They, Missouri Medicaid, must not have been aware of that asset. If a policy has a cash value greater than $1500, it is considered a countable asset Had they been aware of it she would not have qualified for Medicaid. She is fortunate that they are not taking punitive measures.
I am thinking that what they are allowing her to do is not exactly to turn the policy over to a funeral home but instead to establish a an Irrevocable Funeral Trust (perhaps through a funeral home). Current laws allow persons on Medicaid to retain assets for a proper funeral. Unfortunately, these amounts are usually woefully inadequate. However, a life policy used with an Irrevocable Funeral Trust allows for a lump sum deposit of $15,000 per individual. At passing, funds are paid to the funeral home of her choice. Using this technique, the family should have sufficient funds to pay for the funeral of the deceased. These funds are not subject to the spend-down process. Or they are requiring her to surrender the policy and use the cash value to fund a prepaid burial policy.
You can be sure that she will be required to make some changes. Seeking advice from an expert on elder law might be useful here.