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AUTOMATIC PREMIUM LOANS

A policy provision found in some�but not all�policies that bears a close resemblance to the paid-up term insurance option but is technically not a surrender option (since the policy is not surrendered) is the automatic premium loan feature. It grew out of the conventional premium loan clause, which states that at the request of the policyowner any premium may be paid by means of a loan against the surrender value, provided that a surrender value is then available and large enough to cover the loan. Such a loan usually bears interest at the rate applicable to all policy loans.

The automatic premium loan clause provides that any defaulted premium will be automatically paid and charged against the cash value without request from the policyowner unless he or she elects to surrender the policy for cash or one of the paid-up insurance options.

The effect of the premium loan clause is to extend the original plan of insurance for the original face amount decreased by the amount of premiums loaned with interest. Such extension will continue as long as the cash value at each premium due date is sufficient to cover another premium. It should be noted that each premium loan increases the cash value, lengthening the period during which the process can be continued. At the same time, however, the indebtedness against the cash value is growing, not only by the granting of additional premium loans but also by the accrual of interest. Eventually a premium due date will be reached when the unencumbered cash value is no longer large enough to cover another full premium.

The principal advantage to the policyowner of an automatic premium loan provision is that in the event of inadvertent nonpayment of the premium or temporary inability to pay the premium, the policy is kept in full force. Several collateral advantages flow from this basic fact. First, premium payments can be resumed at any time (as long as the equity in the policy remains sufficient to pay premiums as they become due) without furnishing evidence of insurability. This is in contrast to the reinstatement of policies surrendered for paid-up insurance, in which case evidence of insurability is almost invariably required. Second, special benefits�such as waiver of premium, disability income, and accidental death or double indemnity�remain in full force, contrary to the situation under the paid-up insurance options. Finally, if the policy is participating, the policyowner continues to receive dividends, which is usually not true of paid-up term insurance and might not be true under reduced paid-up insurance.

On the other hand, unless the provision is used only as a temporary convenience, as intended, it may prove disadvantageous to the policyowner. If premium payments are not resumed, not only will the period during which the policy is kept in force usually be less than under extended insurance, but the amount payable in the event of death will be less, and the disparity will become greater with each passing year.

In the event of the insured�s death during the period covered, the insurer is better off financially under the automatic premium loan arrangement than under extended term insurance, since the former receives additional premiums by way of deduction from the policy proceeds, but offsetting this advantage to some extent are the additional outlays for commissions, premium taxes, and dividends (if participating).

The effect of the automatic premium loan feature on the structure of a whole life policy is shown in figure 10-4. Upon default of the first premium the effective amount of protection is reduced by the amount of the gross premium. Each year thereafter that the feature is permitted to operate, the amount of protection is reduced by the gross premium due that year, plus interest on that premium and all unpaid premiums of previous years. Hence the protection element will decline at a constantly increasing rate. The surrender value will be exhausted, however, before the protection element is reduced to zero.

 

 

 

FIGURE 10-4

Effect of Automatic Premium Loans on Structure of Cash Value Whole Life Insurance Contracts

 

 

 

The effective or unencumbered investment element also turns downward, but not immediately, and it never declines at the same rate as the protection element, so the solid and broken lines are not parallel. The nominal investment element�cash value�increases with the payment of each gross premium (regardless of the source of the funds) by the amount of the net premium, plus interest at the contractual rate and benefit of survivorship, less the cost of insurance.

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