Situation: This monthly publication traditionally focuses on technical life insurance concepts. However, this month we are taking a slightly different approach. In this article, we will discuss how the collateral assignment of a life insurance policy can be used to help secure a loan.
Solution: Lenders will often require life insurance to secure a loan because it ensures that they can collect if the borrower passes away before the loan is repaid in full. The subject comes up with some frequency, so I am surprised by how many lenders and financial advisors are not familiar with this arrangement. We will start with an example showing how a collateral assignment on a life insurance policy works to secure a loan.
Example: Mr. Business Owner went to his local bank to secure a 10-year loan for $400,000 to fund the expansion of his successful business. As part of the loan arrangement, the bank required that he name the bank as the beneficiary of a $400,000 life insurance policy. The business was a second generation, closely held operation that employed 10 people in addition to the owner. One employee was the owner’s long-time friend who oversaw the operation, and another was the owner’s college-age child who worked in the business during the summer. The owner netted $105,000 after expenses.
With the help of his financial advisor, the owner applied for a $400,000 10-year term life insurance policy with the business as the owner and beneficiary. The financial advisor included a cover letter with the application which stated that the purpose for the insurance was to liquidate the business debt and to leave funds in the business to provide a stay bonus to his close friend and operations manager to keep him working in the business in the event of the owner’s death before the college-age child was prepared to run the business. A collateral assignment form was executed at policy issue, assigning an amount equal to the outstanding loan to the bank.
Eight years after the policy was issued, Mr. Business Owner died in a car accident. At the time of his death, he still owed $75,000 on the original loan. The insurance carrier issued a check to the bank in the amount of $75,000, and the balance of $325,000 was paid to the business.
Financial Underwriting Guidelines Limit Amount of Coverage: The first point that a financial advisor must be aware of when acquiring a policy to cover debt is that carrier guidelines typically limit the face amount to between 60-80% of the outstanding loan. This is because carriers reasonably believe that the insured will not die, at least from a medical condition, for several years and they assume that the loan will decrease during this time.
Financial advisors are often surprised to learn that an insured normally cannot receive life insurance for the full amount of the loan based solely on the need to cover a loan. However, it is possible to get coverage equal to the full loan by
adding an additional need for insurance. Depending on whom the insured ultimately wants to benefit, it
might be possible to add a key person or survivor income insurance need on top of the desire to eliminate debt to qualify for the full coverage. In our example, the insured also needed the insurance coverage to help provide a smooth transition by retaining a key person. By including a cover letter explaining the additional need for coverage, it may be possible for a financial advisor’s client to cover the full loan amount.
Lender or Investor? It Makes a Difference: It is important to note that insurance carriers distinguish between lenders and investors. It is possible to get coverage to help liquidate business debts, but carriers will not insure an investor’s risk of investment loss. So, carriers will want to know if there is an expectation of repayment versus acquiring an interest in a business.
Policy Structure: Who Should be the Insured, Owner and Beneficiary? Advisors should be aware that carriers will require a situation-appropriate policy structure. Specifically, they will expect the insured to be the person whose death will either trigger the loan repayment or materially impact the business’s ability to repay the loan. Furthermore, carriers will typically reject an application where the lender is the proposed owner or beneficiary of the policy. Carriers expect to see the business as the owner and beneficiary for a business loan, and the insured as owner with the spouse or family as the beneficiary for a personal loan. Instead of naming the lender as a beneficiary in either situation, carriers usually suggest use of a collateral assignment form because the amount of death benefit that a lender receives decreases as the loan amount decreases, while a standard beneficiary designation may result in the lender receiving more death benefit than the amount of the outstanding loan. The assignment form also prevents the policyholder from releasing the assignment without the consent of the lender, thus protecting the interest of the lender.
The Process of Obtaining a Collateral Assignment: The form can be provided by the insurance carrier, bank or drafted by the client’s legal advisor. When using a bank assignment form or one drafted by the legal advisor, the insurance carrier will want to approve the form before its use. This form is typically completed once the policy is active. The form is filed with the carrier and restricts the policy owner’s rights until the assignment is released.
In Summary: A collateral assignment is a simple form that can be used in many situations. It is most often used when an insured wants to secure a loan, however it may also be utilized when the insurance strategy calls for restricting a policy owner’s rights in a policy.