If your client base includes business owners, chances are that you have considered what might happen to their life insurance proceeds and superannuation interests should their circumstances drastically change and they become bankrupt. The first article on this topic will look at bankruptcy and life insurance outside superannuation.
Though no one is immune from bankruptcy, some self-employed business people, certain professionals (for example, doctors, dentists, accountants, architects and engineers) and company directors may particularly be vulnerable to lawsuits from disgruntled patients, dissatisfied clients or vindictive former business partners. Successful litigation against these individuals may send them bankrupt, as can merely mounting a defence against a spurious claim.
Knowing the ins and outs of the rules around bankruptcy may help financial advisers in setting up an ownership structure for life insurance policies which can be more appropriate for clients who are among those at high risk of becoming bankrupt, due to the nature of their profession or business.
The good news is that according to the Australian Financial Security Authority (AFSA), the number of bankruptcies in Australia decreased by 11.4% in 2021/22 compared to 2020/21. In 2021/22, 91% of new bankruptcies were by debtors’ petition (voluntary bankruptcies), this proportion decreasing from 95% in 2020/21.
The remaining 9% of new bankruptcies in 2021/22 were by sequestration order (bankruptcies initiated by creditors). The bad news is that personal insolvency volumes (bankruptcies, debt agreements and personal insolvency agreements) are expected to revert towards levels observed in 2019 over the next 2 financial years. The Official Trustee in Bankruptcy (at AFSA) administers most new bankruptcies. Of the 5,886 new bankruptcies in 2021/22, 76% were administered by the Official Trustee and 24% were administered by registered (private) trustees.
Section 149 of the Bankruptcy Act 1966 (Cth) (Bankruptcy Act) provides that usually, in the ordinary course of events, a bankrupt is automatically discharged from bankruptcy three years after the date on which they filed their statement of affairs. This period can be extended in certain circumstances.
Section 116(1)(a) of the Bankruptcy Act states that among other things,
- “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 among the creditors of the bankrupt.”
The property or assets that the bankruptcy trustee may be able to claim and sell include real estate, vehicles, bank balances, tools and lottery winnings. A vehicle used mainly for transport and tools of trade can be kept, both up to a set amount. The trustee can also claim a portion of after-tax income earned by the bankrupt above a set threshold (currently $64,264.20, with no dependants).
The exemption for ordinary (non-super) life insurance policies
Section 116(2) of the Bankruptcy Act excludes (subject to certain provisions) 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 the bankruptcy.
There is a longstanding discrepancy between the Bankruptcy Act and Life Insurance Act as to what constitutes a policy of life insurance. This means that a life insurance policy under the Life Insurance Act may not be considered a life insurance policy under the Bankruptcy Act or at common law, and may therefore not be exempt from being property divisible amongst a bankrupt’s creditors under section 116(2).
Berryman v Zurich Australia Ltd  WASC 196
The decision by the Supreme Court of Western Australia in Berryman v Zurich Australia Ltd  WASC 196 held that a bankrupt’s entitlement to claim a TPD benefit under a life insurance policy is not an entitlement that is divisible among the bankrupt’s creditors and therefore does not vest in the Official Trustee in Bankruptcy.
Mr Berryman was a self-employed carpenter who suffered an accident at work on 7 July 2009, when a large granite rock crushed his foot. On 16 November 2009, he made a claim under his Protection Plus policy with Zurich, which commenced on 17 June 2009, for the payment of a TPD benefit of $2 million, which was subsequently declined. On 29 August 2014, Mr Berryman commenced an action for damages against Zurich for breach of contract in the sum of $2 million. He was declared bankrupt on 31 August 2015.
The judge, Justice Tottle, held that the TPD claim fell within sections 60(4) and 116(2)(g) of the Bankruptcy Act. Section 60(4) preserves the right of a bankrupt to continue with an action in respect of the rights specified in section 116(2)(g). It states:
Notwithstanding anything contained in this section, a bankrupt may continue, in his or her own name, an action commenced by him or her before he or she became a bankrupt in respect of:
(a) any personal injury or wrong done to the bankrupt, his or her spouse or de facto partner or a member of his or her family; or
(b) the death of his or her spouse or de facto partner or of a member of his or her family.
Section 116(2)(g) of the Bankruptcy Act excludes from property divisible amongst the creditors of a bankrupt:
any right of the bankrupt to recover damages or compensation:
(i) for personal injury or wrong done to the bankrupt, the spouse or de facto partner of the bankrupt or a member of the family of the bankrupt; or
(ii) in respect of the death of the spouse or de facto partner of the bankrupt or a member of the family of the bankrupt;
and any damages or compensation recovered by the bankrupt (whether before or after he or she became a bankrupt) in respect of such an injury or wrong or the death of such a person;
Justice Tottle considered that with respect to the law of bankruptcy, the TPD claim should be characterised as a claim for compensation for a personal injury or wrong which was not part of the legitimate entitlements of creditors.
Policy ownership by spouses or de facto partners
Subject to one obtaining professional legal advice, it may be worthwhile for individuals who are generally at greater risk of being sued by potential creditors to consider having their spouses or de factor partners own TPD and/or trauma policies on the lives of the persons at risk, thus ensuring that any policy proceeds would be protected, regardless of bankruptcy status. However, this ownership structure has inherent risks, for example, that in the event of a relationship breakdown, there may be issues for insured persons in lodging a claim or accessing claim payments if they are not the policy owner.
Depending on one’s circumstances, one’s life insurance policies and their proceeds may afford protection for bankrupts against claims by creditors. The timing of a life insurance claim may be crucial in ensuring that policy proceeds are received on or after the date of bankruptcy of the insured person.
Alex Koodrin, National Technical Manager
This is intended to provide general information only and the information has been prepared without taking into account any particular person’s objectives, financial situation or needs. Before acting on such information, you should consider the appropriateness of the information having regard to your personal objectives, financial situation and needs. This information does not in any way constitute tax or legal advice. You should seek independent financial advice and read the relevant Product Disclosure Statement (PDS) before making any decision about a product. While we have taken all care to ensure the information is accurate and reliable, to the extent the law permits we will not assume liability to any person for any errors or omissions however caused. The information provided in this article is current as at 30 March.