4.3 Dividend Options and Settlement Options

4.3 Dividend Options and Settlement Options

Dividends are paid only on participating (par) policies, which are typically issued by mutual insurers (owned by policyholders). Stock insurers usually issue non-participating policies that pay no dividends. A dividend is the return of an insurer's divisible surplus when actual mortality, expense, and investment experience are better than the conservative assumptions built into the premium.

Because a dividend is legally treated as a return of overpaid premium, it is not taxable income. Dividends are also not guaranteed, the insurer's board declares them annually based on results, and an illustration of future dividends is only a projection. The exam expects you to know the standard dividend options and how each affects the policy's value and the owner's taxes.

Dividend Options

• Cash - the insurer mails a check. Simple, not taxable.
• Reduce premium - the dividend is applied against the next premium due.
• Accumulate at interest - the insurer holds dividends and pays interest; the interest is taxable even though the dividend is not.
• Paid-up additions (PUA) - dividends buy small single-premium amounts of permanent insurance at the insured's attained age, increasing both face amount and cash value. Frequently the most efficient use of dividends.
• One-year term (the fifth dividend option) - the dividend buys one year of term insurance, often used to cover an outstanding policy loan.

The paid-up additions option is powerful because each PUA is itself a tiny single-premium whole life policy that immediately has its own cash value and pays future dividends, compounding the policy's growth. The one-year term option (sometimes the "fifth dividend option") is often used to buy term coverage equal to the cash value so that a policy loan is fully covered if the insured dies. Selecting the right option is a suitability decision: a client needing current income picks cash; a client maximizing long-term value picks PUA.

Settlement Options

Settlement options govern how the death benefit (or surrendered cash value) is paid to the beneficiary. The default is a lump sum, which is income-tax-free to the beneficiary. Any interest earned under a deferred settlement option is taxable. The owner may pre-select an option (binding the beneficiary), or leave the choice to the beneficiary. The recognized options are:

• Interest only - the insurer holds the proceeds and pays interest; the principal stays intact for a later lump-sum or option payout.
• Fixed-period - proceeds plus interest are paid over a chosen number of years; the payment size is whatever divides the fund across that fixed time.
• Fixed-amount - a chosen dollar amount is paid each period until the proceeds and interest are exhausted; the number of payments varies.
• Life income - proceeds are annuitized over the beneficiary's lifetime. Variants: straight life (highest payment, stops at death with nothing to heirs), life with period certain, life with refund, and joint and survivor.

Worked example

A $300,000 death benefit under a fixed-period option of 10 years pays roughly $300,000 plus interest divided across 120 monthly payments, about $2,650 per month at a 3% credited rate. Under a fixed-amount option of $3,000 per month, the same proceeds simply last fewer months (about 105 months) until exhausted.

Distinguish them clearly: fixed-period locks the time and lets the payment float; fixed-amount locks the payment and lets the duration float. The life income options instead guarantee payments for life but the per-payment amount depends on the beneficiary's age and the variant chosen, straight life pays the most because it carries no guarantee to survivors.

Dividend Options in Detail

Dividends on a participating policy are a return of overcharged premium and are therefore not taxable as income (they reduce basis instead). Policyowners may elect any of five standard uses:

• Cash - a check is mailed.
• Reduce premium - the dividend is applied against the next premium due.
• Accumulate at interest - left with the insurer to earn interest; the interest (not the dividend) is taxable.
• Paid-up additions - buys small, fully paid-up chunks of additional whole life at the insured's attained age, each with its own cash value; this is the most efficient compounding choice.
• One-year term (fifth dividend option) - buys one year of term equal to the cash value.

Settlement Options for the Death Benefit

Settlement options govern how the death proceeds are paid: lump sum; interest only (insurer holds the principal, pays interest); fixed period (equal payments that exhaust principal and interest over a set number of years); fixed amount (a chosen dollar payment until funds run out); and life income (payments for the beneficiary's life, optionally with period certain or refund). In every annuitized settlement option, the portion of each payment representing earnings is taxable while the return of principal is tax-free.