As shown in some of our previous case comments, life insurance is commonly an issue in the estate administration and litigation process. Because death benefit payouts from life insurance can be substantial, careful consideration as to who is named as beneficiary(ies) of life insurance proceeds is warranted.
This article explains the basics of life insurance and how it works within estate planning and administration processes.
Basics of life insurance
A life insurance policy is a contract between the policy holder and their insurance company. By analyzing the health, routines, habits, and other factors of the life insured (who can be the policy holder, or another person), the insurance company provides, in exchange for a monthly premium paid by the policyholder, a predefined sum of money - commonly known as the death benefit - to the policy’s designated beneficiary(ies) when the insured individual passes away.
Policies can be on a term or permanent basis. Term life insurance means that this contract lasts for a specific period—usually 10, 20, or 30 years. For named beneficiary(ies) to receive the death benefit, the insured must die during the specified term. Permanent life insurance, on the other hand, guarantees a payout regardless of when the insured passes away. The basic features of permanent policies include: level premiums; cash values that can be used to boost the death benefit, pay premiums, supplement retirement income, or take out a policy loan; participating policy dividends which share in the financial experience of the insurance company and receive annual dividends; and non-forfeiture options, which allow the policyholder to keep the policy in force or take a cash settlement if they miss or decide to discontinue paying premiums on the policy.
Another feature of life insurance policies is revocability. A beneficiary can either be revocable or irrevocable. Revocable beneficiaries can be changed at any time without informing the beneficiary. In contrast, you need an irrevocable beneficiary's written permission to make beneficiary changes.
An insurance contract is entirely separate from the insured’s Will. Life insurance carriers only understand that it needs to pay Beneficiary A an amount of X when the insured dies, so the statements or intentions of the insured’s Will are irrelevant to the contract between the policyholder and the insurer. If the policyholder and the life insured are the same person - as is often the case - he or she would be best advised to change the beneficiary of their life insurance policy by contacting the life insurance company directly.
Importance of life insurance in estate administration
Life insurance is a significant component of a comprehensive and wealth transfer optimizing estate plan. It provides money to beneficiaries directly without the bureaucracy or probate fees related to the estate administration process. Life insurance's ability to skip the probate process can save the estate - and in turn, beneficiaries with financial interests in the estate - thousands of dollars in probate fees. Usually, death benefits are also free of income tax, so the amount won't be added to a beneficiary's annual income.
When the insured passees away, their estate trustee must balance payouts to beneficiaries with debts to creditors. However, because a life insurance policy with a designated beneficiary avoids the estate in general, the payout can also avoid the estate's creditors.
Generally, life insurance payouts will pass through an estate (and thus become subject to probate taxes and creditors) in three situations:
- The estate is named as the beneficiary;
- No one is named as a beneficiary to the insurance policy; or,
- The designated beneficiary is no longer alive at the time of the insured’s death.
There are other instances where you may see a death benefit pass through the estate administration process. Often, this is the subject of complex estate litigation.
To avoid defaulting the death benefit payout to the estate, it's vital to set an alternate or contingent beneficiary who can receive the death benefit if the original beneficiary is no longer alive.
Important scenarios relating to life insurance and estate administration
Life insurance, separation, and divorce
It's common for policies to name the insured’s spouse as the life insurance beneficiary. But upon separation or divorce, things may get complicated, especially if the separation is hostile and thes spouse is named as an irrevocable beneficiary. However, some may choose to keep their ex-partner as the beneficiary to fulfill their children's needs if they're no longer alive.
Status as an irrevocable beneficiary may be part of a separation agreement. A partner may want to continue as an irrevocable beneficiary because the other partner's death would mean a loss of spousal and/or child support payments. Additionally, a former spouse's irrevocable beneficiary status may be leveraged to receive more out of the separation agreement.
This is only one of the many contentious issues at the intersection of estate and family law.
Children as the beneficiary
Another common practice is to name minor children as the alternative/contingent beneficiary of a life insurance policy. But in some provinces such as Ontario, children under 18 cannot control money left to them via an insurance policy. As a result, the policyholder needs to name a trustee that can manage the capital on the minors’ behalf until they reach the age of majority. If the policyholder doesn't name a trustee, the benefit and any accrued interest are held by the province and paid to the child upon reaching 18.
Collecting the death benefit during an estate administration
It is best to advise the beneficiary - or executor (if the estate is named as beneficiary) - to contact the life insurance company as soon as possible after the insured’s death. The claims representative will let them know which documents are needed to review the claim. In order to expedite the claim payout, required documents - which most often include a certified copy of the death certificate and other supporting documents - must be produced quickly.
Every life insurance policy has a provision outlining a procedure for submitting a claim. It usually describes how long a beneficiary has to file a claim for benefits and how it must be filed. It specifies such details as the deadline for submitting a new life insurance claim, notice of claim, and proof of loss. Life insurance payouts can often be collected within 30 to 60 days after completed claim forms and the supporting documents have been submitted.
However, insurers are notorious for finding reasons to unreasonably delay and even deny a valid life insurance claim. A claim delay often happens when an insurer cannot get a copy of the original death certificate from the beneficiary or if they do not receive all the documents they require. Other reasons for claim delays include: the two-year contestability clause, which may arise if the policyholder dies within the first two years of the policy issue date and there is a question as to whether the insured made any material misrepresentations in application documents; if death occurred due to suicide, in which case the insurer may refuse to pay the claim altogether; or if the death was the result of a homicide, in which case the insurance company will require a detective to provide a statement about the circumstances surrounding the insured’s death to make sure the beneficiary is not a suspect.
As the proceeds of life insurance often represent significant sums of money and can provide much needed liquidity to pay expenses shortly after the death of the insured, it is important that the appropriate beneficiary be designated with the provider before death. Should delays in payouts occur, it is best practice to advise your client to consult with a lawyer specializing in the field of life insurance law.