4.3 Dividend Options and Settlement Options

Dividend Options (Participating Policies)

A participating policy issued by a mutual insurer, or a participating policy of a stock insurer, may pay policy dividends. A dividend is a return of the divisible surplus when actual mortality, expense, and investment results are better than the conservative assumptions used to set the premium.

Because dividends are treated as a return of overpaid premium, they are not taxable as income unless cumulative dividends exceed total premiums paid. Dividends are never guaranteed; an illustration may project them, but the insurer makes no promise. The exam will reward you for knowing both points.

Understand why dividends arise. A participating policy is priced with deliberately conservative assumptions: high projected mortality, high expenses, and a low assumed interest rate. When the insurer's real experience beats those assumptions, the excess is the divisible surplus, and the board of directors may declare a dividend from it. Nonparticipating policies, common with stock insurers, are priced at a lower fixed premium and pay no dividends, so the owner gives up the upside of favorable experience in exchange for a guaranteed lower cost.

The Standard Dividend Options

Policyowners choose how dividends are applied. The common options are:

• Cash - the insurer mails a check.
• Reduce premium - the dividend is applied against the next premium due.
• Accumulate at interest - dividends are left on deposit and earn interest (the interest is taxable, the dividends are not).
• Paid-up additions (PUA) - dividends buy small, single-premium amounts of fully paid-up permanent insurance at the insured's attained age.
• One-year term (the fifth dividend option) - dividends buy one-year term insurance, often up to the policy's cash value, useful to protect a loan.

Tested traps: dividends are not interest, and they are not guaranteed even though illustrations may project them. Paid-up additions are the most efficient way to grow the death benefit and cash value because each addition is purchased at net single-premium rates with no new underwriting, and each addition itself earns future dividends.

When dividends accumulate at interest, only the interest portion is reportable as taxable income; the dividend deposits themselves remain a non-taxable return of premium. A paid-up option lets dividends accumulate until the policy can be declared paid up early.

Settlement Options

Settlement options govern how the death benefit, a matured endowment, or a surrender value is paid out instead of as a single lump sum. The policyowner can lock in a method, or can leave the choice open so the beneficiary selects it at the time of claim.

These options spread payments over time and usually credit interest, so a portion of each non-lump-sum payment can be taxable to the payee even though the underlying death benefit principal is income-tax-free.

Settlement options exist to protect beneficiaries who might mishandle a large lump sum, to provide guaranteed income, or to time payments for a specific need such as a college fund. When the owner selects and locks an option during life, the beneficiary cannot change it; this is how an owner can control proceeds from beyond the grave. When the owner leaves the option open, the beneficiary chooses at claim time. Pairing a settlement option with a spendthrift clause shields the held proceeds from the beneficiary's creditors until each payment is actually made.

The Five Settlement Options

Worked Example: Fixed Period vs. Fixed Amount

A beneficiary receives a $120,000 death benefit. Under a fixed-period option of 10 years, she might receive about $1,100 per month, with principal plus interest spread evenly over 120 payments. The duration is fixed; the payment size is whatever the math produces.

Under a fixed-amount option she could instead choose $1,500 per month; the proceeds plus interest then last until depleted, roughly 7 years and a few months. The trade-off is duration certainty (fixed period) versus payment-size certainty (fixed amount). Life-income options trade away principal certainty for a guaranteed income the payee cannot outlive.

Variations of the Life Income Option

Life income comes in several forms that change what happens if the payee dies early. A straight life income pays the most per dollar but stops at death, even if only one payment was made; the insurer keeps the balance. A life income with period certain guarantees payments for a minimum number of years (for example, 10 or 20) to a contingent payee if the primary payee dies within that period.

A life income with refund (cash or installment) guarantees that total payments at least equal the proceeds applied; any shortfall is refunded to a beneficiary. A joint and survivor option, common with annuities, continues income (often reduced to two-thirds or one-half) to a surviving second payee. The more guarantees attached, the smaller each periodic payment, because the insurer assumes less mortality risk.