Structuring Income Protection Cover for Self-employed Clients After 31 March 2020

You’ve probably already considered which cohort of clients is likely to be affected by the removal of agreed value IP.  Intuitively, it will be those with fluctuating levels of income, such as self-employed individuals and contractors; and given the current uncertainty in the job market and challenging business environment, it’s indeed important to weigh up the impacts of different IP strategies for such clients. What is your starting point when considering where to house IP cover after 31 March 2020?  Inside or outside of the super environment, or a combination of the two?

What is your starting point when considering where to house IP cover after 31 March 2020?

While there is no right or wrong answer, the default position may be to house the IP cover within super, especially now that agreed value IP is no longer an option. Doing so obviously brings superannuation law conditions of release considerations into play.

For self-employed or contractor clients, it means that if at the time the disablement occurs, the contractor wasn’t engaged in paid work, or if the self-employed client’s enterprise has since come to an end, the temporary incapacity condition of release won’t be satisfied.  This is because ‘temporary incapacity’ requires that the client ceases work due to illness or injury.  If they have ceased work prior to becoming disabled, this condition cannot be satisfied.   Claim proceeds will not be payable, as under the Stronger Super measures in place since 1 July 2014, and cover can only be offered by the super trustee, where one of four conditions of release can be met – one of these being temporary incapacity.

…the non-super policy provides a second line of defence

To combat this risk, one option is to ‘link’ IP benefits under two policies held inside and outside of superannuation.  In doing so, the majority of the premium is funded from retirement savings and the non-super policy provides a second line of defence, in the event that the temporary incapacity condition of release isn’t satisfied.

While the prospect of holding most of the IP cover inside super resonates with many clients, as part of the decision-making process advisers should consider the impact of the premiums on the underlying retirement savings, particularly when advising self-employed clients. Some key points to note are listed below.

• Capital gains tax (CGT) and contributions – The current tax law allows eligible small business owners to contribute part or all of the proceeds stemming from the sale of qualifying business assets into super, in accordance with the CGT contribution cap (as a result of qualifying for CGT relief). This may make up for the erosion of retirement savings from premiums during the accumulation years. However, it’s important to note these concessions / contribution caps have been the subject of recent reviews and may well be less accommodative in the future.
• Regulations on paying premiums out of super – Regulatory scrutiny over the impact of insurance cover on the retirement income of super members has intensified, and in particular whether retirement savings are inappropriately being eroded by premiums.
• The effect of compounding – If IP is self-owned, more capital remains compounding inside super and a greater proportion of contributions actually augment retirement savings, rather than merely replenishing accounts that have been eroded by premiums. Over time that could make a meaningful difference for self-employed clients who are otherwise coming off lower superannuation capital bases, especially if lump sum cover is housed within the account and contribution caps remain persistently low.

If IP is self-owned, the life-insured is generally entitled to a personal tax deduction for part or all of IP premiums paid.  For example, if a $3,000 premium payable on an IP policy was directly debited from the client’s bank account during the financial year, the ensuing $3,000 tax deduction that the client can claim in their tax return reduces their overall income tax liability, meaning the actual cost of the cover is only $1,830 or $1,590, for a client in the second highest and highest tax bracket respectively.  While a tax deduction claimed by the super trustee may be passed on to members, this is not guaranteed, and may only apply to a certain cohort.

Clients who are self-employed possibly stand to lose the most from the removal of agreed value IP…

Clients who are self-employed possibly stand to lose the most from the removal of agreed value IP.  For these clients, self-owned IP is clean, simple and free from the superannuation law overlay.  Further, unlike Life and Total Permanent Disability cover, self-owned IP clients can receive direct tax deductions for premiums paid.  Importantly, retirement savings are quarantined from IP premium erosion, thereby aiding underlying contribution strategies/retirement planning.  These factors may be helpful when canvassing self-owned IP, as a structure with such clients, particularly against a backdrop of ever-changing super and tax regulations and laws.

¹In accordance with APRA’s sustainability measures for individual disability income insurance, announced 2 December 2019.  These measures address product design aspects and include a Pillar 2 capital charge for insurers and reinsurers.

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