As practitioners, we are often asked about the treatment of life insurance in the event of bankruptcy.
Individuals who are unable to pay their debts as and when they fall due may voluntarily petition to become bankrupt. Creditors can also petition for the bankruptcy of an individual if the individual is insolvent and owes the creditor an amount above the statutory limit currently set at $5,000 in Australia. Bankruptcy generally lasts for three years, but can be extended in certain circumstances.
Though no one is immune from bankruptcy, self-employed business people, professionals such as doctors, dentists, lawyers, accountants, architects, engineers, etc. who are at risk, and company directors are particularly vulnerable to lawsuits from disgruntled patients, dissatisfied clients, or vindictive former partners. Successful litigation against these individuals may send them bankrupt, as can merely mounting a defence against a spurious claim.
Fortunately, life insurance – both inside and outside super – may be protected against bankruptcy. Under section 116(1) of the Bankruptcy Act 1966, all property that:
- belonged to, or was vested in, a bankrupt at the commencement of the bankruptcy, or
- has been acquired or is acquired by him or her, or has devolved or devolves on him or her, after the commencement of the bankruptcy and before his or her discharge is property divisible amongst the creditors of the bankrupt. The definition of ‘property’ would normally include life insurance policies and their proceeds. However, the Act goes on to provide certain exemptions, as follows:
Superannuation policies
Section 116(2) of the Bankruptcy Act excludes the following (as defined by the Superannuation Industry Supervision) Act 1993 – (“the SIS Act”): the bankrupt’s interest in a regulated superannuation fund; or an approved deposit fund; or an exempt public sector superannuation scheme; or a payment to the bankrupt from such a fund received on or after the date of bankruptcy provided the payment is not a pension within the meaning of the SIS Act. It also excludes the amount of money a bankrupt holds in a Retirement Savings Account (RSA) or a payment to a bankrupt from an RSA received on or after the date of the bankruptcy provided the payment is not a pension or annuity within the meaning of the Retirement Savings Accounts Act 1997.
However, separate provisions of the Bankruptcy Act cover contributions to the trustee of a superannuation fund both by a future bankrupt (section 128B) or by a third party (section 128C) for the benefit of a future bankrupt. These provisions allow bankruptcy trustees to recover superannuation contributions made prior to bankruptcy with the intention to defeat creditors. These provisions apply to any ‘out of character’ transfers which may be outside the normal contribution patterns of members.
Based on the above, provided there was no intention to defeat creditors, insurance policies within super would not be subject to a claim by a bankrupt’s creditors.
Ordinary life insurance policies
Section 116(2) of the Bankruptcy Act also exempts from section 116(1) the following property:
- policies of life assurance or endowment assurance in respect of the life of the bankrupt or the spouse or de facto partner of the bankrupt
- the proceeds of such policies received on or after the date of bankruptcy.
It is important to note that the exemption of life insurance (or assurance) policies is based on the common law definition of life insurance expressed by the High Court in National Mutual Life Association of Australasia Ltd v Federal Commissioner of Taxation (1959), not the Life Insurance Act 1995. Therefore, a life policy under the Life Act may not equate to a life insurance policy at common law and may not be exempt from being property divisible amongst a bankrupt’s creditors under section 116(2).
A policy of life insurance includes a term life policy and following various stamp duty cases, most likely, TPD or trauma policies that are riders to that policy. These policies are not property divisible amongst the creditors of a bankrupt. If the proceeds of these policies are received on or after the date of bankruptcy, the proceeds are also not divisible amongst the creditors of the bankrupt. The proceeds would go to the bankrupt policy owner, a surviving joint owner or a nominated beneficiary, or to the bankrupt policy owner’s estate.
Stand-alone TPD and trauma cover and income protection cover are not life insurance at common law, and are therefore not excluded from being property divisible amongst creditors of a bankrupt. Therefore, for ‘at risk’ professionals, it is worth considering having their spouses own these stand-alone policies. This strategy would not be applicable, however, for income protection policies. Any income protection policies owned by a bankrupt would normally be subject to a legislated ‘income contributions’ amount which is periodically indexed.
SV Partners can assist you with any questions or advice relating to bankruptcy, and how bankruptcy can affect a person’s life insurance or superannuation policies. If you would like any advice, please contact one of our expert advisors for more information on 1800 246 801.
Article written by Michael Carrafa, Executive Director, Victoria