3.5 Settlement Options

What Settlement Options Do

Settlement options are the methods by which the insurer pays the death benefit (or matured endowment/cash value) to the beneficiary. Either the policyowner pre-selects an option or the beneficiary chooses at claim time. If the policyowner locks in an option in advance, the beneficiary cannot change it; if the owner leaves the choice open, the beneficiary elects at the time of claim. The exam tests the mechanics of each option, when each makes sense, and how each is taxed.

Non-Life Options

• Lump sum: the full face amount is paid immediately; this is the default and is received income-tax-free.
• Interest only: the insurer keeps the principal and pays the beneficiary interest at a guaranteed (or higher) rate; principal is paid later or to a contingent payee.
• Fixed period: the proceeds plus interest are paid out evenly over a chosen number of years; the payment amount adjusts to exhaust the fund in that time.
• Fixed amount: the beneficiary chooses a set dollar amount per period; the number of payments adjusts to whatever the fund supports.

Life Income Options

Life income options guarantee payments tied to the payee's lifespan, using mortality assumptions like an annuity.

• Straight life income: pays the largest periodic amount for the payee's lifetime, but payments stop at death with nothing to heirs - even if death occurs after a single payment.

• Life income with period certain: pays for life, but guarantees a minimum number of years (e.g., 10 or 20). If the payee dies before the period ends, a contingent payee receives the remaining guaranteed payments.

• Installment refund / cash refund: pays for life, and if the payee dies before receiving an amount equal to the proceeds, the balance is refunded - in installments (installment refund) or as a lump sum (cash refund) - to a contingent payee.

• Joint-and-survivor income: pays for two lives (e.g., spouses); payments continue, often reduced (such as two-thirds or one-half), to the survivor as long as either is alive.

How To Choose

• Need every dollar now or full control? -> Lump sum.

• Preserve principal for heirs and want flexibility? -> Interest only.

• Cover a known time horizon (e.g., until college ends)? -> Fixed period.

• Need a specific income each month until funds run out? -> Fixed amount.

• Cannot outlive the income? -> a life income option; add period certain or refund to protect against early death.

Taxation Of Settlement Options

The rule the exam loves: lump-sum death proceeds are received income-tax-free. Under any option that spreads payments over time, each payment is part principal (death benefit - tax-free) and part interest (taxable). So under interest-only, the entire payment is taxable interest; under fixed-period, fixed-amount, or life-income options, only the interest portion of each payment is taxed.

Trap: Straight life pays the most but leaves nothing to heirs; if leaving money to a contingent payee matters, choose a period-certain or refund variation, which pay a smaller periodic amount in exchange for the guarantee.

Worked Taxation Example

Suppose a $200,000 death benefit is taken under a fixed-period option paying $22,000 per year for 10 years (total $220,000). The original $200,000 of death benefit is tax-free and is spread across the payments as principal; the extra $20,000 represents interest the insurer credited and is taxable as it is paid. So roughly $2,000 of each annual payment is taxable interest and the remainder is tax-free principal. Had the beneficiary simply taken the $200,000 lump sum, none of it would be taxed - the entire amount would pass income-tax-free.

Worked Payout Example

Now compare two income elections on that same $200,000. Under straight life income, a 65-year-old payee might receive about $1,200 a month for life - the highest amount available - but if the payee dies after two years, the insurer keeps the balance and heirs get nothing. Under life income with 20-year period certain, the monthly check drops to roughly $1,050 because the insurer guarantees at least 240 payments; if the payee dies in year two, a contingent payee collects the remaining 18 years of guaranteed payments. The lower amount is the price of protecting heirs against early death.

Settlement Option At A Glance

Trap: Only the lump sum is fully income-tax-free. Every option that spreads payments includes a taxable interest component, so a beneficiary choosing income over a lump sum trades simplicity and tax-free treatment for a guaranteed stream.