Is life Insurance Protected in Bankruptcy?

A bankruptcy filing can provide debt relief and protection against collection activity and creditor harassment. Bankruptcy also provides asset protection, as many debtors file without losing any property. Exemptions help debtors protect their assets, including life insurance policies. However, receiving life insurance proceeds for a certain amount of time before and after filing bankruptcy is a significant event that must be reported to your bankruptcy trustee.  

Using Your Exemptions to Protect Your Life Insurance Policy

After a Chapter 7 bankruptcy case is filed, a Chapter 7 trustee is assigned to the case to liquidate any of the debtor’s non-exempt assets and distribute the proceeds to creditors. However, a trustee only liquidates assets that are non-exempt, and cannot sell any of the debtor’s property that is exempt. To be classified as exempt, a debtor’s asset must fall within a bankruptcy exemption, which is either based on state law or federal law. 

Federal law allows states to set their own bankruptcy exemptions through state exemption laws. States may require debtors who file in that state to use the state exemptions. While all states have elected to create and own bankruptcy exemptions, the state law of the following jurisdictions - Alaska, Arkansas, Connecticut, D.C., Hawaii, Kentucky, Massachusetts, Michigan, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Texas, Vermont, Washington, and Wisconsin - allow individuals to choose between federal and state exemptions when they file for bankruptcy.

Currently, federal law exempts unmatured life insurance (except for credit insurance); a life insurance policy with a loan value up to $13,400, and/or payments from a life insurance policy owned by a person you depend on for financial support. 

If state law doesn’t provide a life insurance exemption, filers in that state may be able to use a wildcard exemption to protect the value of that policy. It may also be possible to use the wildcard exemption in conjunction with another exemption if the life insurance exemption is not enough to protect the entire cash value of the policy. It’s important to note that because a term policy doesn’t have any cash value, an exemption is only necessary to protect the cash value of a policy that is whole life by nature.

Term Life Insurance vs Whole Life Insurance Policies

Most people own one of two types of life insurance policies - whole life and term life insurance. A term life policy doesn’t have any cash value, unlike whole life, but pays a set amount to the named beneficiary. A term life insurance policy, which matures upon the death of the insured, guarantees payment of a stated death benefit to the insured's beneficiaries if the insured person dies during the specified coverage period or term. These policies have no value other than the guaranteed death benefit and feature no component of value as found in a whole life insurance product. Even though it has to be listed on the bankruptcy forms, this kind of policy is not considered an asset in bankruptcy because it lacks a cash value at the time of the bankruptcy filing.

In contrast, a whole life insurance policy accumulates cash value over time. It features the flexibility of allowing the policyholder to take a loan against it, thus giving it loan value, or cash it in, thus giving it cash value. Because of this, federal law considers it an asset that makes it part of the debtor’s bankruptcy estate. Unless exempt, a trustee may be empowered to seize and sell it to distribute the proceeds to unsecured creditors. If you benefit from this type of policy, you’ll need to determine whether you can protect any funds that you receive as a beneficiary.

Receiving Life Insurance Proceeds During Your Bankruptcy Case

It is crucial when considering bankruptcy to know which of your assets will become part of the debtor’s “bankruptcy estate,” a fundamental concept of the Bankruptcy Code. Filing a bankruptcy case creates this “estate,” which becomes a temporary legal titleholder of all the debtor’s assets and property rights, subject to exception. Any property received within 180 days of filing the bankruptcy case becomes part of your bankruptcy estate.

Assets contained in the estate are subject to the exclusive control and protection of the bankruptcy trustee, unless and until those assets are excluded from the estate with an exemption available under federal or state law. By contrast, assets that are not part of the estate are not controlled by the bankruptcy court and remain subject to the protection of the automatic stay. 

Determining whether a debtor may exempt life insurance proceeds from becoming a part of their bankruptcy estate depends on when such proceeds were received. If you receive a death benefit before filing your bankruptcy case, it is considered a cash asset, regardless that it was derived from a life insurance policy. It will be necessary to exempt this property, since it is part of the debtor’s bankruptcy estate and thus subject to liquidation by the trustee unless exempted.

If you filed your bankruptcy case and have a right to death benefits from another person’s policy, but have yet to receive these proceeds, this right is an asset of your bankruptcy estate. It is, therefore, necessary to determine if an exemption for life insurance proceeds is available under state law where you filed your case. The type of insurance policy from which you are receiving proceeds is an important determining factor. For example, in some states, like Ohio, the proceeds of a group policy are exempt, but the proceeds of a private policy are not.

The relevant date for determining whether the property is part of your bankruptcy estate is the date of the insured’s death, rather than the date on which you receive the proceeds. If someone dies 30 days after you file your case, these life insurance proceeds will become the property of your bankruptcy estate unless exempt, since the death was within 180 days of the bankruptcy filing. It is also important to notify the trustee of this windfall even if it falls within an exemption. Bankruptcy debtors submit all information and underlying documentation to the trustee and bankruptcy court under penalty of perjury. Thus, it’s never a good idea to conceal any relevant information since you will potentially face criminal charges for bankruptcy fraud.   

Conclusion

In conclusion, assets  (including the cash value of whole life policies and any life insurance proceeds) are part of a debtor’s bankruptcy estate unless you can protect them with bankruptcy exemptions. Failure to report the receipt of life insurance proceeds or the existence of any other assets may result in criminal charges for bankruptcy fraud. If you have questions about how any of your life insurance insurance policies will be affected by filing bankruptcy, consult with an experienced bankruptcy attorney.