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SMSFs and insurance: how much do you need?

It is interesting that most Australians do not hesitate to insure their car, but when it comes to their own lives they are reluctant to take out life insurance.

Research undertaken by the Australian Securities and Investments Commission has confirmed underinsurance is a significant life insurance problem in Australia. The work undertaken found up to 60 per cent of families with dependants had insufficient life insurance to financially care for the family for greater than 12 months, should the main breadwinner die.

For those who have an SMSF, one requirement for the fund trustees, under regulation 4.09 of the Superannuation Industry (Supervision) Act, is to consider whether insurance should be held on the lives of fund members. This is to be reviewed regularly, which means at least once a year, according to the regulators.

Like most of us, many trustees find insurance confusing as the types of policy and level of cover differ significantly. They seek information from their advisers on the type of insurance that is appropriate and how the amount of cover is calculated. This should take into account the whole circumstances of the individual and their immediate family or business.

There is a limit to the type of insurance cover that can be provided in superannuation. These rules were tightened from mid-2011 to ensure the type of cover was consistent with the superannuation conditions of release, that is, any cover is to be limited to death, terminal illness, total and permanent disability (TPD) and temporary disability, such as sickness and accident.

The benefits of having insurance through super are:
• Insurance inside super can be cheaper due to the bulk-buying power of funds. These days that can include SMSFs.
• Automatic cover may be available under some policies as there may be no medical examinations required.
• Super policies may include TPD insurance and income protection insurance.
• It can be tax effective as the premiums paid out of super contributions may generate a direct tax deduction to the fund.
• Premiums may be deducted from super contributions, which may be tax deductible to an individual or employer.

The shortcomings of insurance in super are:
• The amount of insurance cover could be less than the amount required.
• A superannuation fund is unable to purchase trauma insurance under the current rules.
• Premiums paid from super contributions provide less money to invest. This may impact on the amount members will have available at retirement or on meeting another condition of release.
• Most income protection policies inside super provide benefits for a limited time, usually up to two years.
• Delays may occur in life insurance claims being met as the amount may be paid initially to the fund, then distributed to the beneficiaries. This may result in a lengthy and frustrating process.
• Members should exercise the option of completing a binding death benefit beneficiary nomination to be certain any life insurance payout goes to those intended by the member.
• Non-financial dependants for tax purposes may be liable to pay tax on the death benefit received. If the same benefit were paid from a policy held outside of superannuation, it would be tax free if received by the same person.

Calculating the amount of insurance cover for members of an SMSF will be different for every person and depend on their personal circumstances, such as age, health, income, expenses and domestic situation.

To determine the amount of insurance required, there are four main financial needs to be taken into consideration if death, TPD or temporary incapacity were to happen to the member. The amount required could be based on the:

1. Personal needs of the member: mortgage/debts, family living expenses, potential medical costs, carer expenses, school fees or any other personal need or estate planning provision important to that person.

2. Cash-flow needs of the fund: if a member is temporarily incapacitated by sickness or an accident and is not making contributions (or not paying rent for a member’s business property owned by the fund), the fund needs enough cash flow to meet operating expenses, investment expenses, loan repayments, investment strategy objectives and benefit payments, such as pensions to other members.

3. Liquidity needs of the fund: if the fund holds mostly illiquid assets (non-cash assets such as property), to prevent a forced sale of the assets when a lump sum death or TPD benefit payment needs to be made, it is possible to use insurance as a strategy for providing cash that can be used for benefit payments to exiting members and their beneficiaries.

4. Debt/liability needs of the fund: insurance can also be used as a strategy for eliminating the debt and liabilities a fund holds upon death or TPD of a member, which helps to protect the assets and provides a greater benefit to the continuing member(s) and the exiting member or beneficiaries.

The following formula is a guide to calculating the amount of insurance required:

Is insurance affordable?

It is possible to insure for everything at a cost, however, to be practical most people do not have insurance cover for every possible outcome and accept the risk to a certain level themselves.

Funding large amounts of premiums from super can impact significantly on a member’s balance in the fund. The flipside is that not having adequate insurance in place could leave the member or members in financial hardship if they suffer an insurable event before reaching retirement age or as they continue as a fund member during their retirement.

Another side to considering the affordability of insurance is the depth of the benefits provided and the pricing of the premiums. The old saying is so true, “It is not cheap if you cannot claim on it”, meaning it is important to ensure you put in place quality insurance policies that will pay in the circumstances intended by the trustees at the time the policy was taken out.

There are hundreds of insurance policies to choose from, with the quality of benefits, features and definitions within each contract varying substantially. This can be influenced by whether the policy is being held inside or outside of superannuation.

When considering insurances the fund can hold for the members, qualified professionals, such as those with a full or limited licence, will be able to assist in selecting appropriate insurances available through SMSFs, or other insurances such as trauma and own occupation TPD, which are required to be taken outside super. This would depend on the terms of the licence authorised by the licensee.

It is also the role of trustees and their advisers to ensure SMSF trustees do not contravene regulations relating to cross-insurance strategies, which the ATO has confirmed are not acceptable from 1 July 2014 onwards. In addition, an eye should be kept over buy/sell arrangements to ensure they are not outside the ATO’s interpretation in ATO Interpretative Decision 2015/10 in regard to the sole purpose test and the provision of financial assistance to members or their relatives.

In summary, as part of the fund’s investment strategy and the members estate planning, it is important for SMSF trustees to plan for and implement strategies that deal with a member’s unexpected death, terminal illness, permanent disability, sickness or accident, while also taking into account the:

• Potential financial losses associated with not having insurance versus the financial protection of having it in place. This not only includes insurance in the superannuation, but also held externally to superannuation.

• Cost of insurance premiums over time being debited from the member balances versus the cost of having insufficient funds available if no insurances are in place when unexpected death or disability occurs.

• Benefit of having some life insurance rather than none, but it is wise to know exactly what that insurance will or won′t pay and in what circumstances, whether it is through the super fund or held externally.

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