A semiconductor device has a substrate. An insulating layer is formed over a surface of the substrate. A semiconductor die is mounted over the surface of the substrate. A channel is formed in the insulating layer around the semiconductor die. An underfill material is deposited between the semiconductor die and the substrate and in the channel. A heat spreader is mounted over the semiconductor die with the heat spreader thermally connected to the substrate. A thermal interface material is formed over the semiconductor die. The underfill material is deposited between the semiconductor die and the substrate along a first edge of the semiconductor die and along a second edge of the semiconductor die opposite the first edge. The channel extends partially through the insulating layer formed over the substrate with the insulating layer maintaining coverage over the substrate within a footprint of the channel.