For The Cash-Strapped Business, Cash Values Can A Be Life-Saver

"The contract loan bought the company time to get to the next real estate deal," says Wessel. "The firm's owners were very thankful they had the capital they needed inside the policy."

All well and good. But sources caution that clients need to be mindful of the dangers inherent in policy loans. Chief among them: The prospect of a policy lapse because of a failure to adhere to the loan's repayment terms. If ignored for too long, the loan interest can compound to such an extent as to render a continuation of the policy unsustainable.

"A policy loan needs to be treated like a bank loan," says Mark Weber, a chartered financial consultant and principal of Private Client Services at Silverstone Group, Omaha, Neb. "Clients need to prepare a repayment plan that amortizes the loan over time out of cash flow. Where people get into trouble is when they take out a loan with no intention of paying it back. The interest accrues and, sometimes, the contract will lapse without prior notice."

The threat of a policy lapse hovers over even those with good intentions. Businesses that borrow against variable UL and secondary guarantee UL products are especially vulnerable, experts say. The cash values of such contracts can dip to perilously low levels, in the first instance because of a market downturn; and in the second because (as is often the case) the client covers only mortality costs. Upshot: The funding needed to recapitalize the policy becomes overly burdensome.

One option to mitigate such risks, says Wessel, is to buy a paid-up additions rider, which can increase the cash value by overfunding the contract during the early years of the policy's life. In cases involving VUL contracts, clients can also shift funds from variable subaccounts to the policy's general or fixed account during the period when a loan is outstanding, says Terri Getman, a chartered financial consultant and vice president of advanced marketing at Prudential Financial, Newark, N.J.

Inadequate funding of a policy could also render unfeasible a commonly used alternative to borrowing against the policy: pledging the contract as collateral for a bank loan (a strategy that is also used among the affluent to finance premium payments of expensive contracts). Weber notes, however, that banks don't generally specify which part of a policy has to be collaterally assigned. In most cases, a financial institution will accept the death benefit, allowing the policy owner to hold onto the cash value.

A second alternative to a policy loan, a partial surrender of the contract in exchange for a reduced death benefit, may also be considered (excepting in most cases whole life contracts). But experts warn that such withdrawals generally make sense only after a contract has been in force for 15 years. The reason: Withdrawals made within the first 15 years can be taxed even though there is basis in excess of the distribution. Contracts issued after January 1, 1985 are subject to this "forced out gain" rule.

Clients who do elect to borrow against a policy should generally strive to repay the loan within a short period, such as 60, 90 or 120 days. The less interest that accrues on the loan, experts say, the better positioned the client will be to meet long-term obligations for which the policy was intended.

Wessel, however, says that a short-term repayment commitment can actually put business objectives–and potentially the business itself–at risk, particularly in instances where the firm is experiencing severe cash flow difficulties.

"If the loan is taken out under duress, then paying it back fast could negatively impact what the business is trying to accomplish," says Wessel. "For businesses that are already experiencing financial troubles, an aggressive repayment schedule may kill cash flow."

For Weber, businesses experiencing a severe cash crunch and those in volatile industries that cannot count on a steady revenue stream would do well to purchase convertible term insurance, converting the policy to permanent insurance only when they achieve financial greater stability.

"If the business doesn't know what cash flow will be or what impact a downturn will have on their ability to meet business obligations, then I would recommend purchasing convertible term insurance," says Weber. "You don't want the premium to be one of the causes that drags the business down."