Life policy settlement options

Life policy settlement options

When an insured dies, the insurer owes the death proceeds. Settlement options (also called modes of settlement) are the different ways the insurer can pay those proceeds out. The same choices usually apply when a policyowner surrenders a cash-value policy or an endowment matures, but the exam focuses on death claims.

Who chooses

• The policyowner can select a settlement option while the insured is alive. The owner can also make the choice irrevocable, which stops the beneficiary from changing it. Owners do this when a beneficiary is a minor, is inexperienced with money, or needs a guaranteed income.
• The beneficiary can choose the option at the time of claim if the owner did not.
• If nobody elects an option, the insurer pays a lump sum. That is the automatic, or default, mode.

The five standard options

1. Lump sum (cash)

The entire face amount, less any outstanding policy loans and plus any dividend accumulations or paid-up additions, is paid in one payment. Life insurance death proceeds paid by reason of the insured's death are generally not taxable income to the beneficiary under federal law.

2. Interest only

The insurer keeps the principal and pays the beneficiary only the interest it earns, at no less than a guaranteed minimum rate. The principal is paid out later, for example when the beneficiary reaches a set age, or it passes to a secondary beneficiary. The beneficiary may be given limited withdrawal rights. The interest is taxable income. This option is often used to "park" proceeds temporarily.

3. Fixed period (period certain)

Principal and interest are paid out in equal installments over a chosen length of time, such as 10 years. Time is fixed; the payment amount is calculated. If the insurer credits interest above the guaranteed rate, each payment gets larger, but the period does not change. If the beneficiary dies early, the remaining installments go to a contingent beneficiary or the estate.

4. Fixed amount

The beneficiary chooses the size of each payment, such as $1,500 a month. Payments continue until the principal and interest run out. The payment amount is fixed; the length of time is calculated. Excess interest makes the payments last longer. It does not make them bigger.

5. Life income (life annuity)

The proceeds are converted into an income the beneficiary cannot outlive. The payment depends on the amount of proceeds and the beneficiary's age, and on sex where the law permits it. Variations include:

• Straight life income: the highest payment per dollar. Payments stop at the beneficiary's death and nothing is refunded.
• Life income with period certain (for example, 10 or 20 years certain): payments for life, but guaranteed for at least the certain period. If the beneficiary dies first, a contingent payee receives the rest.
• Life income with refund (cash or installment refund): payments for life, plus a guarantee that the total paid will at least equal the proceeds.
• Joint and survivor life income: payments to two payees, continuing for as long as either one lives. The survivor's share may stay the same or be reduced.

The more guarantees an option carries, the smaller each payment is.

Taxation in one line

The principal of death proceeds comes out income-tax-free. The interest the insurer earns while it holds or installs the money is taxable. Under any installment option, each payment is split into a tax-free principal part and a taxable interest part.

Protection from creditors: the spendthrift clause

Many policies include a spendthrift clause. It prevents a beneficiary from assigning or commuting installment payments not yet due, and it protects those unpaid installments from the beneficiary's creditors. It applies only to proceeds the insurer is still holding under a settlement option. A lump sum, once paid, is not protected by this clause.

Do not confuse these

Settlement options are not nonforfeiture options (cash surrender, reduced paid-up, extended term), which apply when premiums stop on a cash-value policy. They are not dividend options either. And they are not a life settlement, which is the sale of a policy by a living owner to a third-party life settlement provider for an immediate payment.