Is Life Insurance Protected in Bankruptcy?

Life insurance probably isn’t the first thing that comes to mind when you think about bankruptcy, but it can affect your bankruptcy case. Every life insurance policy has an owner, an insured, and a beneficiary. The owner controls the policy. They can make changes or cancel the policy. The insured is the person whose death triggers the benefit payments. The beneficiary is the person who receives the insurance proceeds. If you’re the owner, you might also be the insured or the beneficiary (but not both).

In bankruptcy, there are two primary ways that life insurance might come into play. The first is if you own a life insurance policy that has a cash value. The second is if you’re the beneficiary under a life insurance policy and the insured dies within a certain time before or after you file bankruptcy. This article explains what happens in each of these situations and how you can protect your interests.

Life Insurance and Bankruptcy: Key Concepts

To protect your life insurance interests, you’ll need to understand what type of interests you have, their values, whether they’re part of your bankruptcy estate, and whether they’re exempt from liquidation. This task is much easier if you first understand a few key concepts, such as maturity, exemptions, assets, and the bankruptcy estate.

Assets and Your Bankruptcy Estate

Asset is just another word for property. Any property you own, including property rights, counts as an asset. All the property you own when you file bankruptcy is called your bankruptcy estate. Your bankruptcy trustee oversees your bankruptcy estate. Among other duties, they make sure that: 

• All the assets in your estate are listed correctly in your bankruptcy paperwork. 

• You actually own all the assets listed.

• The approximate value of each asset is correct.

• You didn’t forget to list any assets on your bankruptcy forms.

Liquidation and Exemptions

In Chapter 7 bankruptcy, the trustee can liquidate (sell) the assets in your estate and use the proceeds to pay your debts. But exemption laws let you claim some of your property as exempt from liquidation. The trustee can’t take or sell exempt assets. Most people who file Chapter 7 bankruptcy can claim all the assets in their bankruptcy estate as exempt, so there’s nothing that the trustee can liquidate.

In Chapter 13 bankruptcy, your creditors are entitled to get at least as much as they would in Chapter 7. But in Chapter 13, the trustee doesn’t liquidate your property. Instead, the trustee estimates how much creditors would get if you’d filed Chapter 7 instead of Chapter 13. This is equal to the total value of your bankruptcy estate minus the total value of all your claimed exemptions. You pay this amount to your creditors over time through a court-ordered repayment plan.

Each state has its own exemption laws. There is also a set of federal exemptions. In some states, you’re allowed to use either the state or federal exemptions. You must stick with one set or the other, though — you can’t mix and match. Other states have opted out of allowing you to choose which exemptions to use. There are currently 31 of these “opt-out” states. If you’ve lived in an opt-out state for at least two years, you must use that state’s exemption laws. If you’ve lived in an opt-out state for less than two years, you must use the federal exemptions.

Matured Versus Unmatured Life Insurance

The federal bankruptcy exemptions, as well as many state exemption laws, have different rules for unmatured life insurance versus matured life insurance. A life insurance policy that’s still active is unmatured. Term life insurance matures when the policy term ends. Other life insurance typically matures when the insured person dies. Some policies also have maturity clauses. For example, a maturity clause might say that the policy matures either when the insured dies or turns 99 years old, whichever happens first. An interest in an unmatured policy is always a part of your bankruptcy estate, but it doesn’t always affect your estate’s value.

What Happens to an Unmatured Life Insurance Policy in Bankruptcy?

All life insurance involves paying some type of death benefit to the beneficiary or beneficiaries when the insured person dies. In bankruptcy, this is sometimes called the “insurance component” of life insurance. But many types of life insurance also have a savings component. Over time, these policies accrue a cash value (sometimes called a loan value or a surrender value). Bankruptcy law has different rules for the insurance component of a policy compared to the savings component.

The insurance component of your life insurance policy doesn’t have a cash value because it doesn’t pay anything while the insured is alive. In other words, your bankruptcy trustee couldn’t increase the value of your estate by liquidating this component. Under the federal exemptions, the insurance component of any unmatured life insurance policy is fully exempt. It’s also exempt under most states’ exemption laws.

The savings component of a life insurance policy works a little like a savings account. It typically accumulates interest or dividends. As the policy owner, you can choose to pay extra to increase the principal balance. Depending on your policy terms, you can usually cash out all or part of the accumulated value. You can also take out a loan against it. In bankruptcy, the cash value of your policy’s savings component is equal to the amount of money you (or the trustee) can access at the time you file bankruptcy.

Does My Life Insurance Policy Have a Cash Value?

To determine your policy’s cash value, you need to know what type of policy you have. There are four basic kinds of life insurance:

• Term

• Whole (sometimes called permanent)

• Variable (sometimes called flexible or adjustable)

• Universal 

Term life insurance policies don’t have a cash value. A term policy pays a fixed, guaranteed death benefit to the beneficiary when the insured person dies. You should still list your term life policy as an asset in your bankruptcy forms, even though its cash value is $0. 

All other types of life insurance have a savings component. Just because your policy has a savings component, though, it might not have a cash value at the time you file bankruptcy. For example, your policy might not allow you to cash out the saving portion until a certain time has passed. Or you may have already taken a loan against the savings, leaving the policy with no cash value. Check your policy documents or contact your insurance provider to learn your policy’s current cash value. You’ll need to list your policy and its cash value in your bankruptcy forms.

Is My Policy’s Cash Value Exempt?

Under the federal exemptions, you can claim up to $13,400 of your policy’s cash value as exempt. The policy must meet two criteria to qualify for this exemption. First, you (the debtor) must be the policy owner. Second, the insured must either be you or someone who can claim you as a dependent.

If your policy’s cash value is higher than $13,400, you may be able to combine this exemption with the federal wildcard exemption, which protects up to an additional $13,100. If your state’s exemption laws don’t include an exemption specifically for life insurance, you may still be able to protect your policy’s cash value with other exemptions, such as your state’s personal property, cash, or wildcard exemptions.

What Happens to Proceeds From a Matured Life Insurance Policy in Bankruptcy?

If you’re the beneficiary of a life insurance policy and the insured dies, the insurance proceeds you receive could also affect your bankruptcy case. How much of the proceeds you get to keep depends on whether the proceeds are part of your bankruptcy estate and, if so, whether you can claim them as exempt.

Are Life Insurance Proceeds Part of My Bankruptcy Estate?

Life insurance payments that you received before filing bankruptcy are part of your bankruptcy estate. The money is treated like any other money in your possession. It doesn’t matter that it came from life insurance. If you receive life insurance proceeds within the 180 days after you file bankruptcy, those proceeds are part of your bankruptcy estate as well. If you become entitled to life insurance proceeds more than 180 days after you file bankruptcy, the proceeds are not part of your bankruptcy estate.

The 180-day rule does create some gray areas for insurance beneficiaries. For example, what if the insured dies before you file bankruptcy, but you don’t receive the insurance payments until after you file? Or what if the insured dies within 180 days after your file bankruptcy, but you don’t receive any money until the 180 days have passed?

Under the Bankruptcy Code, the relevant date to determine whether proceeds are part of your estate is the date you become entitled to receive payment. This usually happens upon the insured’s death. If that date is before or within 180 days after the date you file bankruptcy, the insurance proceeds are part of your bankruptcy estate, regardless of when you receive the funds. 

The trustee can’t liquidate payments that aren’t part of your estate, so you don’t need to list them in your bankruptcy forms. You also don’t have to worry about claiming them as exempt. If the proceeds are a part of your bankruptcy estate, though, you’ll need to list them in your bankruptcy forms. You can only keep these proceeds if you can claim them as exempt.

Can I Claim Life Insurance Proceeds as Exempt?

Under the federal exemption laws, life insurance payments you receive as a beneficiary are fully exempt if they meet two criteria. First, the insured person must have been able to claim you as a dependent on the day they died. Second, the insurance payments must be reasonably necessary to support you and your dependents. What’s considered reasonably necessary is up to the bankruptcy judge. You may have to provide evidence of your living expenses or explain why the proceeds are necessary.

Some states have exemption laws that specifically protect life insurance proceeds. These exemptions could include restrictions, though. For example, in Ohio, life insurance proceeds from a group policy are exempt, but proceeds from a private policy aren’t exempt. If your state doesn’t have a designated life insurance exemption, you may still be able to protect the proceeds under your state’s personal property or wildcard exemptions.

If you receive life insurance payments or become entitled to receive payments within 180 days after you file bankruptcy, let your bankruptcy trustee know right away. You may be able to protect some or all the money, but you can’t claim an exemption if you don’t list the insurance payment in your bankruptcy forms. Also, if you don’t report the payments to your trustee, you could face a bankruptcy fraud investigation. 

Let’s Summarize…

The insurance component of any life insurance policy you own is usually exempt from being liquidated in bankruptcy. If your policy has a cash value, though, whether you can claim it as exempt depends on which set of exemption laws you’re using. Some exemptions have qualifying criteria and/or limits on how much you can claim as exempt.

If you become entitled to receive life insurance proceeds as a beneficiary within 180 days after you file bankruptcy, the proceeds are a part of your bankruptcy estate. Your trustee can take these proceeds unless you can claim them as exempt. Whether proceeds are exempt depends on which exemption laws you’re using. If you have questions about how filing bankruptcy will affect your life insurance proceeds or policies, consult with an experienced bankruptcy attorney.