Interrogating Alternative Loan Collateral: Life Insurance

Introduction

Insurance is generally defined as an arrangement by which a company undertakes to provide a guarantee of compensation for specified loss, damage, illness, or death in return for payment of a specified premium. The undertaking to pay is usually expressly stated in an insurance policy document.

In addition to providing a guarantee for compensation on the occurrence of a specified risk, an insurance policy can be used as security for repayment of a loan by a policyholder. The use of life insurance as security for repayment of loans is accomplished by way of creation of a collateral assignment of an insurance policy in favour of a lender.

In India, life insurance policies can be assigned to secure loans from banks. Such assignment may be conditional or absolute. In the United States, two types of life insurance policies, the permanent life insurance policy and the term life insurance policy, are preferred as collateral for a loan.

What is a collateral assignment an insurance?

A collateral assignment of an insurance policy refers to the transfer of the benefits or proceeds of an insurance policy, mostly a life insurance policy, to a lender (the “Assignee”) by an insurance policy holder (the “Assignor”) as collateral for a loan.

The Assignor and the Assignee negotiate and agree on the terms of the assignment and once they agree on the terms, the insurer is notified of the assignment. The insurer will then register the assignment in its records. Upon registration of the assignment, the insurer recognizes the assignee as the beneficiary of the policy. The insurer is not a party to the assignment contract but must be informed of any assignment to enable it confirm that the assignment is not prohibited.

There are two types of policy assignment: absolute and conditional. An absolute assignment transfers all the rights in the insurance policy to the assignee, including the responsibility to pay any remaining premiums. A conditional assignment is temporary, and the transfer of ownership rights and interest in the policy is limited to the terms of the agreement, such as until the repayment of a loan. When the conditions of the agreement have been fulfilled, the assignment is terminated. For a lender, the latter is preferable, giving the lender the right to the policy to the extent of the loan balance without creating obligations for the lender to pay premiums.

The consequences of a collateral assignment

Upon assignment of an insurance, the Assignee does not become the owner of the policy. The assignment only serves to restrict the Assignor’s access to the policy.

In the event of the Assignor’s death, the Assignee has the right to the proceeds of the policy with respect to the unpaid balance of the loan amount as at the date of the Assignor’s death. Upon payment of the unpaid balance of the loan, the balance of the proceeds of the policy, if any, is paid to the Assignor’s beneficiary.

The Assignee’s recourse in the event of the Assignee’s default

In the event that the Assignor defaults in payment of the loan secured by an assignment of a policy, the assignee can surrender the policy for its cash value.

It is important to note that where a loan is repaid in full, the assignment is removed and the lender ceases to be a beneficiary of the insurance policy.

Conclusion

It is important to note that some insurers are already granting loans to policy holders using the insurance policies taken up by the borrowers/ policy holders as security. For this reason, prior to making any loans to policy holders, banks should satisfy themselves that the policy is not otherwise encumbered. This can be done by conducting a search on the online Collateral Registry where notice must be filed for any securities on movable assets as stipulated in the Movable Property Security Rights Act, 2017.