court's reasoning and rejecting Citigroup's argument that a mere indirect economic interest in the property would suffice to create an insurable interest.

In Zurich American Insurance Co. v. ABM Industries, Inc. , 397 F.3d 158 (2d Cir. 2005), the Court of Appeals reversed the lower court's grant of summary judgment and held that the insured entity, which provided janitorial services to most of the World Trade Center, had an insurable interest in specific portions of the property, such as equipment it used to perform its janitorial and maintenance services, the offices in the World Trade Center it operated and in which it stored its supplies, freight elevators, janitorial closets, and slop sinks to which it had exclusive access, and spaces for which it had contracts to provide cleaning services. In making this ruling, the court noted that restricting “insurable interest” to ownership or leasehold interests not only would conflict with case law, but also would prejudice insureds whose business entails offering physical labor on the premises of others by ignoring the fact that the insured's exclusive right to access and use of the property was a key feature in its business. Id. at 166-67.

Taking the argument one step further than Citigroup or ABM, both of which occupied space in the World Trade Center complex, Arthur Andersen LLP submitted a claim to its property insurers, which, although it did not own or lease property anywhere within the World Trade Center complex, was predicated on the theory that it had an insurable interest in the property and therefore was entitled to recover more than $200 million in decreased revenue following the attack. Arthur Andersen's theory was that the property was a center of transportation, communication and financial activity of import to the global economy (of which Arthur Andersen was a part).

The Arthur Andersen Analysis of Insurable Interest

Arthur Andersen filed suit in New Jersey to pursue its “insurable interest” claim, and a recent decision from the New Jersey Appellate Division analyzes the arguments advanced, treating the concept of insurable interest within the realities of the modern insurance marketplace. Arthur Andersen LLP v. Federal Ins. Co. , 416 N.J. Super. 334 (App. Div. 2010).

The policies at issue defined the Real and Personal Property insured as Arthur Andersen's interest “in all real and personal property ' which is owned, used, leased or intended for use by the Insured, or in which the Insured may have an insurable interest.” Id. at 340. Arthur Andersen readily conceded that the damaged property was not property which it owned, used, leased or which was intended for its use. It asserted that because the World Trade Center was a locus of substantial economic activity the destruction of which would have a significant impact on its business, it was property in which it “may have an insurable interest.” Id. at 340-41. And, Arthur Andersen argued, because it experienced lower revenues following the destruction of the World Trade Center, the decline in revenue established its “insurable interest” in the property. Id. Under the theory advanced by Arthur Andersen, the scope of its “insurable interest” could extend to any property at all, so long as it could show a reduction in any revenue stream following the destruction of the property.

The New Jersey appellate court affirmed the trial court's rulings and rejected Arthur Andersen's argument. In doing so, the court put the Second Circuit's decision in ABM Industries in context, harmonizing it with a recent New Jersey Supreme Court decision, Shotmeyer v. N. J. Realty Title Ins. Co. , 195 N.J. 72 (2008), noting that both courts required a direct economic interest in the insured property to establish a valid insurance interest. In Shotmeyer, two brothers had formed a general partnership to purchase and hold real estate. The general partnership purchased a tract of farmland and had obtained a title insurance policy. Later, the general partnership transferred the property to a limited partnership, in which the brothers were the sole limited partners. After discovering a defect in the title, the brothers brought suit against the title insurer. In reversing the lower court's ruling for the brothers, the New Jersey Supreme Court held that the brothers, despite their roles in both the general partnership and limited partnership, did not have an insurable interest. Id. at 607. The court noted that although the brothers would experience economic hardship as a result of the title defect, they nevertheless did not have a direct or substantial economic connection to the property. Id. Rather than focusing on the traditional moral hazard concerns, the court framed the issue in terms of certainty for the insurer in connection with the risk assumed at the time of contracting. Id. at 608.

Picking up on the analysis set forth in Shotmeyer, the Arthur Andersen decision focused on the concept of a pecuniary interest that would be susceptible to being quantified prior to the date of the claimed loss. A loss of rental income, for example, could be the basis for establishing an insurable interest. Similarly, a loss of contractual payments for cleaning the subject property, as in ABM, could form the basis for an insurable interest. Arthur Andersen, however, had no such quantifiable pecuniary interest. It did not derive any income from the existence of the World Trade Center or have any potential liability to any other party as a result of the destruction of the World Trade Center.

At the core of the court's analysis was this concern: “Andersen's theory would permit an insured to allege an insurable interest in a class of property so broad as to be impossible to define and certainly not susceptible to a predictable level of risk. ' the interest cannot be read as broadly as Andersen argues, allowing the insured to reap a windfall recovery for a loss so clearly unanticipated in the calculation of the premium.” Arthur Andersen, 416 N.J. Super. at 352 (internal citation omitted). As this decision properly recognizes, insurance is governed by actuarial principles, and the premiums paid by the insured are calculated based on the amount of coverage and degree of risk. Where the risk is an indirect economic one that cannot be quantified or even identified in advance of the loss event, it is one that cannot be rated by the insurer, and therefore cannot be properly viewed as part of what the insurer contemplated it was insuring at the time the policy was placed. The principle ' that one must consider whether the insurer could have had a reasonable basis on which to evaluate the risk now being claimed ' provides a helpful guide in the sometimes murky area of insurable interest. Indeed, it is a useful benchmark more generally and can help to identify and weed out both over-reaching claims by insureds and overly aggressive contract interpretation by insurers, so that both the insurer and insured get the benefit of their actual bargain.

Catherine A. Mondell is a partner and Seth C. Harrington is an associate in the Boston office of Ropes & Gray LLP. Mondell is a member of this newsletter's Board of Editors.