The Fifth Circuit has held that proceeds from a surrendered whole-life policy are not exempt under Texas law. Trautman vs. Milligan, No. 06-50363 (5th Cir. 8/8/07). The Trautman decision relied on both interpretation of the Texas Insurance Code and policy considerations.
In Trautman, the Debtor owned an insurance policy in which he was the insured and his wife was the beneficiary. Prior to bankruptcy, he surrendered the policy and received a check for the cash value. He claimed the un-cashed check as exempt property. The Bankruptcy Court allowed the exemption, but both the District Court and the Fifth Circuit held that the property was not exempt.
The exemption turned upon statutory language which provided that “the cash value and proceeds of an insurance policy, to be provided to an insured or beneficiary” under an insurance policy issued by a life, health or accident insurance company were exempt. Texas Insurance Code Sec. 1108.051.
The Court of Appeals noted the difference between three parties to an insurance contract: the owner, the insured and the beneficiary. In this case, the husband was both the owner of the policy and the insured, while the wife was the beneficiary. The Insurance Code protects “cash value” and “proceeds” payable to an “insured” or a “beneficiary.” At first blush, there appears to be a reasonable argument for the exemption. After all, the undisputed facts were that the policy was surrendered and that the cash value was paid to the husband, who was both owner and insured. However, the Court found that the funds were paid to the husband, not as insured, but as owner. Since amounts paid to owners are not listed as exempt, the argument failed.
The Court of Appeals also noted that cash values had not always been protected from creditors. The Court surmised that the legislature allowed exemption of cash values in order to prevent creditors from seizing the value of the policy and thwarting the interest of the beneficiary. However, the Court did not feel that allowing the debtor to use a whole-life policy as a savings account free from the claims of creditors was a worthy goal. Indeed, the court noted that under the debtor’s proposed interpretation, a person could transfer funds into an insurance policy and then immediately surrender the policy and shelter the proceeds from creditors. The Court succinctly remarked that “That can’t be the law.”
This case points out an important bankruptcy planning consideration. Cash value contained within an existing insurance policy is protected by statute, while cash value in a surrendered policy is not. As a result, a financially distressed debtor will be better off waiting until after bankruptcy (and after the period for objecting to exemptions has passed) before accessing the cash value of a policy. Additionally, a debtor who needs temporary access to policy cash values will be better served by borrowing against the policy rather than surrendering it.
While the Court of Appeals was concerned about debtors fraudulently transferring their cash into an insurance policy, this possibility is addressed by the statute itself. Under Texas Insurance Code Sec. 1108.053(1), the exemption does not apply to “a premium payment made in fraud of a creditor, subject to the applicable statute of limitations for recovering the payment.”