SMSFs face life insurance law challenges

SMSF trustees have had another duty imposed on them by the Federal Government, but it appears some practitioners are taking a worryingly minimalist approach to meeting the new requirement, says David Glen. 

The response to the investment strategy requirements of the Superannuation Industry Supervision (SIS) regulations that now require self-managed super fund (SMSF) trustees to consider life insurance has been underwhelming. 

In broad terms, SMSF trustees are now obliged to consider the life insurance needs of their members. The Government introduced this new requirement because the Super System Review by Jeremy Cooper found that very little life insurance was held with SMSFs and such a risk posed a major threat to the largest segment of the superannuation system. 

The SMSF insurance strategy requirement is the latest response by a Federal Government concerned about the massive life insurance gap in Australia in general.

The Federal Government, in the Cooper report, estimates that only 13 per cent of SMSF members have any form of life insurance cover.  

The SMSF requirement follows the recent introduction of automatic insurance cover within default retail and industry funds under MySuper. 

This risk to the community is represented by Rice Warner figures that show total national under-insurance at a staggering $10.6 trillion, with the disability gap increasing 10 per cent in 2012 to $7.9 trillion, the income protection gap up 30 per cent to $589 billion and the end-of-life insurance difference down 30 per cent to $2.166 trillion. 

Response to the new measures  

It is important to note that the Federal Government has not specified a minimum level of life insurance cover for an SMSF member.

This response is appropriate because SMSF members may not need life insurance cover, or alternatively, they may have appropriate levels of life insurance cover outside the SMSF. This means that the SMSF trustee’s obligations are limited to considering the members’ life insurance needs.  

Anecdotal evidence suggests the response of the SMSF market to this requirement has been a mixture of indifference, denial and scepticism.

Some SMSF practitioners have advocated a minimalist approach by recommending that compliance involves a simple statement that the trustee has considered the life insurance question.  

This minimalist approach ignores the Federal Government’s policy intent behind the new measure.

However, more importantly, the minimalist approach ignores the duty of care that SMSF practitioners owe to their clients.

This duty is to assist our SMSF trustee and member clients to manage their business and lifestyle risks to ensure that any losses arising from the materialisation of these risks are minimised.  

In the life insurance context, this means that the points of vulnerability in the client’s domestic and business circumstances are identified, and appropriate cover put in place to compensate if any of these losses materialise.

In short, we do our SMSF clients a disservice if we adopt a minimalist approach to the important question of considering the life insurance needs of SMSF members. 

Consequences of non-compliance 

The new regulation forms part of the investment strategy requirements outlined in Regulation 4.09 of SIS.

It is interesting that the Government has seen fit to incorporate this requirement in Regulation 4.09 because by doing so it now makes the new measure an operating standard for which reckless or intentional breaches of operating standards can subject the trustee to a penalty of 100 units. 

The present penalty tariff is $170 per unit, and therefore trustees who ignore this provision are potentially exposed to a penalty of $17,000. 

It is also important to note that the new measure also constitutes a covenant by the trustee. Members of superannuation funds are entitled to sue trustees for any loss they may suffer as a result of a breach of a covenant by the trustee. 

For example, a member of an SMSF who is disabled by a severe stroke may be able to allege that the trustee should have considered his/her insurance needs, and taken out an appropriate level of disability insurance.

The trustee may therefore be liable to pay compensation equal to the cover which should have been purchased by the trustee, had the trustee considered the member’s life insurance needs as required by Regulation 4.09. 

Of course, in the SMSF context all parties are closely related, and the member may also be a trustee. However, this may result in other members of the SMSF being dragged into a conflict where there are no victors.

How can we assist SMSF trustees? 

Our response as SMSF advisers should be to provide a practical way of assisting SMSF trustees to comply with this requirement.

More importantly, we should be urging our SMSF trustee clients and members to address the question of under-insurance. This can be achieved by identifying to all involved the underlying business and domestic risks. 

Once identified, an appropriate risk mitigation strategy can be formulated. This may include taking an appropriate level of life insurance cover. 

SMSF trustees can only discharge their duties if they are aware of the circumstances of the members. It is important to provide documentary evidence of this awareness. 

TAL has recommended that SMSF trustees ask each member to complete a brief questionnaire detailing their current circumstances. A suggested template has been compiled to assist trustees and advisers to complete this task. 

This would expose a need for insurance, or alternatively, indicate that there is no need for insurance. The questionnaire should ask for details of items such as domestic debt levels, income levels and support commitments. The questionnaire should also cover any existing insurance arrangements of the member. 

We also suggest that the members be asked to state whether or not they consider their life insurance needs to be adequate.

A statement by a member that he or she does not want the trustee to address insurance needs does not necessarily give the trustee an out to ignore the regulation, but from a practical point of view a statement by members that they do not require life insurance within the SMSF may assist the trustee in defending any breach of covenant action brought by the member. 

The questionnaire plus sign-off by the member could also reduce the likelihood of the Australian Taxation Office as the SMSF regulator seeking to impose a penalty for breach of Regulation 4.09. 

Reviewing completed questionnaires 

The Trustee should then review the completed questionnaires submitted by members. The questionnaires may indicate mature members approaching retirement with substantial assets, and no domestic commitments. 

They may also indicate members with domestic commitments, but who possess sufficient insurance outside superannuation. In these cases, there is no insurance need, and the review plus conclusion should simply be documented. 

This is contrasted with the position of a younger member with substantial debt and family commitments, and no life insurance cover inside or outside the SMSF.

This situation should prompt the diligent trustee to have discussions with the member on the need for life insurance cover inside or outside superannuation. 

The questionnaire answers may also indicate a number of grey areas. In this case, the diligent trustee may consider it appropriate to seek advice from a qualified life insurance adviser on an appropriate action plan.

Practically the identified insurance gap should be resolved by constructive discussion between the trustee, adviser and member.

Way forward 

This new regulation represents an enormous opportunity for accountants and insurance advisers to add value to their clients by assisting trustees to fulfil their obligations.

However, far more importantly, everyone should see this regulation as an opportunity to address the yawning insurance gap in the SMSF market. 

If a diligent review is conducted, everyone will have comfort that there is adequate cover already in place; or where there are identified gaps, that appropriate life insurance cover has been obtained. This review should also be conducted on a regular basis as members’ circumstances change over time. 

David Glen is the tax counsel at TAL Life Insurance. 

Originally published on SMSF Essentials.