Did you also know that the cash value in a life insurance policy is also protected from creditors? All life insurance policies and life insurance products like segregated funds offer creditor protection if set up properly. This is because there is a designated beneficiary in the policy. However, for a life policy to be properly protected, the beneficiaries have to be set up properly.
I recently came upon a client who is undergoing bankruptcy. The bankruptcy happened because of a divorce and the ex-wife is now entitled to payment and the client had to file for bankruptcy. So the ex-wife is now the creditor of the husband.
Prior to the separation, the husband has a Universal Life policy where he is putting extra funds in the policy to build up his investments and cash values. The ex-wife was designated as a beneficiary of the policy with the kids set up a contingent or secondary beneficiaries.
After the divorce, the husband no longer wanted the wife to be the beneficiary. He wanted his kids to be the new beneficiaries but he didn't think his children (aged 19 and 21) should suddenly inherit a lot of money at a young age should he suddenly pass away. He is afraid that they may squander the money if they get it at a young age and thought that 30 would be an appropriate age for them to get the life insurance proceeds.
Instead of speaking to me about his situation, he directly called the insurance company to have his beneficiaries changed. He changed the primary beneficiary from his ex-wife to his sister and set up his children as contingent or secondary beneficiaries and had his brother be the trustee for the children until the children turn 30.
Then he filed for bankruptcy. Big mistake.
Life Insurance in Bankruptcy
As a general rule, all assets of an individual are security for unpaid debts owing to a creditor. This applies whether or not the individual is bankrupt.
When someone files for bankruptcy, his properties are turned over to his trustee. The life insurance policy of that individual is then put into a status called "Assignment in Bankruptcy". When a policy is under Assignment in Bankruptcy. The owner of the life insurance policy cannot make any changes to the policy until that person is discharged from bankruptcy.
Remember when I said that a life insurance offers creditor protection? It does but only if at least one of these two conditions are met:
- The beneficiary is designated as "Irrevocable"
- The beneficiary designated are certain family members specified in the provincial insurance legislation. In most common law provinces, the family member must be a spouse, child, grandchild or parent of the life insured in order for the policy to provide creditor protection.
Unfortunately, under the provincial insurance legislation, when you designate a sibling as a beneficiary, they are NOT considered as family members. Hence, no creditor protection exists. And when your policy is under assignment in bankruptcy, you cannot do any changes to the policy like changing beneficiaries, etc.
Because the client has built up significant values in the life policy, the creditor now wants the cash in the life policy to pay off his debts. So now the client will either be forced to surrender the life insurance policy and leave nothing to the children and use the cash values to pay the creditor, or he has to borrow money from someone equal to the amount in the life insurance policy to pay the creditor. And you know you can't just borrow money from anyone when you're in bankruptcy.
Fortunately, the trustee was kind enough to tell him that they're not going to force him to cancel his policy. But did tell him to borrow money from his brother or sister and pay the equivalent of the cash value in the policy then they will release his policy from bankruptcy. Once released, the client can how do what he wants with his policy.
How could the client have saved himself from this headache? There are two thing he could have done.
- Assign the children to be the beneficiaries and assign his sister to be the trustee for the children until age 30 or whatever age he decides to give the children the full amount. That way, the sister controls the money until the children reaches age 30. At which point, they are entitled to get the full amount.
- Assign the sister or the children to be the irrevocable beneficiaries.
There are also some rules that govern bankruptcy with regards to protecting your assets. The main thing is that if it was deemed you did something for the specific reason of hiding them from your creditors, you will not get protection. The general rule of thumb is, any assets you protected say in your life insurance or RRSP within one year from bankruptcy, they are not creditor protected.
If the client changed the beneficiary just prior to filing bankruptcy, he may only get partial protection from his creditors on his life insurance or he may not get any protection at all. That is up to the court to decide. But if he changed the beneficiaries two years ago, then he will be fully protected if it was deemed the change wasn't for the purpose of protecting the assets from creditors.
To summarize, life insurance is a great way to invest and also protect your assets from your creditors. They offer competitive rates of return and the death benefit bypasses probate and is tax free.