Advanced Underwriting Consultants

Ask the Experts – May 28

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: I have a client who received $100,000 as the beneficiary of his deceased wife’s life insurance policy. My client and his wife were in bankruptcy at the time of her death. Will the death benefit be protected from both of their creditors?

Answer: It depends on the state law and other facts surrounding their situation.

For example, consider the recent Alabama bankruptcy case, In re White, in which a married couple was in Chapter 13 bankruptcy when the wife died. Prior to filing a petition for bankruptcy relief, the debtors purchased a $50,000 life insurance policy on the life of the wife through the husband’s employer. The wife was the insured and policy owner, while her husband was designated as the sole beneficiary.

The wife died and the husband received $50,000. Ordinarily, money received during a bankruptcy plan would go to the bankruptcy estate and the trustee would dictate where that money was allocated. However, the husband asserted that the funds were exempt from the bankruptcy estate because of the following state asset protection statute:

(b) If a policy of insurance . . . is effected by any person on the life of another in favor of the person effecting the same . . . the latter shall be entitled to the proceeds and avails of the policy as against the creditors, personal representatives, trustees in bankruptcy and receivers in state and federal courts of the person insured. If the person effecting such insurance . . . is the wife of the insured, she shall also be entitled to the proceeds and avails of the policy as against her own creditors, personal representatives, trustees in bankruptcy, and receivers in state and federal courts.

Alabama Code Section 27-14-29(b). The statute is rife with legalese, but here’s a translation: if the husband effects a life insurance contract on his wife’s life and names himself as the beneficiary, then the death benefit is exempt from both of their bankruptcy estates.

The husband argued that he “effected” the policy because it was purchased through his employment and paid for with payroll deductions. The bankruptcy trustee disagreed, claiming that the $50,000 death benefit should go to the bankruptcy estate—not to whomever the debtor-husband wants.

The bankruptcy court agreed with the trustee, reasoning that although the wife purchased the policy through her husband’s employment, and, although it was funded with payroll deductions, the policy was owned by the wife, and it was therefore not effected by the husband. Therefore, this particular Alabama creditor exemption did not apply to the husband, and the $50,000 death benefit was not protected from his creditors. (Note that it was protected from his wife’s creditors, but since they were jointly in bankruptcy, that made no difference.)

The White case reinforces the idea that a policy’s death benefit, when paid to a beneficiary going through a bankruptcy, might also be lost to creditors. The court’s decision hinged on its interpretation of the Alabama state law bankruptcy exemption and the ownership of the life policy on the deceased wife’s life. It probably never occurred to the husband in this case that policy ownership might make a difference as to whether he might be able to keep the death benefit later on. Even though state bankruptcy exemptions provided some protection for life insurance proceeds, the specific circumstances of this case didn’t extend those protections to the surviving husband.

Finally, the decision serves as a reminder (again) to life insurance professionals to

  • Review the ownership and beneficiary designations of all their clients’ life insurance and financial products on a regular basis.
  • Consider naming a spendthrift trust as beneficiary instead of the individual directly to protect beneficiaries who might have future financial difficulties.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.