For years, the task of creating income from a life insurance policy was all about balancing the growth of policy loans against the growth of policy cash values. Assuming the policy cash values grew at a faster pace than the loan balance, everything was a-okay.
But what happens if the loan balance outpaces the growth of the policy’s cash value?
If a loan balance grows larger than the cash value of a policy, the policyholder must pay down the loan to make the balance smaller than the cash value balance or the policy will lapse.
If the policy lapses, the policyholder will be forced to recognize all gain from the policy as ordinary income and owe taxes on this income.
When a policy lapses due to an outstanding loan balance, the policyholder receives no money from the policy upon lapse, but could owe substantial income taxes on the recognized income.
This means the policyholder will need use funds from somewhere else to cover the tax bill. It’s unlikely most policyholders would be willing or able to do this.
We avoid such situations by ensuring the rate at which loans are created against policy cash values will not cause the loan balance to exceed the cash value balance of the policy.
Over-loan protection riders are an innovation of the life insurance industry that (at the policyholder's discretion) essentially freeze policies where loan balances exceed a certain threshold as a percentage of cash value in the policy.
This stops the policyholder from continuing to take additional loans from the policy, but it also avoids a lapse meaning it avoids a potentially disastrous situation.
The exact parameters of how and when these riders are used varies by insurance carriers and availability is mostly found on universal life policies (though there is one whole life insurance product that offers such a benefit).
Because a policy lapse is undesirable, we generally target distributions to exhaust all monies in a policy at age 120. For life insurance this means we intentionally want the loan to exceed cash values at age 120.
But if we have an over-loan protection rider available, we can target a closer date with less worry about a large tax bill (e.g. age 100).
Being able to dial down the years we target increases the money we can extract from the policy since we don’t need to leave enough cash in the policy to accumulate beyond the year we’ve chosen (again generally a couple decades sooner).
This is a long–but hopefully thorough–way of pointing out that this benefit enables us to get more money out of a policy and create greater benefit to the policyholder per dollar placed into an insurance contract.
I do want to be careful about making lapse through excessive policy loans sound like an easy mistake. In truth lapsing a policy due to loans is rather easily avoided by any competent agent.
Still, having an additional safety net is rarely a bad thing, especially since these rider’s only present a cost to the policyholder if they are triggered (the cost is a reduction in death benefit).
The bigger gain from these riders comes in the additional money one can extract from the policy.
Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. A specialist in the design and application of life insurance cash accumulation features, Brandon is one of the foremost authorities on the subject of coordinating life insurance cash values in a financial plan.