Creditor Protection and Life Insurance

Creditor Protection and Life Insurance Introduction As a general rule, all assets of an individual or entity are security for unpaid debts owing to a creditor. This applies whether or not the individual or entity is bankrupt. An attractive feature of life insurance policies is that they may be able to provide protection from the owner s creditors if the proper beneficiary designations are made, and are made well prior to any insolvency on the part of the owner, or collection action by the creditors. This Tax Topic will summarize the nature of creditor protection of life insurance policies (including registered and non-registered annuities). It should be read along with the Limitations on Creditor Protection and Life Insurance" Tax Topic. An Appendix including relevant definitions and a Table of Concordance with respect to the relevant statutory provisions are appended to this Tax Topic. Creditor Protection under Provincial Insurance Legislation Traditionally, life insurance policies have been given special protection against the claims of creditors under provincial insurance legislation. The legislation, which is generally consistent across Canada, is intended to protect the rights of the beneficiaries under the contract. Creditor Protection while the Life Insured is alive Creditor protection during the life of the individual whose life is insured can be achieved in two ways: by the owner making an irrevocable beneficiary designation in a life insurance contract or by designating as beneficiaries certain family members specified in provincial insurance legislation. In all provinces except Quebec, the relationship must be between the life insured and the beneficiary. In Quebec, it is between the owner and the beneficiary. Where a beneficiary is designated irrevocably, the owner, while that beneficiary is living, may not alter or revoke the designation without the consent of the beneficiary. The insurance money is not subject to the control of the owner or of the owner s creditors and does not form part of the owner s estate for instance see the Ontario Insurance Act. Citations of other provincial insurance acts and the relevant sections of these acts can be found in the Table of Concordance in Appendix A. Where certain family members are designated as beneficiary, the legislation prevents creditors of the owner from seizing and surrendering the contract during the lifetime of the individual whose life is insured. In most common law provinces, the family member must be a spouse, child, grandchild or parent of the life insured in order for the policy to provide creditor protection (Ontario Insurance Act, s. 196(2)). In Quebec, the class is wider and includes all ascendants and descendants of the owner (Quebec Civil Code, Art. 2457). The definition of spouse may include common law spouses or same-sex spouses, depending upon provincial legislation. In Quebec, only married and civil union spouses can benefit from creditor protection. Common law partners have to be designated irrevocably to get the same benefit. 1

Where the beneficiary is a member of the designated class, the contract is exempt from seizure, even where the appointment of the beneficiary is revocable. In the case of the appointment of a revocable beneficiary other than one in the designated class, the policy does not qualify for creditor protection under provincial insurance law during the lifetime of the insured. Where the owner or the owner s estate is designated, there would be no creditor protection available during the lifetime of the life insured because under the Ontario Insurance Act, s. 171 the definition of beneficiary excludes the owner or the owner s personal representative. Following that logic, where an owner and a life insured are different people, there is an argument that the owner may inadvertently lose creditor protection if he or she designates themselves as beneficiary. This would occur for instance in the scenario where the wife owns the policy on the husband and designates herself as beneficiary. This would be considered a designation in favour of the life insured (owner). If this is the case, there would be no creditor protection on the death of the life insured (owner) from the creditors of the owner of the contract because there would be no beneficiary as defined or designated under in s. 196(1) of the Ontario Insurance Act. The key is in the wording of this section as it relates to insured and policy owner. Whether the above scenario under s. 196(2) of the Ontario Insurance Act, would allow for creditor protection during the life of the insured however is debatable and insurers interpretation of the Act may differ on this point. Under this section, if the wife makes a designation in favour of herself, then arguably a spouse of the life insured has been designated. In the decision in Tennant v. Tennant (2002) 34 R. F.L (5 th ) 167, the court considered subsection 196(1) and (2) of the Ontario Insurance Act. A former spouse was enforcing an order for spousal support against her ex-husband. The husband asserted that the annuity contract was protected because his former spouse was a beneficiary under both contracts. In this instance the former wife was the creditor. The court concluded former spouses are not mentioned as part of the protected class therefore allowing the ex-wife s claim against the income-stream arising from the annuity contracts. However, the outcome of the case may have been different if the parties had not been ex-spouses. While there is no case law directly on point, it is arguable. Creditor protection is not available if the life insurance policy or annuity contract is surrendered by the owner for its cash value. One exception to this rule is annuities purchased with locked-in RRSP funds, which are in themselves derived from registered pension plans. As well, it was previously thought that there was no statutory protection for payments received under a life insurance or annuity contract: while the contract itself may not be subject to seizure and surrender, payments from the policy would be subject to the claims of creditors. However, the Ontario Court of Appeal, Whalley v. Harris Steel (1997) 46 C.C.L.I. (2d) 250, (1997) 17 C.C.P.B. 1 held that such payments are payments of insurance monies and are therefore creditor-protected, even when paid to a life insured or annuitant. Similar reasoning was applied in the Christianson case, (1996) 39 Alta. L.R. (3D) 101 C.A. This trend appears to have reversed the previous thinking on this issue. Life insurance RRSPs and RRIFs The definition of life insurance in all provinces includes annuity contracts. Most RRSPs issued by insurance companies take the form of an undertaking to provide an annuity and as such come under the definition of life insurance in provincial insurance legislation. Note should be taken of the amendments to the Federal Bankruptcy and Insolvency Act, proclaimed in 2008. The amendments provide creditor protection in the bankruptcy context to all RRSPS and RRIFS of any issuer without the need for any particular beneficiary designation with certain limitations (e.g. a 12 month claw back of contributions). It does so without impacting the provincial exemption enjoyed by RRSPs and RRIFs that are life insurance products. This means that if a life insurance RRSP has an appropriate beneficiary designation, it receives creditor protection under provincial insurance law and consequently the provincial exemption in the BIA also applies. Where registered insurance products do not fall under the provincial Insurance Act exemption (i.e. where a family class beneficiary is not named) and the insurance RRSP is not held in a province that has enacted legislation that provides provincial protection to all RRSPs (currently Saskatchewan, PEI, Manitoba, B.C., Alberta, Newfoundland and Ontario by 2

introduction of Bill 70 which has not yet been passed at the time of updating) then protection can now be found under the BIA. This protection is still however subject to the limitations cited above (i.e. the clawback). Annuities in Quebec In Quebec, annuities can be issued by life insurers and trust companies. Case law has considered creditor protection for such annuity products. The Supreme Court of Canada in Scotia Capital Inc. v. Bank of Nova Scotia and Guy Thibault, [2004] 1 S.C.R. 758, concluded that a contract that reserves the investors ownership and control of his or her capital does not reflect the idea that creditor protection is for family members, which is the underlying reason for creditor protection. Shortly after the Supreme Court of Canada decision in Thibault, the Quebec National Assembly responded with amendments to the legislation dealing with annuity contracts sold in the province. Any contracts constituting an annuity in compliance with article 2367 of the Quebec Civil Code will continue to have creditor protection. As of December 6, 2005, the capital of any "contract that was offered as an annuity contract" (before March 1, 2006 and not fully compliant with article 2367) will remain exempt from seizure until the end of the contract, provided certain conditions are met. Planning Points Where creditor protection during life is important, it is advisable to name alternate beneficiaries within the protected class since the exemption from seizure can be lost if the designated beneficiary dies. It may be possible to designate an irrevocable beneficiary to receive a portion of the death benefit proceeds of a policy, and to designate revocable beneficiaries for the remainder. Similarly, part of the death benefit proceeds could be designated for receipt by members of the protected class, and the remainder by others. Although there have been no decided cases on point, one could argue that, in either case, the policy remains creditor-protected. Caution however, should be used with this approach, as it is unknown how a Court would decide the issue. Where both irrevocable and revocable beneficiaries are designated to receive portions of the death benefit proceeds, an issue arises as to whether the policy owner maintains the ability to change the beneficiary designation in respect of the revocable beneficiaries he or she has designated. For instance, sections 191(1) and 197 of the Ontario Insurance Act require the consent of the irrevocably designated beneficiary to alter or revoke the designation. The argument can be made, however, that those provisions were intended to protect the rights of irrevocably named beneficiaries and not to give them a veto power with respect to transactions which do not affect their rights. Thus, it may be argued that if there is one beneficiary designated irrevocably to receive a small percentage of the death benefit proceeds, these provisions would not prevent the policy owner from naming new beneficiaries for the remainder of the death benefit. However, the irrevocably named beneficiary would have to consent to any exercise of ownership rights by the owner which would affect his or her interest (for example, the surrender or partial surrender of the policy, or the absolute transfer or collateral assignment of the policy). To summarize, while the life insured (or annuitant) is alive, there are two sources of creditor protection for the policy under provincial insurance law: a) while a designation in favour of a spouse, child, grandchild or parent of a person whose life is insured is in effect, the rights and interests of the owner in the insurance money and in the contract are exempt from execution or seizure. In Quebec, the relationship is between the owner and the beneficiary in determining whether protection is available. As well, the protected class in Quebec is wider and includes all ascendants and descendants of the owner and only married and civil union spouses can benefit from creditor protection unless a common law partner is made an irrevocable beneficiary. b) where an irrevocable beneficiary designation is made, the owner may not, while the beneficiary is alive, alter or revoke the designation without the consent of the beneficiary and the insurance money is not subject to the control of the owner or of his creditors and does not form part of his estate. In effect, the insured owner surrenders all effective control over the policy, its proceeds and any cash value it may afford. It follows, therefore, that the owner s creditors can have no greater access to or control over the policy than the owner has. 3

Creditor Protection on Death of the Insured Creditors of the policy owner cannot make a claim against the proceeds of a policy which are payable upon the death of the life insured. Where a beneficiary is designated, the insurance money, payable upon the death of the life insured (annuitant), is not part of the estate of the owner and is not subject to the claims of the owner s creditors (for instance, subsection 196(1) Ontario Insurance Act). Until the proceeds actually become payable to the beneficiary, there is no protection for the cash surrender value or any other rights of the owner in the policy (unless a beneficiary is named irrevocably or is in the designated class discussed above). Once the insurance monies become payable, however, protection extends to all designated beneficiaries and not just to a particular group of beneficiaries as provided while the life insured is still alive. As mentioned above, the definition of beneficiary excludes the owner or his personal representative. Therefore, there would be no protection from creditors where the insurance proceeds are payable to the owner s estate on death or where the proceeds of an endowment fund are payable to the owner at maturity. Where insurance proceeds are paid to a beneficiary directly those proceeds do not flow through the owner s estate. As a result, the proceeds will not be subject to the claims of creditors of the owner s estate. As indicated at the beginning of this Tax Topic, reference should be made to the Tax Topic on Limitations on Creditor Protection and Life Insurance for a more in-depth discussion as to the application of creditor protection to life insurance products generally and when payout of insurance funds occurs at death. Conclusion While creditor protection remains available in many instances, despite numerous challenges in recent years, it is important to be aware of the limitations that exist to its application. The Tax Topic, Limitations on Creditor Protection and Life Insurance, addresses that issue in detail and should be read in conjunction with this Tax Topic in order to gain a full understanding of this area. Last updated: April 2016 Tax, Retirement & Estate Planning Services at Manulife writes various publications on an ongoing basis. This team of accountants, lawyers and insurance professionals provides specialized information about legal issues, accounting and life insurance and their link to complex tax and estate planning solutions. These publications are distributed on the understanding that Manulife is not engaged in rendering legal, accounting or other professional advice. If legal or other expert assistance is required, the service of a competent professional should be sought. This information is for Advisor use only. It is not intended for clients. This document is protected by copyright. Reproduction is prohibited without Manulife's written permission. Manulife, the Block Design, the Four Cubes Design, and strong reliable trustworthy forward-thinking are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license. 4

APPENDIX A General Definitions (under the Ontario Insurance Act) Generally, there are three parties to a life insurance policy: the policy owner: the individual or entity that owns the contract and generally pays the premiums. The policy owner normally holds all rights under the policy including the power to name beneficiaries and change beneficiary designations. It should be noted that the policy owner may differ from the life insured. For instance, a corporation may be the owner of policies insuring the lives of shareholders; the life insured: the measuring life. When the life insured dies, the death benefit proceeds become payable; the beneficiary: the individual or entity that is named by the owner to receive the death benefits that are payable when the life insured dies. It should be noted that the terminology is different for annuities, whether registered or unregistered. From a contractual standpoint, the term annuitant would refer to the measuring life. For registered annuities, the owner and the measuring life must be the same person and are referred to as the annuitant. The beneficiary is the individual or entity named by the owner to receive any balance remaining in the annuity on death. Creditor Protection, Statutory Provisions In the Ontario Act, s. 196(1) addresses the issue of creditor protection. This section states that where a certain type of beneficiary is designated under a life insurance policy and the insurance proceeds become payable, such proceeds will not form part of the insured s estate and will therefore not be subject to the claims of creditors of the owner. Subsection 196(2) sets out this protected class of designated beneficiaries which include the spouse, child, grandchild or parent of a person whose life is insured. Where such a beneficiary is designated under the policy, the contract is also protected from seizure by creditors during the life of the insured. The definition of classes of insurance is made by order of the Superintendant pursuant to s. 43(1) of the Ontario Insurance Act which includes the following definitions are found in s.1 of the Ontario Act: insurance means the undertaking by one person to indemnify another person against loss or liability for loss in respect of a certain risk or peril to which the object of the insurance may be exposed, or to pay a sum of money or other thing of value upon the happening of a certain event, and includes life insurance ( assurance ); insurance money means the amount payable by an insurer under a contract, and includes all benefits, surplus, profits, dividends, bonuses, and annuities payable under the contract ( sommes assurees ); life insurance means an undertaking by an insurer to pay insurance money, (a) on death, (b) on the happening of an event or contingency dependent on human life, (c) at a fixed or determinable future time, or (d) for a term dependent on human life, and, without restricting the generality of the foregoing, includes (e) accidental death insurance but not accident insurance, (f) disability insurance, and (g) an undertaking entered into by an insurer to provide an annuity or what would be an annuity except that the periodic payments may be unequal in amount and such an undertaking shall be deemed always to have been life insurance 5

Section 171 of the Ontario Act sets out the following: beneficiary means a person, other than the insured or his personal representative, to whom or for whose benefit insurance money is made payable in a contract or by a declaration. (It is important to note that the definition of beneficiary excludes the insured (owner) of the contract or his or her personal representative. Creditor protection requires the designation of a beneficiary. A designation in favour of the heirs, next of kin, estate or the like of the insured is deemed to be a designation in favour of the insured s (owner s) personal representative and therefore not of a beneficiary.) contract means a contract of life insurance; insured means, i) in the case of group insurance, means, in the provisions of this Part relating to the designation of beneficiaries and the rights and status of beneficiaries, the group life insured, and ii) in all other cases, means the person who makes a contract with an insurer (i.e. the owner). R.S.O 1990, c.1.8 S.B.C. 2012, c. 1 R.S.A. 2000, c.1-3 S.S. Sask. 1978, c. S-26 TABLE OF CONCORDANCE C.C.S.M. 1987, c.140 R.S.N.B. 1973, c.i-12 R.S.P.E.I. 1988, c.i-4 R.S.N.S 1989, c.231 R.S.N.L 1990, c.l-14 s.1 1(1) 1 2 1 1 1 3 2 s.171 37 637 133 148 132 119 173 2 s.196(1), (2) 59 660 158 173 157 144 198 27 6