Rights Of Creditors In Insurance—Rationale For The Insurance Exemption (CC 03-14)

Every state and the federal government sets limits to the rights of creditors to insurance where the debtor has not sought to use this approach merely to avoid payment of debts. Because insurance, particularly life insurance, has expanded beyond its social origins to become an important financial planning tool, planners need to be aware of these rules.

Society has long recognized the individual’s obligations to provide for his or her family, but only in relatively recent times did it develop a mechanism to mitigate the devastating effects of death or disability on this responsibility. Burial societies, whose members were assessed when one of their number died, date to antiquity and are recognizable precursors to fraternal benefit societies.  However, life insurance as we know it only became widespread in the seventeenth and eighteenth centuries in England. The very names of the first life insurance associations—“The Friendly Society for Widows” (1696) or “The Society of Assurance for Widows and Orphans” (1699) clearly show that the origin of life insurance is the impulse to provide for family members left bereft by the death of their breadwinner. Life insurance originated, not as a commodity for sale, but as a social institution.

If there were no insurance exemption from the claims of creditors, this social purpose for owning insurance would be undermined. The financial security of an insured’s dependents would depend upon whether the insured was solvent or insolvent at the time of death. This is why state laws limit creditors’ rights: to help ensure that the persons for whom insurance was intended receive at least some of the proceeds regardless of the insured’s solvency.

Ironically, now that life insurance has evolved into a product, that original social purpose is more important than ever. Its basic, inherent function remains vividly relevant—it allows us to create an estate for the benefit of our dependents. As the only practical protection available to people with limited sources of income, it has become a crucial planning vehicle.

Of course, insurance exemptions have not been enacted to discriminate against the claims of legitimate creditors or to encourage placing property beyond the reach of those creditors. Most states’ exemption statutes contain an explicit provision permitting recovery of premiums paid in fraud of creditors.  But generally, policyowners do not secure life insurance to defraud creditors. In most cases, the issue of fraud does not arise.

One might characterize life insurance as a "creditor-free"  investment. This point is further demonstrated by the trend of  broadening the application of these statutes to cover any beneficiary without regard to relationship or dependency, either actual or implied.

These substantial immunities help diminish the fear that our plans will not be carried out due to the demands of our creditors.

AUS Section 19.5, Subdivision A further details the rationale for the insurance exemption and catalogues its many variations among the states and the different kinds of insurance products. 

AUS Section 19.5, Subdivision B contains a digest of the various state exemption laws.

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