The topic of nonstatutory protection can itself be broken down into various subtopics, but the most important distinction is between creditors of the insured and creditors of the beneficiary.

Creditors of the insured may seek to satisfy their claims out of the cash value of a policy still in force or out of the proceeds of a matured policy. The legal principles involved in these two types of action are so different that they must be dealt with separately.

If the policy is payable to the insured or to a revocable third-party beneficiary, the insured is the owner of the policy and is entitled to the cash value upon surrender of the policy. The cash value is an asset of the insured and is reflected as such in his or her financial statements. It would seem therefore that in the absence of special statutory rules, the cash value of such an insurance policy would be available to the creditors of the insured on the same basis as any other personal property. Such is not the case, however.

In theory, the insured�s creditor is entitled to the cash value of a policy owned by the insured; in practice, the creditor is generally unable to enforce his or her rights because of procedural difficulties. The normal collection processes are not effective against the cash value since the insurance company is under no obligation to pay the money to anyone until the insured exercises his or her privilege of surrendering the policy. Moreover, the courts are loath to force the insured to exercise the right to surrender. Direct action against the company, in the form of a garnishment or distraint proceeding, has uniformly been unsuccessful, while attempts by judgment creditors to force the insured to surrender the policy have been successful in only a few jurisdictions.

If the creditor has no contractual rights in the policy, he or she may seek to satisfy the debt by securing a judgment against the policyowner. The creditor may try to execute the judgment by seizing the debtor�s property�including the insurance policy. The creditor might seek to obtain the cash value of an unmatured policy or the policy proceeds if the insured-debtor has died.

Bankruptcy Reform Act of 1978. Federal law and the laws of all 50 states permit creditors to protect themselves from defaulting debtors in this fashion. However, the states, as well as the federal government, create special protection from creditors for certain kinds of property. The applicable federal law is the Bankruptcy Reform Act of 1978. That law, like the state laws, exempts certain categories of property from creditors� claims. One category of property uniformly protected under these exemption laws is life insurance. This, like the tax advantages given to life insurance under the Internal Revenue Code, adds to the value of life insurance as the foundation of an individual�s financial plan.

Under federal bankruptcy law, an individual filing bankruptcy may elect either the exemptions provided under the federal statute or those provided by the applicable state law. However, the federal Bankruptcy Reform Act of 1978 also permits states to "opt out" of the reach of the federal law. If a state passes such an opt-out statute, then its citizens are deprived of the federal alternative and may protect property from creditors only under that state�s exemption statute. More than 75 percent of the states have enacted legislation to opt out of the federal bankruptcy system. The situation is different when the insured is bankrupt and a trustee in bankruptcy has been appointed. The federal Bankruptcy Reform Act of 1978 provides that the trustee of the bankrupt�s estate will be vested with the bankrupt�s title, as of the date the petition in bankruptcy was filed, to all property that the bankrupt could have transferred by any means prior to filing the petition or that might have been levied upon and sold under any judicial process. Since a life insurance policy payable to the insured or to a revocable third-party beneficiary could have been transferred, title to it passes to the trustee in bankruptcy. The trustee, as owner of the policy, can then surrender it for its cash value. Policies without a cash value do not pass to the trustee in bankruptcy.

Note, however, that the interest of the trustee in bankruptcy is limited to the cash value of the insurance on the date the petition in bankruptcy was filed. Thus if the insured dies prior to adjudication of the bankruptcy and before the policy is surrendered, the excess of the proceeds over the cash value must be paid to the designated beneficiary, if any, or otherwise to the insured�s estate. Under the federal law prior to the 1978 act, if the insured, within 30 days after the insurance company certified the amount of the cash value to the trustee, paid the trustee the sum of money so certified, the insured was entitled to recover his or her policy free from the claims of the creditors participating in the bankruptcy proceeding. (Funds borrowed for this purpose could have been repaid almost in full from the proceeds of a policy loan.) This provision was to prevent the hardship to the bankrupt�s family if all his or her life insurance policies were to pass absolutely to the trustee in bankruptcy. Unfortunately, this provision, known as the insurance proviso, was not included in the Bankruptcy Reform Act of 1978.

Federal Tax Lien Act of 1966. There are special rules for federal tax liens against a person�s property. Under the Federal Tax Lien Act of 1966, the government�s lien overrides state exemption laws. The federal government may require the insurance company to withdraw the policyowner�s policy loan values up to the amount of the tax and pay that amount to the government within 90 days after notice.

The government�s right to the policy loan values extends to the policy proceeds if the federal tax lien was attached prior to the insured�s death. In this case, the beneficiary will be paid only if the policy proceeds exceed the amount of the government�s lien. However, if the insured dies prior to the attempted attachment of the federal tax lien, the state exemption laws apply and the proceeds will be protected to the extent of the state law.

When proceeds are payable to the insured or the insured�s estate, they become available to estate creditors on the same basis as any other unrestricted assets in the estate. When they are payable to a third-party beneficiary, however, they vest in the beneficiary immediately at the insured�s death, whether the beneficiary designation was revocable or irrevocable. In this case, the proceeds are free from the claims of the policyowner�s creditors.

The cash value of a life insurance policy cannot be levied upon by a creditor of a third-party beneficiary, whether the designation is revocable or irrevocable. When the designation is revocable, the policyowner (whether or not he or she is also the insured) is the sole and absolute owner of the policy. When the designation is irrevocable, the policyowner has rights that cannot be defeated by a creditor of another person regardless of his or her status as beneficiary. Once the policy has matured, however, the proceeds are the property of the beneficiary and can be freely levied upon by his or her creditors.