Pitfalls of policy ownership structures

Term life insurance ownership structures outside superannuation continues to present challenges to people in general, and your adviser should take great care in setting up ownership structures based on your needs and objectives.

So, how should non-super term Life Insurance policies be structured to ensure the right people receive the right payments at the right time, whilst minimising potential tax liabilities? Let's explore two examples.

Example 1 - Two policy owners

An adviser has set up a term life insurance policy for two friends (whom we'll call Mary and Sally) for term life insurance, with TPD insurance and trauma cover as riders (known as a bundled policy) - they did not want to pay two policy fees. Mary and Sally were both lives insured and policy owners. The adviser explained that, as policy owners, Mary and Sally had nominated appropriate beneficiaries for the term life insurance policy (who would receive claim proceeds tax free), but that the adviser had not considered the consequences of a TPD insurance or trauma claim. What were the pitfalls regarding this scenario?

Term life insurance

Although there was a nomination of beneficiaries, circumstances do change, and if Mary wanted to change the nomination, she could only do so with the agreement of Sally and would be relying on her good will to agree to this change. Most Life Insurance Companies only allow nomination of beneficiaries if all the policy owners are also lives insured, but this impedes situations where there is a valid reason for having a policy owner who is not the life insured (i.e. business partnerships) and also for nominating beneficiaries.

TPD insurance and trauma insurance with term life insurance

Let's say the TPD and trauma sums insured in Sally & Mary's case were $300,000. If Mary suffered a heart attack that satisfied the life insurance company's trauma definition, the life insurance company would be obliged to pay the claim proceeds in equal share to Mary and Sally, so each would receive $150,000 (there is generally no ability to nominate a beneficiary other than for term life insurance proceeds). The payment of insurance proceeds may constitute a disposal of a CGT asset.

However, Mary would receive her monies tax free, as there is a CGT exemption on TPD and trauma proceeds if paid to the life insured (also to her spouse or de facto, or a defined relative - s118-37 ITAA 1997). On the other hand, the proceeds paid to Sally (who is unrelated to Mary) would not qualify for a CGT exemption; she would pay tax on the taxable capital gain, which would be determined by deducting the taxpayer's cost based from the proceeds of the disposal. So even if Sally, out of the goodness of her heart, handed over her share of the proceeds to Mary, it would not be the full amount of the insurance payment.

As you can see from this possible outcome, the adviser's initial recommendation and policy set-up was fraught with danger. Our recommendation may be to immediately remove Sally as a policy owner, regardless of any loss of discount, and provide Sally and Mary each with a self-owned policy.

Example 2 - Death of the policy owner

What happens to a life insurance policy where a sole policy owner, who is not a life insured, dies? In this case, the husband owned a life insurance policy on the life of his wife, and died prematurely. The wife wanted to know what would happen to this policy, as there was no nomination of beneficiary.

In this scenario, the policy would form part of the deceased husband's estate and its ownership would be determined by the provisions of the husband's will, or if there was no valid Will, ownership would be determined by the laws of intestacy in each state or territory. If there are no instructions in the will and, as the life insurance policy has no cash value, it is likely that the executor or administrator of the deceased estate would agree to transfer the policy ownership to the deceased's wife if she wished to continue the life cover. Obviously, if the estate decided not to pay life insurance premiums when they were due, the policy would lapse.

Both the above cases illustrate the importance of appropriate term life insurance ownership structures and the need for people to discuss with their advisers the impact of these structures if an insurable event occurs.

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June 2010