Collateral assignment of life insurance for business loans

A collateral assignment pledges a life insurance policy to a lender as security for a loan. The policy owner keeps ownership. The lender gets a limited claim on the death benefit, and sometimes the cash value, up to the amount owed. When the loan is repaid, the assignment is released and the policy goes on as before.

What a collateral assignment is

The document is a contract among the policy owner, the lender (the assignee) and, through acknowledgment, the insurer. The owner assigns specified rights in the policy to the lender as collateral for a named debt. It is an assignment for security, not a sale. The usual wording gives the lender the right to be paid from the death benefit to the extent of the debt, along with rights to restrict surrender, policy loans, beneficiary changes and withdrawals without the lender's consent. Rights beyond that stay with the owner.

Lenders ask for it when they depend on an owner or key person for repayment. The most common settings are an owner-operated business borrowing against equipment and real estate, a key person policy, and loans under SBA programs. For the SBA rule, see SBA loans and the life insurance requirement: when it applies, where SOP 50 10 8.1 requires a collateral assignment, acknowledged by the insurer's home office, for each required policy.

Collateral versus absolute assignment

A collateral assignment does not transfer ownership, so it generally does not raise the transfer-for-value concerns under IRC 101(a)(2) that arise with an absolute assignment for consideration. If a lender forecloses and takes the policy, the analysis changes. Ask a tax adviser about that scenario if the policy is large.

What the lender gets

The standard form assignment, often a bank's standard form or the insurer's own, gives the lender, subject to the form's wording:

• The right to receive the death benefit up to the unpaid debt, with any remainder going to the named beneficiary.
• The right to prevent the owner from borrowing against, withdrawing from or surrendering the policy without consent.
• The right to pay premiums if the owner does not, and to add those payments to the debt.
• The right to borrow against cash value or surrender the policy if the owner defaults, subject to the policy terms.
• Notice of lapse or default from the insurer.

Some forms also let the lender collect the cash surrender value on default, which can be material in a whole life policy. Read the document that the lender provides rather than assuming the standard terms, because lender forms vary in how far they reach.

The insurer's role

The insurer is not a party to the loan, but it must record the assignment to honor it. Most carriers have an assignment form or accept the lender's form after review. The carrier notes the assignment on the policy record, and the lender should get a written acknowledgment of the filing. The SBA SOP says the acknowledgment should come from the insurer's home office. A faxed copy that never reaches the carrier's service center creates a gap: the carrier may pay the named beneficiary and ignore the lender's claim.

Premium notices matter too. Ask the carrier to send lapse notices to the lender as well as the owner, because a lapse ends the collateral.

Who can assign and what to check

• Policy owner signs. The owner must be the person who signs, not necessarily the insured. For a business-owned key person policy the business signs. For an owner's personal policy, the owner signs.
• Ownership by trust. A policy owned by an irrevocable trust is assigned by the trustee, and the trust document must permit it.
• Spousal or joint ownership. Community property states and joint owners may need additional signatures.
• Beneficiary designation. The lender's interest ranks ahead of the beneficiary to the extent of the debt. The beneficiary should know that.
• Existing assignments. A policy already assigned to one lender cannot easily be assigned to another.

Process, step by step

1. The lender states the amount, term and type of policy required.
2. The owner confirms the policy meets those terms or applies for a new one. A new application goes through underwriting; see how insurers underwrite business life insurance.
3. The owner and lender sign the assignment form.
4. The assignment is filed with the insurer, and the insurer acknowledges it in writing.
5. The lender keeps a copy of the policy or a certificate in the loan file.
6. The owner pays premiums on time, and the lender monitors.
7. On repayment, the lender signs a release, and the owner sends it to the insurer.

Other uses

Collateral assignment also appears in the loan regime of split-dollar life insurance: economic benefit and loan regimes explained: an employer advances premium on a policy an executive or trust owns, and the policy is collaterally assigned to the employer to secure repayment. It is also used where a partner or investor lends money and wants insurance on the borrower. Funding a buy-sell is separate. The policies there are owned by owners or the entity, as in Funding a buy-sell agreement with life insurance after Connelly.

Hypothetical example

Say a bakery owner borrows $400,000 for equipment from a bank that wants coverage on her life. She has a $1 million term policy bought for family protection. The bank accepts the policy and takes a collateral assignment limited to the loan balance. She keeps ownership and names her spouse as beneficiary. Two years later, she dies when the balance is $310,000. The insurer pays $310,000 to the bank and the remaining $690,000 to her spouse. The insurer would have paid the bank only if it had received and recorded the assignment before the death. The numbers are invented.

Related tax and ownership points

If the business owns the policy and the insured is an employee, the policy is employer-owned life insurance, and the notice-and-consent rules in Employer-owned life insurance: notice and consent rules under IRC 101 apply whether or not the policy is pledged. Premiums on a policy where the business is a beneficiary are generally not deductible, as explained in COLI and BOLI explained: corporate and bank-owned life insurance. The lender must have a legitimate interest, and the policy must rest on an insurable interest when issued. If the loan is tied to a planned sale or transition, coordinate the assignment with business succession planning and the insurance that funds it so the lender's claim does not collide with the buyout funding.

Mistakes that cause trouble

• Not filing the assignment with the insurer, or filing and not keeping the acknowledgment.
• Assigning more than the debt, or using wording that gives the lender rights to the full death benefit.
• Letting the policy lapse for non-payment.
• Forgetting to release the assignment after the loan is repaid, which can block later loans or policy changes.
• Using a policy that expires before the loan does.

Key takeaways

• A collateral assignment pledges a policy as security for a loan without transferring ownership.
• The lender's claim is limited to the debt; the rest goes to the beneficiary.
• The insurer must record the assignment, and the lender should hold the acknowledgment.
• Release the assignment when the loan is repaid.
• Read the lender's form, since its rights over cash value and premiums vary.