When arranging a loan, a borrower may pledge his life insurance as collateral by means of a document called a collateral assignment. This guarantees that the lender can recover any unpaid portion of the loan in the event of death or default. Many industrialists and entrepreneurs, including Walt Disney, John Cash (JC) Penney and McDonald's founder Ray Kroc, have borrowed against their life insurance policies to start or save their companies.
A life insurance policy can be used as collateral only if it is specifically permitted by the policy certificate, and the borrower owns the policy.
What it Does
A collateral assignment of a life insurance policy notifies the borrower’s insurance company the borrower has assigned an interest in her life insurance policy to the lender. Once properly executed by borrower and lender, the document must be filed with the insurance company to have effect. Many insurance companies provide boilerplate collateral assignment forms, but there usually is no requirement that these forms be used.
Protecting the Lender’s Interest
Upon receiving the collateral assignment document, the insurance company is obligated to protect the lender’s interests. Until the assignment is released, the borrower’s right to cash in the policy, make withdrawals from its cash value, or use it as collateral for another loan is restricted.
Payment Upon Borrower’s Death
If the borrower dies before the loan is paid off, the lender is treated as the first beneficiary, and is paid the amount still due under the loan; the remaining balance of the death benefit is paid out to the policy’s listed beneficiaries.
Payment Upon Borrower’s Default
If the borrower defaults, the lender has the right to cash in the policy or withdraw the amount due from the cash value, depending on how the collateral assignment document is drafted.
A borrower who assigns her life insurance as collateral for a loan is obliged to keep the policy in force until the loan is fully repaid. A lender may, at its discretion, make premium payments to keep a policy in force and subsequently demand reimbursement from the borrower or add the amount paid to the loan balance.
Cancellation of Assignment
Once the loan has been paid in full, the assignment must be lifted from the policy by means of a release form sent by the lender to the insurance company. When it receives the release, the insurance company cancels the assignment and restores all rights in the policy to the owner.
Types of Life Insurance That Can be Pledged
Both permanent policies and term life policies can be used as collateral for a loan.
These include whole life, universal life, variable life and variable universal life. All of these policies remain in force for the lifetime of the insured, as long as premiums are paid on time, and develop cash value which grows over time. When assigned as collateral, depending on how the assignment document is crafted, the lender may access either the policy’s cash value or its death benefit upon the insured’s death.
Term Life Policies
A term life insurance policy develops no cash value and remains in force only for a set period of time, in most cases no more than 30 years. It pays its face amount to the named beneficiaries upon the insured’s death. An assignment of collateral gives the lender only an interest in the death benefit when the insured dies.