Legally speaking you're probably wrong. The main contract is between the insurer and the insured. The FIL may argue a constructive trust but that'd be a stretch. Ultimately, unless there was some other consideration in a separation agreement provided to the MIL the FIL has no legal cause of action. There is one overarching goal in law regarding instruments that deal with death: try and uphold the testator's intent as best as possible. The designation of a beneficiary is a simple trust arrangement used for a variety of goals; to dishonor that would make for a more complicated world and protracted litigation. Courts are non-responsive to this. It's the same reason mutual wills don't hold up. Of course, wills and estates law is governed fairly equally by federal and provincial laws so different provinces handle certain arrangements differently. 

A final thought: not returning the money to the FIL could mean being cut out of his will. If it's money you care about, consider this.