All financial advisors know that designating a bank as the beneficiary on a life insurance policy against a loan makes no financial sense. But when a client insists, you can solve the problem with a collateral assignment.

Bob Dickson, an insurance advisor in Carleton Place, Ont., who runs most of his business through Copoloff Insurance Agencies Inc. of Montreal, had a client who had applied to a major bank for a secured line of credit. Against all of Dickson’s advice, the client wanted assurance that the loan would be paid in full if he died, so he insisted on naming the bank as the beneficiary.

Dickson’s client thought the bank was more likely to approve the loan and give him a better rate if it was the beneficiary of the policy, although the bank had never expressed that to him.

Most advisors know the arguments against this decision. It’s similar to the mortgage-life insurance misstep clients make: as the client closes the mortgage deal with the bank, the bank offers its own creditor insurance. That is a bad deal for many reasons, chiefly that the creditor insurance effectively names the bank as the beneficiary of the policy and, as the mortgage declines, the premiums stay the same.

Persuading a client to buy independent life insurance is usually easy once he or she understands the benefits. For roughly the same premium, the life insurance allows a surviving spouse, beneficiary or executor the flexibility of deciding what to do with the death benefit.

“They could pay off the mortgage, pay off some of it or simply invest [the benefit] and keep the mortgage, although special tax planning is required in that case,” says Bruce Cumming, a financial planner and owner of Oakville, Ont.-based Cumming & Cumming Wealth Management Inc., which operates under the DundeeWealth Inc. umbrella.@page_break@Dickson was able to convince his client that independent life insurance was a better deal, but the client still wanted to name the bank as a beneficiary. If the policy was ever paid out, all proceeds of the life insurance policy would flow immediately to the bank, regardless of the size of the loan. The client’s estate or heirs would then be at the behest of the bank’s goodwill to return what it was not owed. At worst, the case could end up in the courts if the bank wasn’t compliant and the heirs wanted to pursue the issue.

Dickson sought advice through an online forum called For Advisors Only (www.foradvisorsonly.com). Through that site, Gerald Burgess, an advisor in Toronto with Burgess Leclerc Financial Group Inc. and a former bank manager, reminded Dickson that his client could name the bank in a “collateral assignment,” a.k.a. “as their interests may appear” or ATIMA.

The collateral assignment protects the bank, earmarking the amount it is owed. The rest of the policy’s payout would be paid to another, named beneficiary.

“This way, the bank would only get what it was owed at that unknown time in the future when the claim arose,” says Burgess, who runs most of his insurance policies through Mississauga, Ont.-based IDC Financial Inc. “This way, the [client’s] named beneficiaries would get all the balance straight away, without any delay.”

The insurer pays out the assignment to the bank first, and then pays what’s left over to the named beneficiaries in the policy.

Some insurers, and most banks, have a collateral assignment form for a client to sign, Burgess says. The assignment is then registered with the insurer.

Cumming adds that banks may require collateral assignment in certain key-person situations — for example, if the bank makes a loan to a business owner whose death almost certainly would bring an end to the business.

Otherwise, he says, in many cases, banks are satisfied that a life insurance policy is in place to protect the loan. Most banks aren’t actually motivated to have the loan paid off, because the loan keeps generating interest for their business. IE