Yes, in general you can deduct investment interest, but this interest isn't deductible because the insurance company looks solely to the cash surrender value of the policy to pay the principal and interest, and no true personal liability arises against the borrower.
You can't deduct interest on a loan when there is no true personal liability for payment of the loan.
Here are two Tax Court cases on this matter:
Murray Kay v. Commissioner, 44 T.C. 660, 672 (1965). It is well established, however, that to be deductible, interest must be paid on genuine indebtedness.
In Knetsch v. United States, 364 U.S. 361, 366 (1960), the Supreme Court held that when a loan transaction lacks economic substance, no true indebtedness exists, and interest on such loan is not deductible. A transaction will be determined to be lacking in economic substance, a "sham" transaction, when there is nothing of substance to be realized beyond a tax deduction. See id.; 6 Mertens Law of Federal Income Taxation section 26.10 (1988).
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