All life insurance policies have certain contract provisions that they may apply somewhat differently depending on the type of policy. Those that need special attention when purchasing single premium life insurance include the following:
Loan provision – Many single premium policies allow the policyowner to borrow against the interest accumulated in the policy at what the companies call a “0 percent net cost” (i.e., the interest rate on borrowed funds equals the rate credited to the funds in the policy). The borrowing interest rate for principal amounts (the original premium) is generally 1 to 2 percent higher than the rate credited to policy cash values.
From a quick reading of the paragraph above, it would appear that the cost of borrowing would be offset dollar for dollar with the earnings of the fund; however, this may be misleading. One should check policy loan provisions carefully because the net borrowing rate may be effectively higher than the stated rate in many cases. Frequently, in current assumption policies the company sets aside an amount of the remaining cash value as collateral for the loan. The insurer may credit this “set aside” with interest at the minimum guaranteed rate in the policy (or some higher rate that is still less than that credited to nonborrowed amounts), while they credit nonborrowed cash values that are not subject to the set aside provision with a higher current rate.
For example, assume the insurer is crediting nonborrowed funds with 6 percent interest and the loan rate on interest accumulations is also 6 percent, while the guaranteed rate is 3 percent. If the company sets aside an amount equal to the debt balance and credits it with only 3 percent interest, the effective interest on borrowed funds is 9 percent (6 percent on the loan and 3 percent in foregone interest on the amount set aside).
Similarly, in participating single premium ordinary policies, many companies “adjust” dividends to reflect borrowing activity. In other words, they pay lower dividends on policies with policy loans. Although the loan rate may be equal to (or only slightly higher than) the interest rate credited to the policy, the actual cost of borrowing is equal to the borrowing rate plus any decrease in dividends relative to that which is paid to policies without loans.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM