Life Insurance And Bankruptcy: What's The Verdict?

Life insurance is often an important consideration when it comes to bankruptcy. While bankruptcy can provide financial relief, it also comes with significant downsides, including a negative impact on your credit score and the potential loss of assets. The specific impact on your life insurance will depend on the type of bankruptcy you file for and the type of life insurance policy you have. Understanding these factors is crucial for navigating this complex situation.

Term life insurance policies are generally exempt from bankruptcy

However, it is still important to list your term life insurance policy as an asset in your bankruptcy forms, even though its cash value is $0. Failure to disclose all assets, including insurance policies, could result in your bankruptcy case being dismissed or even lead to fraud charges.

In contrast, whole life insurance policies typically have a cash value component that grows over time. This cash value is an investment portion of the policy, where part of your monthly premium is invested and accrues interest or dividends. Depending on the policy terms, you may be able to cash out all or part of the accumulated value or take out a loan against it. This cash value is considered an asset with monetary value in a debtor's bankruptcy and may be pursued by creditors to satisfy debt obligations.

The treatment of life insurance policies in bankruptcy depends on the specific circumstances and the laws in your state. It is always recommended to consult with an experienced bankruptcy attorney to understand your rights and options.

Permanent life insurance policies may be subject to liquidation

Permanent life insurance policies are a type of insurance that provides coverage for the full lifetime of the insured person. Unlike term life insurance, permanent life insurance combines a death benefit with a savings component that earns interest on a tax-deferred basis. This savings component, also known as the cash value, can be accessed by the policyholder through loans or withdrawals.

When it comes to bankruptcy, the treatment of permanent life insurance policies can be more complex than term life insurance policies. Here are some key points to consider:

Cash Value and Liquidation

The cash value component of permanent life insurance policies may be subject to liquidation in bankruptcy. This means that the value accumulated in the policy may be used to satisfy your debts. However, exemption laws in your state could protect a portion or all of this value. These exemption laws vary from state to state, and it is important to consult with a bankruptcy attorney to understand the specific protections available to you.

Surrendering the Policy

In some cases, individuals facing bankruptcy may choose to surrender their permanent life insurance policy. By doing so, they can use the cash value to satisfy debts and may qualify for exemptions under bankruptcy laws. However, this decision should be carefully evaluated, as surrendering the policy could leave your loved ones without financial protection.

Policy Loans

If you have taken out loans against your permanent life insurance policy, these loans may be treated as any other debt in bankruptcy. Policy loans are often considered secured debts and may have different implications. Consulting with a bankruptcy attorney is crucial to navigate this aspect effectively.

Impact on Premiums and Coverage

Filing for bankruptcy can impact your ability to maintain regular premium payments due to your financial condition. Failing to make these payments can result in a policy lapse, leading to a loss of coverage and benefits. Additionally, a history of bankruptcy may lead to increased life insurance premiums, as insurers may view you as a higher risk.

In summary, while permanent life insurance policies may be subject to liquidation in bankruptcy, the extent of this depends on the specific circumstances and the applicable state exemption laws. It is important to seek guidance from a bankruptcy attorney to understand the full implications and make informed decisions regarding your financial situation and the protection of your loved ones.

Bankruptcy exemptions vary by state

The US bankruptcy code allows for certain exemptions to protect a portion of the debtor's property. These exemptions vary by state, and there are also federal exemptions. In some states, debtors can choose between state and federal exemptions, but they cannot mix and match—they must choose one set of exemptions or the other.

Exemptions are specific and limited and can vary dramatically depending on where you live. For example, some exemptions that exist in one state do not exist in others. New Jersey and Pennsylvania debtors may choose between using the exemptions that correspond to their state or the nationwide federal exemptions.

Each state has its own exemption laws, and there is also a set of federal exemptions. In some states, you are allowed to use either the state or federal exemptions. However, you must stick with one set or the other—you cannot use both. 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 have lived in an opt-out state for at least two years, you must use that state's exemption laws. If you have lived in an opt-out state for less than two years, you must use the federal exemptions.

Exemptions work differently in Chapters 7 and 13. In Chapter 7 bankruptcy, you lose property not covered by an exemption. The bankruptcy trustee responsible for managing your case will sell the property for the benefit of your creditors. In Chapter 13 bankruptcy, you can keep all of your property, but you will pay your creditors the value of any property not covered by an exemption in your Chapter 13 repayment plan.

The homestead exemption, for example, protects your ownership interest in your home. The specifics of this exemption vary by state, but in all states, the property must be your residence. There is also a federal timing law that caps the homestead exemption at $189,050 if you file on or after April 1, 2022 (the amount changes every three years), unless you have lived in the home for over 40 months.

The motor vehicle exemption is another common exemption. For example, if your state has a vehicle exemption of up to $5,000, and you own a car worth $3,000, filing for Chapter 7 bankruptcy will mean you get to keep your car because the exemption protects the equity fully. However, if your vehicle is worth $15,000, the bankruptcy trustee will sell your car, pay you $5,000 for the exemption, and distribute the rest to your unsecured creditors. In Chapter 13, you wouldn't need to pay extra to your creditors through your repayment plan for a $3,000 car. However, if the car were worth $15,000, you would need to pay your creditors at least $10,000 (minus sales costs) through your plan.

Some other examples of exemptions include personal belongings, retirement accounts, and pensions. Items that are not likely to be covered by exemptions include assets that are luxuries rather than necessities, such as a second home, a sports car, jewellery, or a designer watch.

You may be denied coverage if you are currently going through bankruptcy

Life insurance companies have two key concerns when someone with a history of bankruptcy applies for a policy. These are moral hazard concerns and premium payment abilities.

Moral Hazard Concerns

If you've recently experienced bankruptcy and your financial condition is still unstable, you may feel an urgent need to secure life insurance. While your intentions may be to protect your family or business financially, insurers often see this as a heightened risk. This concern is magnified by the possibility that an individual may consider their death a way to relieve financial burdens on their loved ones.

Premium Payment Abilities

Another concern for insurers is your ability to maintain regular premium payments given your shaky financial condition. Failing to make these payments can result in a policy lapse, meaning you lose the coverage and its benefits.

If you are currently going through bankruptcy, you may be denied coverage. However, each situation is unique and evaluated individually. Some insurance companies may still consider giving you coverage, but this usually involves a thorough review of your finances and bankruptcy repayment details.

Factors that will help your application get approved include:

• Having a steady income
• Not having filed for bankruptcy multiple times
• Having your bankruptcy petition approved by the court
• Not undergoing treatment for psychological, mood, or anxiety disorders, and no history of such conditions
• Having a stable family environment
• No history of alcohol or drug treatment

For those who don’t meet these criteria, insurers will typically want to wait until two years after the bankruptcy has been discharged to offer coverage (five years for multiple bankruptcies).

Bankruptcy can impact your life insurance premiums

If you're considering filing for bankruptcy, you may be concerned about how this will affect your life insurance policy and premiums. Here's what you need to know:

Types of Bankruptcy

Firstly, it's important to understand the different types of bankruptcy. Individuals usually file for Chapter 7 or Chapter 13 bankruptcy, while businesses typically file for Chapter 7 or Chapter 11.

Chapter 7 Bankruptcy

Chapter 7 bankruptcy, also known as "liquidation bankruptcy," is the most common form. During this process, the debtor's assets are sold off, and the proceeds are used to pay back creditors. Insurance companies will generally decline life insurance applications during an active Chapter 7 bankruptcy. To qualify for life insurance after Chapter 7 bankruptcy, your bankruptcy must have been discharged at least one to two years ago.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy involves creating a plan to repay your debts over a period of three to five years. Insurers treat Chapter 13 bankruptcy with more leniency than Chapter 7, as long as you can demonstrate financial stability. Your bankruptcy doesn't necessarily need to be discharged before applying for life insurance. However, you may be offered higher premiums than someone who is not currently in bankruptcy.

Impact on Life Insurance Premiums

A bankruptcy history can result in increased life insurance premiums, as insurers view you as a higher risk. To improve your chances of securing coverage at affordable rates, it's crucial to demonstrate financial stability. This could include having a consistent income, a stable family environment, and holding stable assets like a home or car. The longer the time since your bankruptcy discharge, the less impact it will have on your premium rates.

Working with a Broker

Given that insurance companies can vary in how they evaluate bankruptcy histories, working with an experienced broker can be advantageous. Brokers can shop around and compare policies from multiple insurers to find the best rates tailored to your specific circumstances.

Life Insurance Proceeds and Exemptions

In some cases, life insurance proceeds may be exempt from bankruptcy. This depends on the state you live in and the specific laws and exemptions that apply. For example, in Pennsylvania, life insurance proceeds may be exempted if the beneficiary is the decedent's child, spouse, or dependent relative. It's important to consult with an experienced bankruptcy attorney to understand the specific laws and exemptions in your state.

Frequently asked questions