A collateral assignment is a term used when you take your policy to a third-party institution (ie. the bank) and use your policy and its cash values as collateral for a loan, typically in the form of a line of credit. A primary advantage of doing this is that all monies advanced are considered loan proceeds (instead of income) for income taxes according to present day tax laws. The use of a life insurance policy as collateral for a loan involves the policy owner executing a collateral assignment. As an assignee, the financial institution does not become the owner of the policy, however, it can prevent any action under the policy that would diminish its security interest.
If the borrower defaults on the loan while the insured is still alive, the lender has remedies it can exercise, including a surrender of the policy for its cash value in order to recover the amount that it was owed. The lender also has the right to the proceeds up to the loan balance at the time of the insured’s death if the loan remains outstanding at death.
When you collaterally assign your policy to the bank, the bank has a special collateral assignment letter for you to sign which will be registered with the insurance company. The letter basically acknowledges that you have received a loan and have pledged the policy as security. This approach is usually preferred to directly withdrawing cash from your policy (see “Cash Withdrawal”), and it can be more advantageous than a policy loan depending on the ACB (see “Policy Loans” and “Adjusted Cost Basis”).