Bankruptcy law in the United States is very special. Unlike in other countries, individuals can declare bankruptcy before a court, just like a company. This is a difficult situation that can result in long-term complications for the person in question.
Bankruptcy also has a significant impact on life insurance. First, because it can completely upend the qualification process. Secondly, because bankruptcy can cause insurance to lapse due to lack of payment.
In this article, we will review the complex relationship between life insurance and bankruptcy. Keep reading to find out what happens to life insurance when a person files for bankruptcy.
What Is Bankruptcy?
In the United States, a person can legally declare bankruptcy. This mechanism allows people to go on even when they can’t manage their debts. Bankruptcies aren’t just caused by low income, unemployment, or similar circumstances. They can also be brought on by failed investments, unexpected serious illnesses, legal problems, robberies, scams, or natural disasters. There are many reasons why a person might be in a financial situation so dire that they have to legally declare bankruptcy. Doing so involves going to a court, which will assign a trustee to manage the bankruptcy.
When this happens, the individual will face significant disadvantages. For example, they will lose any assets that are not legally exempt, which will be seized to cover the debts and pay the creditors. It will also ruin their credit score, making it difficult to get loans or mortgages or use credit cards. Further, they will face serious obstacles in renting a property to live in or even finding another job. Another typical consequence of bankruptcy is losing the right to tax refunds, which can seriously impact a business.
However, there are some advantages as well. Any unsecured debts will be discharged: medical bills, loans not backed by collateral, negative credit card balances, utility bills such as those for phone lines and electricity... All tax debts more than three years old are wiped out, and there are some properties the law considers untouchable, such as the family home. Furthermore, the bankruptcy will be managed by a trustee, who will assist with payments and negotiate with creditors so that the filer won't have to.
As you can see, declaring bankruptcy can turn your life upside down. On the one hand, it frees you from most of your debts and the pressure they involve. On the other, you’ll have to start over in a very delicate situation.
In the middle of all this is life insurance. Life insurance policies are assets in the possession of the person declaring bankruptcy. We will look at the impact that declaring bankruptcy can have on purchasing life insurance.
What Happens to My Life Insurance If I Declare Bankruptcy?
For starters, you should ask yourself what will happen to your valid life insurance policy when you file for bankruptcy. The first thing you should know is that each state decides which assets are exempt from bankruptcy and can thus still remain in your possession if you file. To find out what will happen in your specific case, you will need to review the bankruptcy laws of the state where you live. In some states, like Florida, life insurance can be completely exempt from bankruptcy.
Once you determine how bankruptcy works in your state, the next step is determining what type of valid policy you have. If it’s term insurance, which has a set time limit, don’t worry: it doesn’t earn cash value, so it is barely taken into account when deciding what assets will be used to cover your debts.
Permanent life insurance, however, does earn cash value, which can be considered liquid assets. This means that unless it’s exempt, a permanent life policy can be seized.
To avoid this, if there are no applicable exemptions, your state can offer a "wildcard exemption" that you can use to protect your life insurance and prevent it from being sold off to settle with your creditors.
Lastly, if you die during the bankruptcy process and leave behind a valid life insurance policy, the death benefit from this policy is completely exempt. Not only is it tax-free, but it also cannot be confiscated from your beneficiaries to pay your debts.
How to Protect Life Insurance Benefits from Bankruptcy
The benefits you earn from life insurance might also be seized if you file for bankruptcy. There are several scenarios to consider in this case:
- Money received before filing for bankruptcy: If you received money from a life insurance policy (dividends, cash value or even a payout), this will be treated as cash. You can only protect it if there is an exemption for cash in your state, which is rare, or if you have the option to use a wildcard exemption.
- Right to receive funds before bankruptcy: If you are a life insurance beneficiary and haven’t yet collected the death benefit when you declared bankruptcy, your right to collect will be managed as another asset of the bankruptcy. To save it, you should review your state’s bankruptcy law, because there are exemptions in some cases. In Ohio, payouts from group insurance are exempt from bankruptcy.
- Money received up to 180 days after filing for bankruptcy. If you receive a payout within 180 days of filing for bankruptcy, this money could also be used to repay your debts. The relevant date is not the day when you received the money, but when the insured who named you a beneficiary died. 180 days are calculated from this date, so if you receive the death benefit one month after declaring bankruptcy but the insured died a year ago, you will be able to keep the money. In other words, if you receive the money six months after the death of the insured, you won’t need to include it in the assets you’ll use to cover your debts.
Purchasing Life Insurance While Bankrupt
Bankruptcy makes things even messier when you want to purchase a new life insurance policy. As you know, purchasing a policy means going through the qualification process, a series of tests and interviews in which the insurer will evaluate your health and financial risks. These tests can include medical exams and, of course, financial background checks. If you’ve declared bankruptcy, your financial health won't look very good.
Despite this initial difficulty, you can still get life insurance.
The best way to do so is to approach the insurer once the bankruptcy process has progressed enough that you are free of your main debts. If your most pressing debts are behind you, the insurer will look at your situation differently and the qualification process will be easier. That being said, keep in mind that each insurer has their own criteria for determining when a person becomes eligible again after declaring bankruptcy.
The type of bankruptcy you chose to file will also greatly impact your insurance options. In general, there are two types: Chapter 7 bankruptcy, which involves liquidating your assets, and Chapter 13 bankruptcy, which involves reorganizing your assets or business to avoid liquidation. This last option is less severe and viewed more kindly by insurers, especially if you wait six months after declaring bankruptcy.
In any case, it all depends on the financial health you demonstrate when you apply for insurance. If despite the bankruptcy, you already have new income, a stable home environment, good health, don’t suffer from anxiety or are in psychotherapy, and don’t consume alcohol or drugs, you will be able to access life insurance.
When the time comes to buy, remember that it will be much easier to get term life insurance than permanent. You can always start with a term policy and then convert your term insurance into permanent insurance. Or, you can build a life insurance ladder. This way, you can obtain good coverage at a better price and won’t have as many problems with the qualification process.
And if the process is too complex, you can opt for final expense insurance, which will cover the cost of your funeral, or guaranteed issue insurance, which requires the insurer to accept you, as long as you pay much higher premiums than normal and obtain limited coverage.
Whichever option you choose, your premiums will always be affected, because a history of bankruptcy will lead the insurer to negatively assess its risk and impose higher premiums. Remember that you can always review your life insurance policy after some time, in order to prove that you have overcome financial difficulties and are in a more solid situation. This way, you can obtain more affordable premiums.
As you can see, there are many ways in which bankruptcy can affect your life insurance. In any case, you should always consider your policy an asset and try to defend it. Your lawyer and insurance agent can provide more information: ask them how you can protect your life insurance policy or how you can obtain another if you’ve filed for bankruptcy.