Keeping your policies inside the rules

Insurance cover is and continues to be a vital component of many financial plans. Financial planners should work with their clients to determine the most appropriate type of insurance cover required. Alternatively, clients may be covered by insurance policies provided by their employers.

In either case, and in view of the rise in the unemployment rate due to the current economic circumstances, financial planners should fully understand the social security assessment of insurance and compensation policies for those clients who are currently in receipt of, or about to claim, a social security payment.

Social security guidelines state that a life insurance policy is an asset of a customer if the customer:

• owns the policy; or
• is the policy holder; or
• has access to the policy.

The way in which a policy will be assessed will depend on the type of policy.

Note: Where the term ‘social security’ is used, it is as generic substitute for Centrelink and the Department of Veterans’ Affairs.

Insurance bonds

Insurance bonds owned by an individual are treated as financial investments for social security purposes.

To determine the assets test value of the insurance bond, multiply the unit price by the number of units owned. For income test purposes, the account balance is subject to deeming.

Life policies

Policies with no surrender value

Life insurance policies that do not have a surrender value have a nil value under the assets test. These policies are not income tested. These policies include term, trauma, total and permanent disablement (TPD) and income protection insurances.

Policies with a surrender value

Life policies with an investment component may have a surrender value. The surrender value of this type of policy is an assessable asset. An endowment policy is an example of a life policy with an investment component. There is no income test assessment while the policy is held. However, special rules apply when the policy matures or is cashed.

Assessment of insurance payments

Salary continuance payments

Salary continuance (also known as income protection) payments made in respect of lost earnings are generally treated as ordinary income if the employee has contributed towards the premiums. For example, the employer deducts a certain amount from the employee’s salary to cover the cost of the premium.

In cases where the employer pays the premium, salary continuance payments will be assessed in the same way as compensation payments (ie, a dollar for dollar deduction from the person’s social security entitlement).

In some cases it may be difficult to determine who made contributions towards to policy premiums (ie, the employee or the employer). There have been two Administrative Appeals Tribunal (AAT) cases, Macri (AATA 175) and Oprea (AATA 678), which have used the level of pay a person receives to determine who paid the premium.

The resultant social security policy states that if the employee would have received a pay rise if he or she opted out of the salary continuance scheme, the employee has contributed towards the policy premiums.

On the other hand, if the employee would not have received a pay rise if he or she opted out of the salary continuance scheme, the employee has not contributed towards the policy premiums.

Living expense cover

Insurance for living expenses pays a monthly benefit to a person who is significantly disabled. The benefit payment period may range from two years to age 80.

These payments are treated as ordinary income for social security purposes.

Example

Ron receives disability support pension (DSP). Ron has living expense cover and receives a monthly payment of $1,500.

Centrelink will annualise the payments to $18,000 per annum then assess it as a fortnightly amount of $692.30. Assuming Rod had no other income, his DSP will reduce by $221.70 per fortnight.

Trauma payments

Trauma payments made as a lump sum are not assessed as ordinary income. The assessment will depend on how the lump sum is used. For example, if the lump sum is deposited into a bank account, the balance of the account will form part of the person’s financial investments and be assets tested and deemed.

On the other hand, if the trauma payments are made as periodic payments (eg, fortnightly, monthly, etc), they will be assessed as ordinary income.

Example

Bill is single and has claimed the DSP. He is entitled to a trauma payment of $100,000 due to a heart attack. If the payment is made as a lump sum and deposited into his bank account, the $100,000 will be an asset and subject to deeming. Deemed income on $100,000 for a single person is currently $3,590 per annum ($138 per fortnight). Assuming Bill his no other income or assets, Bill’s DSP will not be affected.

However, if Bill receives the trauma payment as monthly payments over the next three years, Bill will be assessed as having $1,282 per fortnight ordinary income. This would result in a reduction of $457.60 per fortnight from his DSP (for the next three years).

Conventional life insurance polices

Bonuses paid under conventional life insurance policies are not assessed as ongoing income during the term of the policy. However, on maturity, the ‘financial gain’ is assessed as income for 12 months under the income test.

The financial gain is the difference between the surrender/maturity payment and the purchase price (if any) and the sum of the premiums paid. The financial gain is assessable as income on maturity even if the policy is not cashed out.

Example

Calvin, an age pensioner, has a life policy which has just matured. The maturity payment is $115,000. The sum of the purchase price and premiums is $90,000.

Centrelink will assess $25,000 per annum (ie, $961.50 per fortnight) as income for 12 months under the income test from the date of maturity. If any amount is cashed out and placed in a financial investment (eg, bank account, managed fund, etc) the amount will also be subject to deeming.

Note: The assessment of the financial gain of the maturity payment as income for 12 months has been regarded by many as unfair and a number of appeals have been lodged in the past with the AAT regarding this assessment. There was an AAT case, Varcoe AATA 1002 in 2002, which found against the current policy, but that ruling has since been overturned by a number of subsequent AAT rulings which found in favour of the current policy.

Conversion of lump sum amounts to periodic payments

Some policies that are usually paid as a lump sum (eg, TPD and trauma) may provide the option of periodic payments. In these cases, the periodic payments will generally be assessed as ordinary income. As the effect on social security entitlement may be significant, it is important to determine the effect prior to choosing the lump sum or periodic payment option.

Example

Lily, a 45-year-old single disability support pensioner is entitled to a TPD lump sum of $300,000 or $2,500 per month for 10 years.

Assessment of lump sum payment

If the $300,000 is invested as a financial investment outside super, it will be assets tested and deemed. Assuming Lily has no other income or assets, her DSP will be reduced by approximately $192 per fortnight.

If the $300,000 is contributed to super, it will remain exempt until Lily reaches age pension age.

Assessment of periodic payment

If Lily accepts a monthly benefit of $2,500, it will be annualised to $30,000 then assessed as a fortnightly amount of $1,153.85. Assuming Lily has no other income, her DSP will be reduced by $406.30 per fortnight.

Compensation payments

Social security recipients and applicants who receive compensation payments may have their entitlements reduced or stopped for a period of time. In some circumstances, past social security payments may be recouped by Centrelink, usually from the paying insurance company, on settlement of a claim.

The assessment of compensation depends on whether it is paid for economic or non-economic loss and further on whether it is paid as a lump sum or as periodic payments.

If any part of the compensation payment is for economic loss, the effect on social security entitlements depends on whether it is paid as a lump sum or periodically and on whether the individual is now applying for, or was receiving, a compensation affected payment (CAP) at the time of the injury.

A CAP is a Centrelink payment affected by specific compensation rules and includes payments such as the age pension (if commenced after March 20, 1970), disability support pension, Newstart allowance and most income support payments.

Periodic compensation payments

Periodic compensation payments reduce a recipient’s CAP entitlements on a dollar for dollar basis if the recipient was not receiving the CAP at the time the compensable event occurred. Periodic payments are deemed to be received from the date they become payable and reduce the CAP for the period that the payments represent. This includes arrears of periodic compensation payments paid as a lump sum.

If the compensation recipient was already receiving a CAP at the time of the compensable event, the periodic payments are treated as ordinary income and will reduce the social security benefit receivable according to the normal income test rules.

Periodic payments converted to a lump sum

If periodic payments relating to a fixed period are converted to a lump sum, this amount is treated as if it were received as periodic payments throughout the period in question.

This does not apply if periodic payments are commuted to a lump sum as full and final settlement or where arrears (or advances) of periodic payments are included in a lump sum final settlement. In both of these cases, the lump sum is assessed under the lump sum compensation rules.

Effect on partners

Social security payments to partners of periodic compensation recipients are only affected if the compensation recipient’s CAP entitlement is reduced to nil. If the recipient’s CAP is reduced to nil, any excess is included as ordinary income for the partner.

It the compensation recipient is not receiving or applying for a CAP, the whole periodic compensation is included as assessable income under the normal income test rules for a couple.

Example

Tom and Sue are both applying for the age pension and would, apart from a periodic compensation payment ($250 per fortnight) received by Tom, be entitled to an age pension payment of $400 each. Tom was not receiving a CAP at the time of the injury. As a result, his age pension entitlement is reduced on a dollar for dollar basis to $150 per fortnight. Sue's age pension entitlement is not affected.

If the compensation payment was $450 per fortnight, then Tom's entitlement is reduced to nil and the extra $50 is assessed as extra income for Sue. This would reduce her entitlement by $20 (0.4 x $50) to $380 per fortnight (assuming she has already used her income-free threshold with other income).

Lump sum compensation payments

Contested judgement

If compensation is received as a result of a contested judgment (ie, settled through a court or tribunal order), the compensation part of the lump sum is made up of the amounts awarded specifically for economic loss. These amounts include:

• lost wages (past economic loss);
• interest on past economic loss;
• lost capacity to earn (future economic loss); and
• lost superannuation contributions.

If a court order does not set out fully the basis of the award, more information should be sought about the nature of the award and a decision made on the basis of all the available information. If no information is available then the lump sum should be treated as if it is an agreed settlement (ie, the 50 per cent rule applies; see below).

In a contested judgment the lump sum is deemed to have been received on the date the amount is payable.

Agreed settlement

Settlement is the most common way lump sum compensation payments are decided (ie, out of court). If lump sum compensation is received as a result of an agreed settlement between the parties (including arbitration) and at least part of the payment is for lost earnings or lost capacity to earn, 50 per cent is assessable to determine the preclusion period.

In an agreed settlement, the lump sum is deemed to be received on the date the agreement is finalised and the funds become payable. A settlement usually requires the agreement to be registered with an appropriate court, tribunal, or statutory authority and must comply with other legal requirements.

In an arbitrated judgment, the lump sum is deemed to have been received on the date the amount is payable.

Divisor for lump sum compensation

Once the assessable compensation amount is determined, it is divided by a factor to determine the number of weeks in the preclusion period.

If the lump sum compensation was made on or after March 20, 1997, the divisor is the weekly income cut-out threshold, above which no pension is payable to a single person at the time the lump sum is received.

If more than one lump sum is made for the same compensable event, the lump sums are aggregated and the divisor applying at the time of the most recent lump sum is used to recalculate the total preclusion period. Each time a subsequent lump sum is made, the divisor applying at that time is used to recalculate the preclusion period.

If lump sums are received for different compensable events, these are treated as separate matters and the payments are not aggregated. Preclusion periods are calculated separately for each compensable event.

Example

Rod received an out of court settlement (ie, agreed settlement) of $300,000 for a work related injury exactly three years ago. Rod was initially living off his savings but claimed DSP six months ago. Rod has been paid a total of $3,500 in DSP payments to date. The current weekly income cut-out threshold above which no pension is payable to a single person is $779.13.

Rod’s preclusion period is worked out as follows:

1. $300,000 x 50 per cent = $150,000; and

2. $150,000/$779.13 = $192 weeks.

Rod’s preclusion period of 192 weeks will commence from the date of injury (ie, three years ago) and will cover the period he received DSP.

Consequently, Rod’s DSP will cease and the $3,500 in DSP payments will be deducted from his settlement amount by the insurance company and paid to Centrelink. As it has been three years (ie, weeks) since Rod’s injury, he will not be entitled to claim any social security income support payment for a further 36 weeks.

George Avramides is a technical manager at ING Australia.