Insurance is a key item self-managed superannuation fund trustees sign off each year as part of their investment strategy and returns (you did know that, didn't you?) Yet it's clear that trustees pay limited attention to this critically important issue.
There are two risks frequently neglected by SMSF trustees which both involve insurance. The first is how much (or little) insurance is in place. The second is tax, and whether insurances should be in super at all.
SMSF trustees are routinely underinsured (numerous studies support this), while a phenomenon known as "misinsurance", where trustees are unaware of the type of coverage they have, is rife. Consider a widow who is struggling through a blizzard of grief being told that they are going to have to sell their home next year and get back to work to stabilise their asset base and provide for their kids because their SMSF didn't have any insurance, or it was simply insufficient for the situation.
If you're about 40 years of age, and have a couple of kids and a capital city size mortgage, you'll likely need between $1.5 million and $2 million in life and total and permanent disability (TPD) cover, and income protection insurance that runs until you're 65. This would equate to a basic level of cover.
If the main income earner in the family passes away, not only is there a mortgage to contend with, there are years of living expenses, child-related expenses and potentially absent retirement savings for the surviving partner that need to be provisioned. If you're totally disabled, the cover you need is arguably higher again, as you'll need to provide for care – possibly changes to your home and rehabilitation and ongoing medical expenses.
And a big one many don't appreciate properly is income protection. The insurance is routinely issued at 75 per cent of your current income, yet most trustees don't have it in their SMSF, or rely on a "coverage lite" workplace policy that typically cuts out after two years, which is roughly the point at which you need the income the most. As a guide you need coverage to continue until you're 65 years of age.
The issue here is that most trustees will say they have some insurance in place, and "that'll do", or they "self-insure" by reconciling which assets they'd liquidate if they needed the money.
Typically, they underestimate their needs by a vast quantum.
Tenant and property insurance
If the SMSF owns a property, trustees need to adequately insure the property. This includes the obligatory building and landlord insurance. The latter is important for a raft of reasons: missed rent, damage to the building and worse.
An SMSF insurance category with mixed support from accountants is so-called audit insurance. This covers the cost to an SMSF of an accountant's time and materials should the SMSF be audited (but it doesn't cover a tax bill). Considering the ATO's intent to audit tens of thousands of SMSFs each year, such insurance seems prudent. However, if your SMSF strategy and asset base is straightforward and your SMSF accountant is experienced in their field, audit insurance can be considered optional, as the chances of an audit involving heavy costs is limited.
In the past some SMSFs may have been encouraged to hold a life insurance policy to meet the obligations associated with a business buy/sell agreement. These agreements are struck between business partners. On the death of one partner, there is a payment of equity to the deceased partner's estate. This payment is often funded with life insurance policies. A buy/sell agreement is vital when you consider that the surviving partner(s) may not want the spouse or family of the deceased as shareholders after the partners' death. Such an event can be a nightmare of epic proportions for the surviving business partners.
SMSFs have at times in the past been used to fund these life insurance policies. But the Tax Office has warned that such a strategy may not meet the "sole purpose test", which dictates that super must be used only for the purpose of retirement savings.
Having mounted a case for holding insurance in your SMSF, it's also critical to consider whether your SMSF should be the place in which to hold the policy in the first place. Bear in mind that the effect of paying insurance premiums in super is to reduce your retirement savings by paying the cost of premiums, so topping up your contributions is key.
In the case of insurance held to meet business succession needs, these situations are extremely complex and trustees need advice to reduce the chances of significant tax liabilities, given that taxes on improperly structured insurance payments can be massive.
For life insurance, if one or more of your children is over the age of 18, consider carefully that part of your life insurance death benefit may be taxed at 30 per cent or more before it leaves super and is paid to your adult child as a beneficiary. The solution may be to transfer ownership of the insurance policy to your name.
And do consider whether your income protection policy should be in your super or in your own name. The product issued in super these days has been modified to meet potential condition of release issues for lower impact claims and the features and timeframes of coverage of the products are typically limited. "Misinsurance", indeed.
Having appropriate levels of coverage or owning insurances in an appropriate structure goes a long way.