All states have seen fit to enact legislation providing special protection to life insurance against the claims of creditors. This legislation has a long history, the oldest law going back to 1840. The laws are a manifestation of a long-standing public policy that sets a higher priority on people�s obligations to their spouses and children than on their obligations to their creditors. Today, these laws are based on the public policy that creditors should not be permitted to make someone destitute and a potential ward of the state. Since the creditor has the right to select his or her debtor, these state exemption laws caution a creditor to be careful in extending credit. They reflect a philosophy that has led to laws exempting workers� compensation awards, veterans� benefits, and other similar payments from attachment by creditors.

The state exemption statutes are diverse in nature. The broadest among them exempt all types of life insurance benefits from attachment by all types of creditors. At the other extreme are laws exempting modest amounts of policy proceeds payable to the insured�s surviving spouse and children from claims of the insured�s creditors. Some of the laws apply to all types of life insurance, while others protect only a particular form, such as group insurance, pensions, disability income, annuity income, or fraternal insurance. Some protect only insurance taken out by a married woman on the life of her husband. There are statutes that protect the insurance against the creditors of the insured only, creditors of the beneficiary only, or any unsecured creditors other than the federal government. Finally, some laws protect only policy proceeds, while others protect all types of benefits, especially cash values. To make matters more confusing, some states have more than one type of statute.

Whether the policyowner�s creditors can obtain insurance policy funds depends on whether the creditor is trying to claim the death proceeds or the policy�s cash value. In some circumstances, the result depends on the identity of the policyowner, the beneficiary, or the creditor.

The identity of the creditor changes the creditor�s rights. The federal government can reach a policy�s cash values via a tax lien, whereas a private citizen creditor cannot. The identity of the beneficiary is also important. As an example, see the New York exemption statute, which provides in part as follows:

Under this statute the policy�s proceeds are not exempt from creditors� claims if the beneficiary is the insured, but they are exempt if a third person is the beneficiary.

The New York statute also provides special protection for certain policyowners as follows:

A comparison of the New York and Oklahoma statutes points out that some statutes provide more protection for the policy values than others. The Oklahoma exemption statute protects the insurance policy proceeds from creditors. The New York statute extends the protection to the proceeds and avails of the policy, and it defines that term to include the death benefit, cash surrender and loan values, premiums waived, and dividends.

At first blush, it seems impossible to classify such a hodgepodge of legislation. Closer inspection, however, reveals patterns that can serve as the basis for classification. The most apparent breakdown is between statutes of general applicability and those that apply to specialized forms of life insurance, such as group insurance, annuities, and so forth. The general statutes may, in turn, be classified into six groups.

The first group embraces those statutes that pertain only to policies taken out by or for the benefit of married women on the lives of their husbands. Appropriately known as married women�s statutes, these were the earliest laws of this type enacted. The early laws protected only a small amount of insurance per married woman, but the amount of insurance exempted under the modern statute is unlimited. As a rule, the protection is effective only against creditors of the insured.

In time, the married women�s type of statute was followed by the so-called distribution type of statute. These laws provide, in essence, that proceeds payable to the insured�s estate will pass to his or her spouse and children free of the claims against the estate. It would be assumed that the very language of these statutes would rule out any protection during the insured�s lifetime, but in Tennessee, by a court decision, and in Florida, by statute, cash values were also protected. These laws have seldom protected the policy against claims of the beneficiary�s creditors, however.

A somewhat later type of statute can be called the procedural type. The common characteristic of these laws is that they were enacted not as a part of the insurance law but as one of the general exemptions from execution that are frequently found in civil practice or procedure codes. Since they were general exemption statutes, they usually provided immunity from all types of creditors, including those of the beneficiary. The amount of insurance exempted is usually quite limited, and the cash values are typically not protected. This is perhaps the most heterogeneous group of statutes dealing with the protection of insurance from creditors� claims.

The type of statute that has wielded the greatest influence was first enacted in the state of New York in 1927. It has served as a model for the statutes of 15 other states and has affected the course of legislation in many other jurisdictions. A majority of states now have statutes similar to New York�s. Hence it can be described as the typical state exemption statute. Unless the context suggests otherwise, the use hereafter of the term New York statute refers to that statute as a generic type, rather than to the specific law of New York state.

The New York statute applies to all policies of life insurance payable to a person or organization other than the insured or the person applying for insurance if he or she is not also the insured. It protects both the cash value and the proceeds against the creditors of the insured and the person procuring the insurance. The protection is available whether the beneficiary designation is revocable or irrevocable, and a reversionary interest in the insured is expressly declared to be immaterial.

The New York statute does not protect anyone against claims of the beneficiary�s creditors. However, there are statutes that provide an exemption for proceeds even after they have been distributed to the beneficiary. These statutes bar the creditors of the insured as well as the beneficiary. Normally this protection would not be available to policy values after receipt; thus dividends payable in cash would usually be subject to seizure.

The broadest protection is available under the so-called comprehensive statutes. This type of statute exempts, without limitation, all types of benefits associated with life insurance from the claims of the creditors of the insured, beneficiary, third-party owner, or any other person or organization.

Finally, there are the laws, called spendthrift statutes and found in most states, that are concerned solely with the protection of proceeds held under a settlement agreement against the claims of creditors of the beneficiary. The statutes are designed to protect the proceeds only while they are in the hands of the insurer and not after they have been received by the beneficiary. Unlike the other exemption statutes, these laws do not provide automatic protection; they are, instead, permissive in nature. They permit the insurance company and the insured to agree that the proceeds will not be subject to encumbrance, assignment, or alienation by the beneficiary, or to attachment by the beneficiary�s creditors. Such an agreement must be embodied in either the policy or the settlement agreement, and the beneficiary must not be a party to it.

The minimum objective of state exemption statutes is to provide protection against the claims of the insured�s creditors for all or a portion of the proceeds payable to the insured�s spouse and children upon the policy�s maturity. The maximum objective, typified by the comprehensive statutes, is to provide unlimited protection against creditors of every description to all types of insurance benefits payable to anyone. An intermediate goal, representing the public policy of most jurisdictions, is to protect�both during the lifetime of the insured and upon his or her death�the benefits of an insurance policy payable to anyone other than the insured�s estate from the insured�s creditors. This objective involves protecting the cash value of the policy; otherwise, the policy may be destroyed by creditors� seizure before it has had an opportunity of serving its basic function�namely, the support of the insured�s spouse and children after the insured�s death.

Many of the early statutes spoke only of proceeds. Some courts adopted a narrow construction of the term, but most gave it a broad enough interpretation to include cash values. To indicate that prematurity values are to be protected, many statutes use the language "proceeds and avails." A few actually use the words "cash value." The result is that practically all statutes, other than the distributive and procedural types, exempt�by specific language or court interpretation�both the cash value and the maturity value.

The word "proceeds" has had to undergo interpretation in another direction. Does it include paid-up additions, accumulated dividends, and prepaid or discounted premiums, or are proceeds limited to the original face amount? The usual interpretation is that proceeds include all amounts payable upon maturity of the policy.

Exemption of the cash value is of singular importance in connection with the Federal Bankruptcy Reform Act of 1978. If a state does not opt out, the act recognizes all exemptions from creditors� claims granted under the law of the state in which the bankrupt resides. Thus to the extent that a state law exempts cash values, the trustee in bankruptcy cannot take title to the life insurance policies of a bankrupt policyowner. The revocability of the beneficiary designation does not affect the exemption. The bankrupt enjoys more protection under the typical state exemption statute than under case law.

As a matter of fact, the treatment of bankrupts under these laws has been the subject of severe criticism by creditor interests. These critics argue that all too often a person in financial difficulty places a substantial amount of assets in life insurance payable to his or her spouse and children, and then�after going through bankruptcy�uses the insurance to reestablish a business. Since most states permit a person who has become insolvent to maintain existing insurance or even acquire new insurance for the protection of his or her family without being in fraud of creditors, there is little that creditors can do to prevent abuse of an otherwise desirable relief provision. Admittedly, the law usually restricts the insurance that an insolvent debtor can acquire or maintain to a "reasonable" amount, but the courts tend to construe the limitation liberally.

The federal tax authorities, on the other hand, have not let state exemption statutes stand in the way of their collection of tax liens. This is true even under the broadest statutes. The government can obtain a policy�s cash value through either forced surrender during the insured�s lifetime or collection from the proceeds after death, provided a lien had been placed against the cash value before the taxpayer�s death.

Among the general state exemption statutes, only those of the married women�s and comprehensive types protect benefits payable to the insured or the third-party procurer of the insurance. Thus disability income and annuity payments are usually not exempt from attachment by creditors. In some states, however, these benefits are protected by special statutes.

Note that the intent of the exemption statutes is to protect third parties�not necessarily the policyowners�from the policyowner�s creditors. Broadly speaking, state exemption statutes protect all third-party beneficiaries against the claims of the insured�s creditors. The New York statute and those patterned after it also protect assignees and third-party owners. The comprehensive statutes protect all the above plus the insured. On the restrictive side, the married women�s and distributive statutes protect only the insured�s widow(er) and children. The clear trend therefore is toward increasing the number of parties who are given preference over the policyowner�s creditors. A few statutes now permit exemption from the policyowner�s creditors if the policy is paid to the insured�s estate. Such statutes, however, are distinctly in the minority.

Consistent with the goal to subordinate the policyowner�s creditors to those of third-party beneficiaries but not to the policyowner, the state exemption statutes do not protect the persons procuring the insurance from their own creditors. Thus with the exception of the comprehensive statutes, policyowners enjoy no protection under the exemption statutes against their own creditors. A policyowner cannot be compelled by his or her creditors to surrender a policy for cash and thus impair the rights of third parties, but if he or she voluntarily does so, the funds can be attached by creditors. Note that the cash value and death proceeds of an endowment policy are exempt in many jurisdictions, despite the fact that the insured is the beneficiary of the endowment proceeds. In a few states, proceeds of an endowment payable to the insured in the form of income are exempt up to the limits of monthly income stated in the law.

As a rule, the statutes of broad application contain no limitations on the amount of insurance that will be protected thereunder. Several of the statutes, however, contain definite limitations, expressed in terms of either the face amount, a stated cash value, or the amount of annual premiums. For example, some states limit the exemption from creditors to $5,000 or $10,000 in proceeds payable only to a surviving spouse or minor child. The exemption in a few states is available against all creditors�the beneficiary�s as well as the insured�s. Several states exempt only such amounts of insurance as can be purchased with a maximum annual premium, such as $500, without specifying the plan of insurance. Some states exempt policy cash values only to certain limited amounts. When protection is afforded to disability and annuity payments, a limit such as $400 per month may be placed on the exempted amount of income.

State exemption statutes as a class are concerned only with creditors of the insured. A sizable number of statutes also provide protection against the claims of creditors of the beneficiary. This is true of the comprehensive statutes, which tend to exempt all types of insurance benefits from all types of creditors. The procedural statutes, likewise, usually make no distinction between creditors of the insured and those of the beneficiary, but the exemption is typically available only for the amount of insurance that can be obtained with a specified premium, such as $500. The law in many states exempts the proceeds and avails of a policy purchased by a person on the life of his or her spouse against the claims of the purchaser�s creditors. Several other states provide a limited amount of protection against the claims of a wife�s creditors in connection with policies on her husband�s life purchased by the wife with her own funds.

The most prevalent and significant form of statutory protection of insurance proceeds against the creditors of the beneficiary, however, is represented by those statutes that authorize the inclusion of spendthrift clauses in life insurance policies. This type of provision originated with personal trusts and had the dual purpose of protecting the trust income from the creditors of the trust beneficiary and preventing the beneficiary from alienating or disposing of his or her interest in the trust. The validity of such a restrictive provision was widely debated in this country during the latter half of the nineteenth century, but it was ultimately held to be valid in most jurisdictions, either by statute or by judicial decision.

Once the validity of a spendthrift clause in a trust agreement was well established, it was a logical development to introduce it into life insurance settlement agreements. At first its validity in this setting was very much in doubt, however, since life insurance companies did not segregate assets, accept discretionary powers, or otherwise conform to the trust pattern in the administration of proceeds under a deferred-settlement agreement. Now more than half of the states have enacted statutes stating that a spendthrift clause will be enforced if it is contained in either the life insurance policy or the settlement agreement, and the use of spendthrift clauses has become widespread. The following are two examples of spendthrift clauses: