Policy Loan

A policy loan is money advanced by a life insurance company to the owner of a cash-value policy, with the policy itself as the only collateral. Washington's version of the standard provision, RCW 48.23.080(1), requires the contract to say that after three full years' premiums have been paid the insurer, at any time while the policy is in force, "will advance, on proper assignment or pledge of the policy and on the sole security thereof", a sum limited by the policy's value. Everything unusual about the arrangement follows from those last six words.

The phrase itself has no single federal definition. The Internal Revenue Code uses "policy loan" as an undefined term of art in section 7702(f)(2), and state insurance codes use it the same way, though some define it for their own purposes: RCW 48.23.085(9)(b) provides that for that section the term "includes any premium loan made under a policy to pay one or more premiums that were not paid to the life insurer as they fell due". It is worth separating this transaction from an ordinary loan early, because almost every intuition transfers badly. A bank lends its money and takes a risk on being repaid. An insurer lends against an obligation it already owes the same person, so there is no credit risk to price, and consequently no application, no underwriting, no covenant and no due date.

What the insurer is actually doing. The loan is secured by the policy alone, and the maximum is set by the policy's value rather than by anything about the borrower. Under RCW 48.23.080(1)(b), for policies issued after the operative date of the state's valuation provisions, the sum advanced, including interest to the end of the current policy year, may not exceed the cash surrender value at the end of that year. The insurer may also deduct any existing indebtedness and any unpaid balance of the current year's premium from the loan value. And under RCW 48.23.080(4) the insurer may reserve the right to defer making the loan for up to six months, with one exception that says a great deal about the purpose of the provision: it may not defer a loan made to pay premiums. The mechanism exists to keep policies in force.

The consequences of "no schedule" run in both directions. Nothing requires repayment, and that is genuinely different from any other borrowing a household can do. But RCW 48.23.080(3) permits the contract to provide that interest not paid when due "shall be added to the existing indebtedness and shall bear interest at the same rate", which is compounding against a slowly growing account. The same subsection sets the end point: when the total indebtedness, including interest due or accruing, equals or exceeds the loan value that would otherwise exist, the policy terminates in full settlement of the debt and becomes void. The consumer protection sits in the next clause, and it is the single most useful thing to know here: no such termination is effective before at least 30 days after the insurer has mailed notice of the pending termination to the insured and to any assignee. A letter that looks like routine administration is, at that point, the last warning.

The price is regulated, and the two shapes are worth telling apart. RCW 48.23.085(2) requires a policy issued on or after August 1, 1981 to contain either a provision permitting a maximum interest rate of not more than eight percent per annum, or a provision permitting an adjustable maximum rate. Where the rate is adjustable, subsection (3) caps it at the higher of two figures: the "published monthly average", defined in subsection (1) as Moody's Corporate Bond Yield Average, Monthly Average Corporates, for the calendar month ending two months before the rate is determined; or the rate used to compute the policy's cash surrender values, plus one percent per annum. Subsection (5) requires the maximum to be redetermined at least once every twelve months and no more often than once in any three-month period, and permits an increase only where the computed change is at least half a percentage point, while requiring a reduction on the same half-point test. Subsection (6) obliges the insurer to tell the policyholder the initial rate and to give reasonable advance notice of any increase. So a fixed-rate loan is priced by the contract and an adjustable one is priced by a bond index the insurer does not control, and which of the two a policy uses is printed in the policy.

A participating policy adds one more variable. Where the contract pays dividends, the dividend on the borrowed portion of the value may be calculated differently from the dividend on the rest, a difference the market calls direct recognition. It is a matter of the insurer's dividend practice and the contract's own dividend provision rather than of statute, which is why the policy and the insurer's current dividend scale, not a general rule, are what answer it for a given contract.

One fact about how this is sold belongs on the page. The idea of borrowing against a policy is a central selling point for cash-value coverage, and the illustrations that carry it depend on assumptions about two future numbers the buyer does not control: the loan interest rate and the rate credited to the policy. Where the credited rate is assumed to run above the loan rate, the illustration shows borrowing that costs nothing on net; where it does not, the same policy drains. The assumption is stated in the illustration's own columns, and the guaranteed columns are the ones that hold if the assumption fails.

1. You request the loan. No application, no underwriting, no credit report. The policy is assigned or pledged to the insurer as the sole security.

2. The insurer sets the maximum. Broadly the cash surrender value at the end of the current policy year, less any existing debt, unpaid premium, and interest to the year end.

3. The money is advanced. The insurer may defer for up to six months, except where the loan is being made to pay a premium.

4. Interest accrues at the rate the policy specifies, either a fixed maximum or an adjustable one recomputed on the statutory formula and schedule.

5. Nothing is due. If the interest is not paid it is added to the debt and bears interest at the same rate.

6. The loan comes off whatever is paid out. It reduces the surrender value if the policy is given up and the death benefit if the insured dies.

7. If the debt reaches the loan value, the policy terminates in settlement of the debt, effective no earlier than 30 days after the insurer mails notice of the pending termination.

A hypothetical, showing why "no repayment schedule" is not the same as "free". Tomas borrows $30,000 against a policy whose cash surrender value at that anniversary is $54,000. The contract carries a fixed maximum loan rate of 8%, and the guaranteed cash surrender value grows by $1,600 a year. He pays no interest and no further premium.

End of year one: interest of 8% × $30,000 = $2,400 is added, so the debt is $32,400, against a cash surrender value of $55,600.

End of year two: interest is now charged on the larger balance, 8% × $32,400 = $2,592, so the debt is $34,992, against $57,200.

End of year three: 8% × $34,992 = $2,799.36, so the debt is $37,791.36, against $58,800.

The debt has moved from 55.6% of the value to 58.3%, then 61.2%, then 64.3%. Nothing dramatic happened in any single year, and no payment was ever missed, because none was ever due. That is the mechanism: a loan with no deadline still has a direction, and the only date that matters is the one on the termination notice.

Pros

• No underwriting and no credit check, because the insurer's security is the policy rather than the borrower.
• Nothing appears on a credit report, so the borrowing does not affect a score or a debt-to-income ratio.
• No repayment schedule and no maturity date, which makes it usable for an irregular need without a monthly commitment.
• The maximum interest rate is capped by state law, either at a stated fixed ceiling or by a published formula the insurer does not set.
• The coverage stays in force while the loan is outstanding, so a household does not have to choose between liquidity and protection.
• The insurer may not defer a loan made to pay a premium, which is what allows the automatic premium loan provision to keep a policy alive through a missed payment.

Cons

• Unpaid interest is added to the debt and then earns interest, so a loan that is never repaid grows against an account that grows more slowly.
• The loan reduces what the beneficiary receives, which is easy to forget because nothing about it looks like a lien.
• If the debt reaches the policy's loan value the contract terminates, and the only warning required is a notice mailed at least 30 days ahead.
• A lapse or surrender while a loan is outstanding turns money already borrowed and spent into taxable income, in a year when the coverage is gone too.
• On a participating policy, the dividend on the borrowed portion may be computed differently, so the true cost is not simply the stated rate.
• Access is not immediate as of right: the insurer may defer an ordinary loan for up to six months.