Policy Loans and Cash Surrender in Variable Life Insurance

4.3.2.3 Policy Loans and Cash Surrender in Variable Life Insurance

Variable life insurance is a unique financial product that combines life insurance protection with investment opportunities. A crucial aspect of managing these policies involves understanding the options for policy loans and cash surrender. This section delves into the mechanics, benefits, and potential pitfalls of these features, providing you with the knowledge needed for both the Series 6 Exam and practical applications in the securities industry.

Understanding Policy Loans

Policy loans allow policyholders to borrow against the cash value accumulated in their variable life insurance policies. This feature can be an attractive option for accessing funds without the need to liquidate investments or undergo credit checks. Here’s how policy loans work:

• Collateralization: The cash value of the policy serves as collateral for the loan. This means that the amount you can borrow is limited by the available cash value.

• Interest Rates: Loans are typically subject to specified interest rates, which can be fixed or variable. The interest charged on the loan is often lower than what you might find with traditional loans, making it a cost-effective borrowing option.

• Repayment Flexibility: Policyholders have the flexibility to repay the loan on their own schedule. However, it is crucial to manage these loans carefully to avoid adverse effects on the policy.

Impact on Death Benefits

One of the most significant considerations with policy loans is their impact on the death benefit:

• Reduction of Death Benefit: If a policy loan is outstanding at the time of the policyholder’s death, the death benefit paid to beneficiaries will be reduced by the amount of the outstanding loan and any accrued interest. This reduction can significantly affect the financial planning goals associated with the policy.

• Policy Lapse Risk: Failure to repay the loan or interest can lead to a policy lapse if the outstanding loan balance plus interest exceeds the cash value. A lapsed policy results in the loss of life insurance coverage and potential tax implications.

Cash Surrender Options

The cash surrender option allows policyholders to terminate their variable life insurance policy and receive the net cash value. This option can be exercised for various reasons, such as no longer needing the insurance coverage or wanting to access the cash value for other purposes.

Mechanics of Cash Surrender

• Net Cash Value: Upon surrendering the policy, the policyholder receives the cash value minus any outstanding loans, accrued interest, and surrender charges. The net cash value represents the remaining funds available to the policyholder.

• Surrender Charges: These are fees imposed by the insurer for terminating the policy early. Surrender charges are typically highest in the early years of the policy and decrease over time. Understanding the surrender charge schedule is essential for making informed decisions about policy surrender.

Tax Implications

• Taxable Income: The cash surrender value may be subject to income tax if it exceeds the total premiums paid into the policy. This excess is considered taxable income and must be reported accordingly.

• Tax-Free Loans: Policy loans, on the other hand, are generally not considered taxable income, provided the policy remains in force. This tax advantage is one reason policy loans can be a preferable option for accessing the policy’s cash value.

Managing Policy Loans and Avoiding Pitfalls

Effective management of policy loans is crucial to maintaining the integrity of the variable life insurance policy. Here are some best practices:

• Regular Monitoring: Keep track of the outstanding loan balance and accrued interest. Regularly review your policy statements to ensure that the loan does not jeopardize the policy’s cash value or risk a lapse.

• Strategic Repayment: Consider repaying the loan or at least the interest periodically to prevent the loan from growing too large. This approach helps preserve the policy’s cash value and death benefit.

• Consultation with Financial Advisors: Engage with financial advisors or insurance professionals to understand the long-term implications of policy loans and cash surrender. They can provide personalized advice based on your financial goals and circumstances.

Practical Examples and Case Studies

Example 1: Policy Loan for Emergency Expenses

Imagine a policyholder, Alex, who has a variable life insurance policy with a cash value of $50,000. Alex faces unexpected medical expenses and decides to take a policy loan of $20,000. The loan has an interest rate of 5% per annum.

• Impact: Alex’s death benefit will be reduced by the loan amount plus any accrued interest if the loan is not repaid. If Alex passes away with the loan outstanding, the beneficiaries will receive the death benefit minus the loan balance and interest.

Example 2: Cash Surrender for Investment Opportunities

Consider another policyholder, Jamie, who wishes to invest in a new business venture. Jamie decides to surrender their variable life insurance policy, which has a cash value of $100,000, with $10,000 in outstanding loans and $5,000 in surrender charges.

• Outcome: Jamie receives a net cash value of $85,000 ($100,000 cash value - $10,000 loan - $5,000 surrender charges). If the cash surrender value exceeds the total premiums paid, Jamie may owe taxes on the excess amount.

Regulatory Considerations

Understanding the regulatory framework surrounding policy loans and cash surrender is vital for compliance and informed decision-making. Here are some key points:

• Policy Loan Provisions: Regulations require insurers to clearly disclose the terms and conditions of policy loans, including interest rates and repayment terms. Policyholders should review these provisions carefully.

• Consumer Protections: Regulatory bodies, such as the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), oversee the sale and management of variable life insurance products to ensure fair practices and consumer protection.

Conclusion

Policy loans and cash surrender options in variable life insurance offer flexibility and liquidity to policyholders, but they come with significant considerations and potential risks. By understanding the mechanics, tax implications, and regulatory environment, you can make informed decisions that align with your financial goals and responsibilities. As you prepare for the Series 6 Exam, focus on these key areas to ensure a comprehensive understanding of variable life insurance products.

Glossary

• Policy Loan: A loan taken by the policyholder using the cash value of the insurance policy as collateral.
• Cash Surrender Value: The amount a policyholder receives if they cancel their policy, after accounting for any fees and surrender charges.

For further reading on policy loan provisions and considerations, you can refer to Investopedia’s guide on life insurance loans.

Series 6 Exam Practice Questions: Policy Loans and Cash Surrender