Avoiding Collateral Damage
The term collateral damage was originally used during warfare when a military target was struck. Even when the attack was successful it often left behind peripheral harmful results – usually affecting nearby innocent civilians. The phrase is now more broadly used to describe negative unintended consequences of an attempt to do something beneficial.
Life insurance is often used as security on a loan, usually in a business situation.
Urgency of the circumstances (or poor advice) usually results in a creditor simply being added as beneficiary on the policy for the amount of the loan. The result is a prime opportunity for collateral damage. Parties to the loan or the policy seldom think to adjust the creditor’s beneficial interest as the loan is paid down or even paid off. So if death occurs the creditor is unjustly enriched and the remaining beneficiaries are short-changed. Or a creditor’s beneficial interest can be too easily changed or eliminated without his or her knowledge.
Here are the rules:
Rule #1 – Never secure a loan with a beneficiary designation. Always use a collateral assignment!
A collateral assignment (C/A) is a formally documented lien on the policy in favor of the creditor who stands first in line for the share of the death benefit described by the terms of the C/A. But there can be collateral damage from a collateral agreement if things are not done properly.
Rule #2 – Use the carrier’s C/A form.
Rule #3 – Get the carrier’s permission before making any modifications on the C/A form
Rule #4 – To avoid the appearance of practicing law, only modify the C/A at the specific direction of the client or the client’s attorney.
Rule #5 – Make sure the C/A is dated after a time the policy is in force.
Rule #6 – Make sure the completed C/A is filled with the carrier, or the carrier won’t know to protect the rights of the creditor if benefits are paid.
Rule #7 – MEC Alert! Make sure the client understands that if a C/A is filed on a modified endowment contract the amount secured by the C/A is reportable taxable income to the extent of gain in the contract (like a LIFO distribution).
For all its conceptual simplicity, the execution of a collateral assignment usually has many problems as different circumstances pop up with each case. Call with any questions or for assistance with the drafting, approval and implementation of a collateral assignment at 706-614-3796 or tom@cpsadvancedmarkets.com.