Collateral assignment of life insurance

A collateral assignment pledges a life insurance policy as security for a loan. You stay the owner, but if you die while the loan is unpaid, the lender is paid first, up to the debt, and your beneficiary gets whatever is left. Lenders ask for it most often on business loans, including many SBA loans, and sometimes on large personal or real estate loans.

Collateral assignment vs absolute assignment

An absolute assignment transfers all ownership rights to someone else; it is what happens when you give away or sell a policy. See transferring ownership of a life insurance policy. A collateral assignment transfers only some rights, as security, and ends when the debt is repaid.

Because ownership does not change, a collateral assignment is generally not a transfer for tax purposes, so it does not by itself raise the gift tax or the transfer-for-value rule issues covered in the transfer guide. A tax professional can confirm how it applies to your facts.

What the lender can do

The insurer follows the assignment form and the policy contract. Typical terms give the assignee rights to:

• Collect the death benefit up to the unpaid loan balance (plus interest and costs, as the form describes), with the rest going to your beneficiaries.
• Block changes that would hurt its security, such as changing the beneficiary, surrendering the policy, or taking loans or withdrawals without its consent.
• Receive notice if premiums go unpaid, so it can pay them to keep the policy in force and add that to the debt.
• Borrow against or surrender the cash value if you default, depending on the assignment's wording. Most standard forms limit this to the amount you owe.

The lender cannot take more than the debt, and does not become the owner. It does not gain control of the policy for any other reason than securing the loan.

Common uses

• Business loans. Banks and SBA lenders often require life insurance on an owner or key employee so the loan can be repaid if that person dies. See Life insurance for an SBA loan and key person life insurance.
• Mortgages and large personal loans. A decreasing or level term policy can be pledged as security. See using term life insurance to cover a mortgage.
• Premium financing. A lender that finances premiums on a large policy takes a collateral assignment of the policy, among other collateral. See premium-financed life insurance: how it works and the risks.
• Divorce or support obligations. A court may require coverage assigned to secure alimony or child support, though that is often done by naming a beneficiary instead. See life insurance and divorce.

Step by step: assigning a policy to a lender

1. Ask the lender what it requires: minimum face amount, type of policy, and whether it needs a specific assignment form.
2. Get the insurer's assignment form. Many insurers have their own collateral assignment form; some lenders also supply one (a bank form is commonly accepted if the insurer agrees).
3. Complete and sign it as owner. If the owner and insured differ, the insured generally does not sign.
4. Send it to the insurer (home office) and request written acknowledgment that the assignment is recorded. A lender usually will not release funds without it.
5. Check the beneficiaries. The beneficiary stays as is, but should know that the loan is paid first.
6. Keep paying premiums. If the policy lapses, the lender's collateral disappears and you may be in default on the loan.

Releasing the assignment

When the loan is repaid, the lender signs a release (reassignment) and sends it to the insurer, which records it. Do not assume it happened automatically. Call the insurer, confirm in writing that the assignment has been released, and keep the confirmation. A lingering assignment can delay a death claim, because the insurer may require the lender's sign-off before paying the beneficiary. Many families discover an outdated assignment only after a death; see documents you need for a life insurance claim.

What happens at a claim

Suppose, hypothetically, a business owner has a $500,000 term policy collaterally assigned to a bank for a $200,000 loan, with her spouse as beneficiary. If she dies when the loan balance is $150,000, the insurer pays the bank $150,000 and the spouse $350,000. If the loan is paid off and the release was recorded, the spouse gets all $500,000. If the loan were larger than the death benefit, the lender would receive the whole benefit and the beneficiary nothing.

Pitfalls

• Overlooked release. The assignment remains of record after the loan is paid.
• Policy loans and withdrawals. They reduce the death benefit and cash value the lender is relying on, and the assignment may prohibit them.
• Lapse risk. Missing premiums can put you in default.
• Too much or too little coverage. The lender may require more coverage than you need, or the collateral value may fall short as the policy ages.
• Employer group coverage. Group policies often cannot be assigned, or only assigned with the plan's consent. A lender may accept an individual policy instead.
• Beneficiary confusion. A collateral assignment does not remove your named beneficiary, but it limits what they receive. An irrevocable beneficiary designation can complicate both the assignment and any later change.

Key takeaways

• A collateral assignment pledges a policy as loan security while you keep ownership.
• At death the lender is paid first, up to the unpaid balance; your beneficiaries receive the rest.
• Get the insurer's written acknowledgment when you assign, and its written confirmation when the lender releases it.
• Keep paying premiums and avoid loans or withdrawals the assignment forbids.
• Unlike an absolute assignment, a collateral assignment generally does not transfer ownership for gift or transfer-for-value purposes.