The Issue
There are generally accepted principles around bankrupts and life insurance policies that bankruptcy trustees are familiar with, including that:
- The proceeds of life insurance policies in respect to the life of the bankrupt, or the spouse/de facto partner of the bankrupt, are not available to creditors of the deceased bankrupt.
- The proceeds of life insurance policies are not available to creditors of the bankrupt spouse of the deceased.
However, there are exceptional circumstances.
An issue with one of our recent bankrupt estates identified circumstances where the proceeds of life insurance policies may ultimately vest in a bankruptcy trustee. This action depends on who is named as the beneficiary under the life insurance policy.
The Facts
- In 2012, Mr Smith[1] obtained a life insurance policy.
- In the life insurance policy, Mr Smith named “the legal personal representative, the estate of the insured” as the beneficiary under the policy. In other words, the beneficiary of the life insurance policy would inevitably be the executor of his will. If he died without a will, the beneficiary would be the person who applied and obtained legal letters of administration of his deceased estate.
- In 2015, Mr Smith made a will. He named his wife, Mrs Smith, as the sole person entitled to the residue of the estate.
- Mr and Mrs Smith had a failed business venture and significant creditors.
- Mrs Smith was made bankrupt and Innis Cull and Gess Rambaldi were appointed as her Trustees.
- Mr Smith subsequently died and a creditor applied for the same trustee(s) to be appointed as Trustees of his bankrupt deceased estate, with a specific request that we consider whether there was a claim to the life insurance policy proceeds.
The Questions
Question 1: Were the proceeds of the life insurance policy available to the creditors of the bankrupt deceased estate of Mr Smith?
Answer: No
Question 2: Were the proceeds of the life insurance policy available to the creditors of the bankrupt estate of Mrs Smith?
Answer: Likely to be yes.
The Legal Framework
Life Insurance Act 1995
Section 205 of the Life Insurance Act 1995 provides that where money becomes payable pursuant to a life insurance policy upon a person’s death, the money is not available to pay the person’s debts.
There are three exceptions to this rule:
- The deceased had entered into a contract that provided expressly for the money to be applied to the debt.
- The deceased had charged the money with payment of the debt.
- The deceased gave an express direction in their will that the money be applied to the debt.
None of these exceptions applied to Mr Smith. Accordingly, none of Mr Smith’s creditors could access the proceeds of the life insurance policy.
Does this change because his deceased estate was made bankrupt?
Bankruptcy Act 1966
Part XI of the Bankruptcy Act 1966 (BA) deals with the administration of deceased bankrupt estates.
Section 249 of the BA provides for the vesting of property in a deceased bankrupt estate. It mirrors the general vesting of property provisions in bankruptcy (s 116) and provides that the proceeds of a policy of life assurance are not divisible property in the bankrupt estate.
Accordingly, as trustee of Mr Smith’s bankrupt deceased estate, the trustee(s) had no claim to the proceeds of the life insurance.
Question 1 must be answered ‘no’.
The Bankrupt Estate of Mrs Smith
Section 116 of the BA provides that all property belonging to the bankrupt is divisible amongst their creditors.
Section 116 (2)(d) excludes:
- policies of life assurance…in respect of the life of the bankrupt or the spouse or de facto partner of the bankrupt
- the proceeds of such policies received on or after the date of the bankruptcy (emphasis added)
Does the exclusion apply to the facts of this case?
Contrasting Circumstances
To answer this question, it is useful to understand the circumstances where life insurance would clearly be not available.
- When Mr Smith took out the life insurance policy, it may have been structured slightly differently.
- Instead of nominating the beneficiary of the policy as ‘the legal personal representative, estate of the insured, he could have specifically named the beneficiary as ‘my wife, Mrs Smith’.
Had he done so, the life insurance company would have paid the ‘proceeds of the policy’ directly to Mrs Smith. Regardless of her bankruptcy, s 116(2)(d)(ii) would obviously apply to exclude the proceeds of the policy from vesting in her bankrupt estate.
The key question we faced was whether the character of the life insurance proceeds changes by being paid firstly to the executor of Mr Smith’s deceased estate, and then disbursed to Mrs Smith in her capacity as a beneficiary, as a residual payment under his will.
Legal Principles
We could not identify any case where this specific issue has been previously decided.
The decision in Cunningham (Trustee) v Gapes [2017] FCA 787 (Gapes) examined the question of whether the proceeds of a superannuation policy of a deceased, paid through an executor to the beneficiaries of the will, would be available to a trustee of one of the bankrupt beneficiaries. Superannuation is protected in bankruptcy in a similar way to life insurance proceeds.
The Court in Gapes indicated that the funds did not retain the character of fund payments after it became part of the deceased estate and there was a distribution
from the estate to the bankrupt in his capacity as a beneficiary of the estate. The Court drew a distinction between tracing remedies, where the character of the fund remains identifiable, and the position where the fund becomes part of the residue of funds in the deceased estate to then be distributed to beneficiaries under the will.
Accordingly, the protection afforded to superannuation was lost when it emerged as a distribution by an executor under a will.
Application to Life Insurance
The facts in Gapes were nearly identical to the facts faced in Mrs Smith’s bankruptcy, save that we were dealing with life insurance and not superannuation.
We determined that the manner in which Mr Smith had structured the life insurance policy meant that the proceeds of the policy would lose their character as ‘protected monies’, when the proceeds were paid by the executor of the deceased estate as a payment of a residual entitlement to Mrs Smith, under the will of Mr Smith.
The Resolution
When he took out the life insurance policy, it is almost certain that Mr Smith did not contemplate that his wife might be bankrupt when he died. Had this issue been brought to his attention, we expect that he would have structured the life insurance policy differently to specifically name Mrs Smith as the sole beneficiary of the policy.
Had we pursued a claim through the courts, we are confident that the entirety of the life insurance policy proceeds would have been a vested asset of Mrs Smith’s bankrupt estate. Such an outcome seems unfair, particularly for Mrs Smith’s family and children.
Thankfully, creditors agreed that an all or nothing situation was not the right outcome and authorised the trustees to agree to a fair compromise for the division of the policy proceeds with Mrs Smith, without the need for the issue to be decided by the courts.
Key Take-outs
Given the broad protections afforded to life insurance, the natural inclination for trustees when life insurance is identified in an estate is to assume that it will not be available to creditors and that there is no point in further investigation. Given the experience in this estate, we recommend that preliminary investigations are appropriate.
Where a bankrupt is entitled to a life insurance payment, it is essential to identify how the entitlement to the payment arises. A payment directly from the life insurer to a named (but bankrupt) beneficiary will not be available to creditors.
If the payment occurs by way of an entitlement from the estate of the deceased, this may well be a payment available to the bankrupt estate. In all circumstances, the wording of the life insurance policy must be reviewed.
This article was co-authored with Innis Cull. Innis is a partner at Pitcher Partners, a bankruptcy trustee, registered liquidator and lawyer. It has also been published in the Australian Restructuring Insolvency and Turnaround Association Journal Volume 34 #04.
[1]
Names have been changed to protect identities.