Superannuation and the growing gap between insurance policy and practice

As superannuation governance increases in complexity, finding common ground between insurance policy and practice is becoming a near-impossible dream, writes Dimitri Diamantes.

A few years ago the Tax Office issued a media release entitled ‘It’s your money ... but not yet!’. Smack. With the tightening of contribution and investment rules, including the upcoming restriction on insurance definitions in super, you might be tempted to think ‘It’s your super ... but not really’. 

What are the alternatives to matching insurance definitions with existing superannuation conditions of release? And what’s the right regulatory framework? Is insurance in super always a perfect match? 

Balancing investor choice and the under-insurance problem (on the one hand) with investor protection and the fundamentals of retirement policy (on the other) is especially tricky where the asset is insurance. Throw in the impact on government revenue and the task is seemingly impossible.  

Possible regulatory framework options 

1. Don’t change. A member can hold insurance in super even if the insurance trigger condition means the existing death or disability Superannuation Industry (Supervision) Act (SIS) conditions of release won’t be satisfied on that event happening (subject to the sole purpose test). 
2. Expand the disability SIS conditions of release. A member can access the proceeds from death and comprehensive total and permanent disability (TPD), trauma, and income protection (IP) insurance held in their super, on the insurance trigger condition happening (subject, again, to the sole purpose test).
3. Aligned insurance cover definitions in super. A member can hold insurance cover in super, but only if the insurance proceeds will satisfy the existing death or disability SIS conditions of release on the trigger event happening. For example, cover for TPD defined more widely than ‘permanent incapacity’ – eg, ‘own occupation’ TPD insurance – would not be allowed in super. 

A member is taken to be suffering permanent incapacity if the trustee is reasonably satisfied the member’s ill health makes it unlikely the member will engage in gainful employment for which the member is reasonably qualified by education, training or experience. 

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Similarly, IP insurance with the potential to pay benefits exceeding the member’s pre-disability income – eg, agreed value cover, and crisis and specified injury benefits), or where the member hasn’t ceased employment or ceased temporarily to receive any gain or reward for employment – wouldn’t be permitted. 

A view on each of the options 

Option 1 (the current rules) gives the investor a wide choice and helps address affordability by allowing premiums to be funded  by compulsory employer contributions and/or the member’s existing balance, and may allow tax savings.

However, disengaged members might accept more insurance (ie, additional cover types) without receiving the advice they need. 

Option 2 gives the investor very wide choice and helps tackle affordability. However, this option conflicts with the fundamentals of retirement policy, as it would allow large lump benefits (eg, trauma) to be released from super even while the member is of working age and still able to work. 

There’s also a danger that disengaged members would accept more insurance without receiving the advice they need. Further, there would also be a hit to government revenue as more insurance was taken out through super and funded with low-tax or no-tax income. 

Option 3 (the new rules, from 1 July 2014) gives the investor narrower choices for cover type, and limits their ability to fund premiums with compulsory contributions/existing balances and to take advantage of tax savings within the super environment.

On the other hand, the scope for disengaged investors accepting insurance without receiving the advice they need is reduced; and the option sits quite comfortably with the fundamentals of retirement policy, as members can’t access large lump sums while the member is of working age and still able to work.  

Option 3 has the additional advantage that trustees aren’t put in the difficult position where a member is expecting to be able to access their insurance proceeds, but can’t because they don’t meet a disability condition of release.  

Committing to a retirement policy 

If you accept that fundamentally superannuation is for providing benefits once you have retired or are no longer able to work, I believe options 1 and 3 are better for saving for retirement.

Further, option 3 doesn’t allow a member’s super to be diverted away from investing for retirement or protecting against an inability to work and, instead, used to pay for contingent benefits designed to protect against an event or change in employability, rather than an inability to continue working. 

This leaves us with some problems, including under-insurance; however, these problems can be addressed outside super.

As some funds already align their insurance definitions with SIS conditions of release, and best practice is generally for insurance cover beyond the death or disability conditions of release to be held outside super (unless the client has reached preservation age), the new rules may not change practice greatly.  

Solution 

What about the client? What’s the best option for a client where for regulatory or commercial reasons insurance definitions in super are matched with the existing SIS conditions of release? There are several solutions.  

We focus on a few. Each gives different relative weighting to affordability (on the one hand) and policy features and benefits (on the other). All solutions generally involve holding some insurance in super. 

Possible solutions:  

1. Hold life and basic TPD (ie, ‘permanent incapacity’) cover and basic IP cover (ie, where, in every situation the insurance proceeds are payable, the benefit can be released from super under the death or disability conditions of release) through default employer super fund. Comprehensive trauma and IP insurance (ie, agreed value with ancillary benefits) with the waiting period the same as the benefit period in super (say, two years) is with an external provider (ie, not the employer fund) and held outside super. 
2. Hold life and basic TPD through default employer super fund. Comprehensive IP and trauma are with an external provider, outside super. 
3. Have all cover with an external provider, with life held through super, TPD held inside super, but split between inside and outside super (where, eg, ‘own occupation’ cover is required) and comprehensive trauma and IP held outside super. 

You’d expect the overall premium to increase as you move from solution 1 to 2 and from 2 to 3. However, you’d also expect the quality of cover to improve.

For example, the default employer plan may only offer IP indemnity cover, whereas under options 2 and 3 clients maybe be able to take agreed value and crisis cover/specified injury benefits.

Similarly, the default employer super fund may only offer basic cover TPD insurance. 

Potentially, any of these options could be appropriate for the client. Working out which one is actually right will depend on how much weight the client gives price relative to quality of cover, given their personal circumstances. 

Let’s take an illustrative example – Brad, a 45-year-old professional who’s a non-smoker. He needs $1 million term life and TPD, $500,000 trauma, and $10,000 per month IP benefit.  

Brad’s default employer fund has a maximum benefit period of two years for the IP, is an indemnity-only policy and does not allow certain ancillary benefits that he values (eg, crisis and specified injury). 

Cover held outside super is comprehensive (eg, agreed value IP with crisis and specified injury benefit; and broad trauma cover). 

Possible premium costs*: 

• Option 1: $5248 ($4835 after tax benefits) 
• Option 2: $5774 ($5240 after tax benefits) 
• Option 3: $7289 ($5423 after tax benefits) 

* premium rates, as at time of writing, from an actual industry fund and an actual retail fund; figures are for illustrative purposes only. 

Affordability might limit the client’s options (even if the client does recognise the value of all of them). Presenting the pros and cons of each option at least allows the client to make an informed choice. 

Insurance for liquidity? 

Committing to the fundamental retirement objective of superannuation doesn’t imply all insurance held by a super fund ought to be able to be released on the insurance trigger condition happening. For example, cover held to ensure the fund can keep meeting its retirement objective may be an appropriate strategy. 

However, there is some concern about whether the new rules would allow a super fund to hold insurance to provide benefits other than to the life insured member.

For example, SMSFs who have a large portion of their capital tied up in illiquid or ‘lumpy’ assets (eg, property) or have debt under limited recourse borrowing arrangements (LRBAs) may have a tough time paying death or disability benefits if they don’t hold insurance, due to the potential difficulty in realising those assets for cash.  

One option is for a SMSF to hold cover that backs the account of each relevant member except the life insured. This allows the proceeds to be paid directly to the backed accounts rather than be reserved or split up among all relevant members’ accounts (including the life insured’s).  

With some reallocation of investments, this may allow the life insured’s benefit to be paid out in cash and for any debt to be paid off or reduced.

The purpose is to ensure the fund can keep meeting its retirement objective, not to provide additional benefits to the surviving members. 

The potential problem is that under the new rules it seems (at least from the associated Explanatory Statement) that where the insurance proceeds can’t be released under the death or disability conditions of release on the insured event happening, the policy is not permitted. This would be the case even if the insurance definitions were aligned with those conditions of release. 

An illustrative example will help. Mike and Lindsay have a SMSF. One of their investments is a LRBA that is invested in real estate and has a large debt. After 30 June 2014, the fund takes out a term life and basic TPD policy over Lindsay’s life.

The policy backs Mike’s account and the premiums are debited from Mike’s account too. The fund also has a policy over Mike’s life, backing – and paid from – Lindsay’s account.  

It is possible in this example that where the policies are set up post-30 June 2014, they won’t be permitted as the proceeds aren’t necessarily able to be released from super on the trigger event happening. This is the case even though the trigger events match the death and disability definitions in the super rules. 

This would be a regrettable outcome as the purpose of the policy is consistent with the fundamentals of superannuation policy.

SMSFs that need a cross-funded insurance arrangement should consider as an option setting up the policies before 1 July 2014, as these policies would be allowed to continue in the fund post-30 June 2014 under grandfathering provisions.  

Where’s the love? 

You never know for sure whether people will fall in love; a ‘perfect match’ is a misnomer in this regard.

However, you may be able to say whether there’s enough in common for the relationship to have a fighting chance.   

A perfect match between superannuation policy and practice is also generally an impossible dream. This is because practice has to deal with real life (which doesn’t always fit neatly into the policy rubric) and with the harsher consequences of the rules.  

The alignment of insurance in super with existing conditions of release may make for a happier match between the rules and the frontline.

Dexter would probably give the coupling the highest compatibility score. But there is still some fuzziness around the edges that needs to be sorted out. 

Dimitri Diamantes is manager of research and technical at Asteron Life.