The double-edged sword of policy loans in whole life insurance
By Ken Godfrey
Life Insurance Financial Evaluations, LLC
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
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
- 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.