Shielding Your Family From Your Creditors With Life Insurance

Naming a beneficiary of a life insurance policy provides a significant benefit in planning and protecting one’s estate.  With a named beneficiary, the death benefit is paid directly to the beneficiary and is received tax-free. It bypasses the policyowner’s estate and is not subject to probate or any other administrative fees.  

Creditor Protection at Time of Death

Under provincial life insurance legislation* when a beneficiary is named, creditor proof status is conferred upon the insurance proceeds protecting them from the claims of the policyowner’s creditors.  This won’t apply, however, if the owner of the insurance policy is a corporation.

It should be noted that it is the owner of the policy, not the beneficiary who receives the creditor protection. Once a beneficiary receives the insurance proceeds, those funds are not protected by claims from the beneficiary’s creditors.  

If the beneficiary designation is done before the owner of the policy becomes insolvent or the creditors commence action the policy is protected. The creditors of the policyowner cannot make a claim against the policy proceeds.

One exception to this could be an action brought by a dependent for whom adequate provisions were not made.

Creditor Protection While the Insured is Living

Many life insurance policies have an accumulating cash value or investment account attached to them.   These could include annuities and segregated funds which are primarily investment vehicles.  

So how does creditor protection during the insured’s or owner’s lifetime work?  

Creditor proofing will exist if the type of beneficiary named in the policy is one of the following:

1. An Irrevocable Beneficiary – while the beneficiary is alive, the owner of the policy cannot change beneficiary or make any material changes to the policy without the Irrevocable Beneficiary’s consent.

2. A beneficiary named from the preferred class – when a beneficiary is a spouse, child, grandchild or parent, the life insurance contract (including segregated funds) is “exempt from execution or seizure”.

When does a policy not have creditor protection?

There is no creditor protection if the owner is the beneficiary of a policy. For example, if a husband owns a policy on his wife of which he is beneficiary, the cash value of that policy may not be protected from creditors.

If creditor proofing of the cash value of a policy is important, it is best not to have the owner also be the beneficiary.

Contingent Beneficiaries

When naming a beneficiary, it is recommended that a contingent beneficiary or beneficiaries be named.  This will avoid having any future proceeds payable to the estate and exposed to creditor claims should the current beneficiary die.

Cautions and Concerns

Generally, if a life insurance policy was purchased for specific needs, and not in an attempt to avoid creditors, the creditor proof nature of life insurance is strongly protected by law.

However, several recent court cases and legal actions appear to have eroded some of the protection previously afforded in this area.  These actions include;

• claims of dependents

• collection efforts of the Canada Revenue Agency

• property claims resulting from marriage breakdown  

The good news is, for the most part, creditor proofing still works the way it was intended.  With proper planning and advice, life insurance and segregated fund contracts can provide a shield from creditors and potential litigants, giving peace of mind and financial protection to you and your family.