4.6 Life Policy Options
Life Policy Settlement Options
Characteristics
Life insurance death benefits are typically paid as a lump sum unless an alternative settlement option has been selected. A settlement option instructs the insurance company on how the death benefit should be distributed to the beneficiary.
Settlement options provide alternatives to receiving the full death benefit or living benefit at one time when the policy matures or upon the insured's death. The policyowner may select a settlement option while the insured is living. If no option has been chosen, the beneficiary may select one after the insured's death. However, if the policyowner has already designated a settlement option, the beneficiary generally cannot change that election.
The principal portion of life insurance proceeds paid after the insured's death is generally not taxable as income. However, any interest earned under a settlement option is considered ordinary taxable income. When the benefit is paid as a lump sum, the entire amount is typically income tax free.
- Settlement options include:
- Interest Only: Under this settlement option, the death benefit remains with the insurer while the beneficiary receives periodic interest payments, typically paid at least annually or more frequently. The principal amount remains intact and does not decrease. The interest payments received by the beneficiary are taxable as ordinary income. This arrangement is often referred to as capital conservation, since the principal (capital) remains on deposit with the insurer and continues to earn interest. When this option is selected, the policyowner or beneficiary must instruct the insurer regarding when the principal amount will eventually be distributed.
- Fixed Amount: Under this settlement option, the beneficiary receives payments of a predetermined dollar amount at regular intervals, typically monthly, until the death benefit and any accumulated interest are fully paid out. The interest earned on the remaining balance may extend the length of time the payments continue. Only the portion of each payment that represents interest is taxable as income.
- Fixed Period: Under this settlement option, payments are made for a predetermined period of time, such as 10 or 20 years, after which the payments stop. Both the policy proceeds and the interest earned are used to fund the payments. The interest earned may increase the amount of each payment, and the interest portion of the payments is taxable as income.
- Life Income Option: Under this settlement option, the insurer uses the death benefit to purchase an annuity for the beneficiary. This annuity provides periodic income payments for the beneficiary's lifetime. As with other settlement options, any interest portion of the payments received is taxed as ordinary income. Several variations of the life income option are also available:
- Straight Life (Pure Life or Life Income Only): This option provides periodic payments that are guaranteed for the lifetime of the beneficiary. Payments continue as long as the recipient is alive and stop upon the recipient's death. The amount of each payment is determined based on factors such as the recipient's age and gender. This is considered a single-life option, since payments are made only to the original recipient and no further benefits are payable to others after the recipient's death.
- Life Income Period Certain: This option provides payments that are guaranteed for the lifetime of the beneficiary or for a specified period of time, whichever is longer. If the beneficiary dies before the end of the guaranteed period, the remaining payments continue to a designated individual until the end of that period.
- Life Refund: Under this option, payments are made to the beneficiary for the duration of their lifetime. If the beneficiary dies before receiving payments equal to the total death benefit, the remaining balance is refunded to a designated beneficiary. The refund may be paid as a lump sum (Cash Refund) or as installment payments (Installment Refund).
- Joint and Survivor Income Option: This settlement option provides periodic payments for the lifetimes of two or more recipients. When the first recipient dies, payments continue to the surviving recipient(s) for the remainder of their lifetime. The amount paid to the survivor may remain at the full amount (100%) of the original payment or may be reduced to a specified percentage, such as two-thirds or one-half of the original payment. Depending on the percentage selected, this option may be referred to as Joint and Full Survivor, Joint and Two-Thirds (2/3) Survivor, or Joint and One-Half (1/2) Survivor.
- Joint Life Income Option: This settlement option provides periodic payments to two or more recipients. Payments continue only while all recipients are living and cease upon the death of the first recipient.
Nonforfeiture Options (Guaranteed Values)
Characteristics
These options are available in life insurance policies that accumulate cash value and are designed to protect the policyowner from a total loss of benefits if the policy lapses due to nonpayment of premiums or is voluntarily surrendered.
Cash value policies typically provide three nonforfeiture options, which offer flexibility in how the accumulated value of the policy may be used if coverage is discontinued.
- Cash Surrender: When a policy is surrendered to the insurer, the policyowner receives the policy's cash surrender value, minus any outstanding policy loans and accrued interest. Any amount received that exceeds the total premiums paid into the policy may be subject to taxation as ordinary income. Once this option is exercised, the policy terminates and the insured no longer has life insurance coverage.
- Reduced Paid-Up: Under this option, the policy's existing cash value is used as a single premium to purchase a fully paid-up permanent life insurance policy with a reduced face amount. No additional premiums are required. Although the death benefit is lower than the original policy amount, coverage continues for the life of the insured, typically to age 100. Among the nonforfeiture options, this choice provides the longest period of continued insurance protection.
- Extended Term: Under this option, the policy's current cash value is used as a single premium to purchase term insurance with the same face amount as the original policy. The coverage continues for as long a period as the available cash value will support, typically expressed in years and days. This option provides the maximum death benefit among the nonforfeiture options and is often considered the automatic or default option if the policyowner does not select another option. When this option is chosen, the policyowner no longer has access to the cash value, and the coverage will expire at the end of the term, which is generally before age 100.
| Male, Age 22 | $50,000 Whole Life Paid Up at Age 90 – Table of Guaranteed Values | $636/yr |
|---|
| End of Policy Year | Cash Value | Paid Up Insurance | Extended Term Insurance (Years) | Extended Term Insurance (Days) |
|---|---|---|---|---|
| 1 | $0 | $0 | 0 | 0 |
| 2 | $289 | $2,050 | 2 | 163 |
| 3 | $597 | $4,100 | 5 | 226 |
| 4 | $925 | $6,100 | 9 | 133 |
| 5 | $1,274 | $8,000 | 13 | 55 |
| 6 | $1,643 | $9,900 | 16 | 334 |
| 7 | $2,043 | $11,700 | 20 | 66 |
| 8 | $2,446 | $13,450 | 22 | 259 |
| 9 | $2,886 | $15,150 | 24 | 231 |
| 10 | $3,339 | $16,800 | 26 | 39 |
| Male, Age 22 | $50,000 Whole Life Paid Up at Age 90 – Table of Guaranteed Values | $636/yr |
|---|
| End of Policy Year | Cash Value | Paid Up Insurance | Extended Term Insurance (Years) | Extended Term Insurance (Days) |
|---|---|---|---|---|
| 11 | $3,820 | $18,350 | 27 | 99 |
| 12 | $4,325 | $19,800 | 28 | 70 |
| 13 | $4,854 | $21,200 | 28 | 328 |
| 14 | $5,405 | $22,550 | 29 | 155 |
| 15 | $5,988 | $23,850 | 29 | 295 |
| 16 | $6,594 | $25,100 | 30 | 27 |
| 17 | $7,227 | $26,250 | 30 | 89 |
| 18 | $7,888 | $27,350 | 30 | 125 |
| 19 | $8,576 | $28,400 | 30 | 126 |
| 20 | $9,294 | $29,350 | 30 | 124 |
| Age 60 | $22,255 | $41,700 | 23 | 200 |
| Age 65 | $26,935 | $43,750 | 21 | 12 |
| Age 70 | $30,522 | $45,400 | 18 | 185 |
Dividend Options
Characteristics
Dividends reflect the favorable operating experience of an insurer and may result from higher-than-expected investment earnings, lower mortality costs, or reduced administrative expenses.
Dividends are available only on participating policies, which are typically issued by mutual insurance companies. When declared, dividends are generally paid annually; however, they are not guaranteed.
Because dividends are considered a return of excess premium paid, they are not taxable as income until the total dividends received exceed the total premiums paid into the policy. Once dividends exceed the total premiums paid, any additional amount is taxable as ordinary income. Additionally, any interest earned on accumulated dividends is taxable as ordinary income.
The policyowner selects the dividend option to be applied and may change that option at any time. If dividends are applied to an option other than cash and all accumulated dividends are later withdrawn, the selected dividend option will resume when the next dividend is declared.
Dividend Options Available
Cash: The policyowner receives the declared dividend as a cash payment, typically issued by check on or near the policy anniversary date.
Premium Reduction: The dividend is applied toward the next premium due. This reduces the out-of-pocket premium payment required from the policyowner. If the dividend equals or exceeds the premium due, the premium payment may be fully covered. Accumulate at Interest – The insurer retains the dividends in an account and credits interest on the accumulated balance. The interest is generally compounded annually.
Paid-Up Additions: Dividends are used to purchase additional single-premium permanent life insurance based on the insured's attained age. This additional coverage increases the policy's death benefit and also generates its own cash value and potential dividends.
One-Year Term: Dividends are used to purchase a one-year term insurance benefit. The cost of the coverage is based on the insured's attained age. This option is sometimes referred to as the fifth dividend option.
Paid-Up Option: Dividends are applied to help pay off the policy sooner than originally scheduled. If the insurer's overall performance declines and dividends are reduced, the policyowner may need to resume premium payments.
Quiz
1. Which statement correctly describes the tax treatment of life insurance settlement options?
A. All payments received under a settlement option are tax free
B. The principal portion is tax free, but interest received is taxable as ordinary income
C. Both principal and interest are taxable
D. Lump-sum payments are taxable as ordinary income
Correct Answer: B
Rationale: The principal portion of life insurance proceeds is generally not taxable. However, any interest earned when the proceeds are left with the insurer under a settlement option is taxed as ordinary income.
2. Which settlement option allows the death benefit to remain with the insurer while only the interest is paid to the beneficiary?
A. Fixed Amount
B. Fixed Period
C. Interest Only
D. Life Refund
Correct Answer: C
Rationale: Under the Interest Only option, the death benefit remains with the insurer and the beneficiary receives periodic interest payments. The principal is preserved, which is why this option is often referred to as capital conservation.
3. Which nonforfeiture option provides the largest death benefit but only for a limited period of time?
A. Cash Surrender
B. Reduced Paid-Up
C. Extended Term
D. Paid-Up Additions
Correct Answer: C
Rationale: The Extended Term option uses the policy’s cash value to purchase term insurance equal to the original face amount. While it provides the maximum death benefit, coverage lasts only for the term that the cash value can purchase.
4. Which dividend option uses dividends to purchase additional permanent life insurance coverage?
A. Cash
B. Paid-Up Additions
C. Accumulate at Interest
D. Premium Reduction
Correct Answer: B
Rationale: Paid-Up Additions use dividends to buy additional single-premium permanent insurance. These additions increase the policy’s death benefit and also accumulate their own cash value and potential dividends.
5. Which settlement option guarantees payments for the lifetime of two individuals and continues payments to the surviving recipient after the first dies?
A. Joint Life Income
B. Straight Life
C. Joint and Survivor Income
D. Life Income Period Certain
Correct Answer: C
Rationale: The Joint and Survivor Income Option provides payments for the lifetime of two or more individuals. After the first recipient dies, payments continue to the surviving individual, often at 100%, 2/3, or 1/2 of the original payment amount.