The double-edged sword of policy loans in whole life insuranceArticle added by Ken Godfrey on June 20, 2011
Ken Godfrey

Ken Godfrey

Arlington, VA

Joined: March 12, 2011

Whole life insurance is a very popular type of permanent insurance because of its stable and predictable results compared to other alternatives. Because of its stability, many policyowners are lulled into a false sense of security.

Many insurance practitioners tout the numerous benefits of owning whole life insurance, but often neglect to highlight the importance for making the required ongoing premium payments and the severe risks if a premium is missed.

Whole life insurance policies require the regular payment of premiums which can be paid in cash, dividends or via policy loans. If a premium is not paid within the designated grace period and there is no cash surrender value, the policy will lapse and coverage will cease. If a premium is not paid and the policy has cash surrender values, the policy will typically convert to one of three non-forfeiture options (subject to the insurance contract):
  • Cash – the policy will be surrendered for its cash surrender value

  • Reduced paid up insurance – the cash values will be used to purchase a reduced amount of insurance coverage for the specified time period

  • Extended term insurance (most common default option if none specified) – the cash values will be used as a single premium to purchase the current death benefit amount for a limited period of time
Since whole life insurance is normally purchased with the intent of holding the policy until death, none of these non-forfeiture options is desirable when payment of a premium is inadvertently missed. If a non-forfeiture option occurs, some whole life insurance contracts will allow for the reinstatement of the original policy for a limited period of time.

To avoid the undesirable non-forfeiture options, most whole life policies now offer automatic premium loan provisions. An APL provision must be elected by the policyholder. If a premium payment is missed and cash value is sufficient to cover the required premium, an automatic premium loan will be taken against the policy’s cash value to pay the missed premium and keep the policy intact.

If elected by the policyholder, an APL can be a useful policy tool to help avoid the undesirable non-forfeiture provisions. However, if elected and used, the policyholder should understand the potential risks and tradeoffs of taking policy loans in life insurance contracts.

Risks and tradeoffs:
  • Upon death, the policy loan balance is subtracted from the total face amount resulting in lower death benefit proceeds than originally anticipated.

  • Interest will be charged on all policy loans, creating a negative drag on long-term policy performance.
  • Once a policy is on APL, insurance companies typically no longer send premium notices since the APL assumes payment responsibilities for future premiums. For the insured to switch back to paying premiums in cash, the insured usually must submit a manual policy change.

  • If the client avoids opening the statements and the agent isn’t proactively monitoring the policy, outstanding loan amounts can become substantial over time while on APL.

  • If a policy with outstanding loans ultimately lapses before mortality, then there may be income tax consequences. The IRS may notify the owner that there was earned income from the policy and income tax will be due on this amount. These IRS notices can come as a complete surprise.

  • The policyholder may face a “surrender squeeze.” A surrender squeeze occurs when the policy loan is too large to pay off and the policy is in danger of lapsing, resulting in an unwanted tax liability. Substantial loan amounts can be difficult to manage when they become a large percentage of the overall cash values. To avoid a surrender squeeze, it is of the utmost importance to monitor the loan amounts and make sure they remain manageable.

  • Some newer life insurance policies now offer overloan protection riders to avoid a surrender squeeze. Some of these available riders are not automatic and require the policyowner to make an election to activate the rider. As a result, this requires paying close attention to the policy and determining the appropriate time to activate the rider.

  • Policy loans may create complications and limit alternatives when considering a policy replacement via an Internal Revenue Code Section 1035 exchange.
Whole life insurance products have been very popular for a long time. For those who already own or are considering the purchase of a new whole life policy, it is important to know the risks/tradeoffs and the importance of properly and proactively managing the policy. A policy loan can be a short term benefit to maintain the integrity of the whole life insurance policy but can quickly turn into a long term financial nightmare.
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