'Own occupation' TPD insurance through superannuation explained

'Own occupation' TPD insurance through superannuation has always been treated with caution by advisers. Zurich's Alena Miles explains what you need to know.

There are a number of issues advisers need to be aware of before recommending ‘own occupation’ total and permanent disability (TPD) through superannuation.

Under the ‘any occupation’ definition, the insurer pays an agreed benefit when, because of a physical or mental ill health, the individual is unlikely to engage in gainful employment for which they are reasonably qualified by education, training or experience.

If the client is a skilled professional, they might prefer a narrower definition of TPD. For example, a dental surgeon who loses his right arm may still be able to practise as a general practitioner — but he will suffer a significant drop in earnings.

If this client wants to ensure that the payment of his TPD claim takes place even though he can work in a different capacity, an ‘own occupation’ definition of TPD needs to be considered.

Under the ‘own occupation’ definition, the insurer pays an agreed benefit when the individual is unable to perform the duties of their own occupation.

Cost is an important issue for clients considering insurance. A common strategy to manage the cost of cover is funding insurance through superannuation.

One of the key benefits of this option is the ability to use pre-tax contributions such as salary sacrifice or personal deductible contributions to fund the cost of the premiums.

The cost saving becomes particularly significant for clients on the highest marginal tax rates.

But the cost should be just one of the considerations. The real value of the adviser’s recommendation will become apparent when a claim is made.

A client who suffers a TPD under an ‘own occupation’ definition may not be able to access benefits from superannuation immediately.

The reason for this is that to access benefits from superannuation, the client needs to meet a superannuation condition of release.

Total and permanent disablement is a condition of release under the Superannuation Industry (Supervision) Act 1993 (SIS).

But the ‘own occupation’ definition is a much narrower definition of incapacity than that contained in SIS.

This means that when an insurer pays a super fund under an ‘own occupation’ definition, unless the broader SIS definition (‘any occupation’) is also satisfied, the funds are preserved in the client’s account.

In this situation, the client can only access his/her superannuation benefits, including insurance proceeds, when he/she meets another condition of release (eg, reaching preservation age and declaring permanent retirement or turning 65).

Another issue to consider is recent developments in the area of deductibility of premiums to the super fund trustee.

The superannuation fund is generally eligible to claim a tax deduction for insurance premiums paid.

For a number of years the industry has been debating whether TPD premiums for both ‘any occupation’ and ‘own occupation’ definitions are deductible to the trustee.

The industry’s practice has generally involved treating a premium for a TPD policy as fully deductible regardless of the TPD definition.

But there had been concern in the industry, especially in recent years, about whether this practice complies with tax law.

On 13 October 2009 the Government announced that TPD insurance premiums are deductible only to the extent the policies have the necessary connection to the liability of a fund to provide ‘any occupation’ benefits.

To minimise disruption to the industry and to provide superannuation funds with time to make any necessary changes to their policies and processes, the Government has announced that it will amend the tax law for the period starting July 1, 2004 and ending June 30, 2011.

For the transitional period the proposed law aligns with current general practice.

From July 1, 2011 TPD insurance premiums will be deductible to a super fund only to the extent the policies are attributable to liabilities of the fund to provide ‘any occupation’ permanent incapacity benefits.

What effect will this have on current and future insurance arrangements? Insurers/trustees will need to review their situation and determine whether:

• the increased administration expenses will result in an increase in premiums; and
• it is still financially feasible to continue providing ‘own occupation’ TPD in super.

When recommending ‘own occupation’ TPD in super, advisers must not only be aware that their clients may have difficulty accessing the funds, but also that the tax-inclusive costs of the premiums are likely to rise.

The preservation issues, combined with the likelihood of rising premiums, are all making holding ‘own occupation’ TPD in super increasingly unattractive.

Should advisers then recommend that all ‘own occupation’ TPD should be held outside of super? Not necessarily.

To maximise the tax-effectiveness and to minimise the impact on the client’s cashflow, some industry practitioners are recommending breaking up the sum insured into the ‘own occupation’ and ‘any occupation’ portion.

They suggest holding the ‘any occupation’ portion inside of super and the ‘own occupation’ portion outside. For example, the adviser meets with James (41), a dental surgeon and determines that:

• if James becomes disabled and can never work again in any occupation, then in order to discharge his debt and provide for a complete loss of earnings for the next 40 years (his life expectancy) he will need $1.5 million of TPD cover; and
• if James can no longer work as a surgeon (eg, loses an arm) but can still work in a different capacity (eg, as a general practitioner), his earnings will decrease significantly. The adviser then works out that James will only need $800,000 to discharge debt and to provide for the shortfall in earnings.

An optimal arrangement for James might be holding $800,000 outside and the excess ($700,000 — which represents the ‘any occupation’ portion) inside super.

This strategy provides James with the security of getting access to funds when they are needed while funding the premiums tax-effectively.

‘Own occupation’ TPD in superannuation has always been treated with caution by advisers.

With the recent clarification regarding the deductibility of the premiums, it is likely to become even less appealing.

The transitional period represents an opportunity to review the clients’ situation to ensure their insurance arrangements are structured effectively.

Alena Miles is a technical analyst at Zurich Technical Services.