6.3 Settlement Options
Key Takeaways
- The five standard options are lump sum, interest only, fixed period, fixed amount, and life income.
- Fixed period sets the number of years (payment varies); fixed amount sets the payment (number of years varies).
- Straight life pays the largest income but stops at death; joint and survivor pays the least but covers two lives.
- Period-certain and refund options guarantee payments to heirs at the cost of a lower monthly amount.
- Interest earned on held proceeds is taxable, though the lump-sum death benefit itself is income-tax-free.
How the Death Benefit Is Paid Out
Settlement options are the methods by which an insurer pays policy proceeds to the beneficiary. The owner can select an option during life, or the beneficiary may choose at the insured's death if none was specified. These same options also apply to cash surrender values when a living owner gives up the policy. The exam tests the five standard options and which produces the largest or guaranteed-for-life income.
The Five Standard Options
- Lump sum (cash) — the entire death benefit is paid at once. This is the default and is income-tax-free to the beneficiary.
- Interest only — the insurer holds the proceeds and pays interest to the beneficiary; the principal is paid later or to a further beneficiary. Interest is taxable.
- Fixed period (period certain) — proceeds plus interest are paid in equal installments over a set number of years. The size of each payment depends on the length chosen.
- Fixed amount — the beneficiary chooses a set dollar amount per payment; the insurer pays until principal and interest are exhausted. Here the number of payments varies.
- Life income options — proceeds are converted into an annuity that pays for the beneficiary's lifetime.
Fixed Period vs. Fixed Amount — The Key Contrast
These two are easy to confuse:
| Option | What You Fix | What Varies |
|---|---|---|
| Fixed period | Number of years | Payment size |
| Fixed amount | Payment size | Number of years (until funds run out) |
Exam trap: if a question fixes the time ("paid over 10 years"), it is fixed period. If it fixes the dollar amount per check ("$1,000 per month until exhausted"), it is fixed amount.
Life Income Variations
Life income options trade longevity protection for the risk of forfeiting principal at an early death.
- Straight life income (life only) — pays for the beneficiary's life and stops at death, even if death is early. It pays the largest monthly amount because nothing is guaranteed to heirs.
- Life income with period certain — pays for life but guarantees payments for a minimum number of years (e.g., 10 or 20); if the beneficiary dies early, a contingent payee finishes the certain period.
- Life income with refund (cash or installment) — guarantees that total payments equal at least the proceeds; any unpaid balance goes to a payee.
- Joint and survivor — pays over two lives (e.g., a couple); income continues, sometimes reduced to two-thirds or one-half, until the second person dies. This pays the smallest amount because it covers two lifetimes.
Worked Numeric: Comparing Monthly Income
Assume $100,000 of proceeds for a 65-year-old beneficiary. Per-thousand monthly factors illustrate the trade-off:
| Option | Approx. monthly factor / $1,000 | Monthly income |
|---|---|---|
| Straight life | $6.00 | $600 |
| Life w/ 10-year certain | $5.60 | $560 |
| Life w/ 20-year certain | $5.00 | $500 |
| Joint & survivor (two lives) | $4.50 | $450 |
Notice income falls as guarantees rise: straight life pays the most ($600) but stops at death; joint and survivor pays least ($450) but protects two lives the longest.
Taxation and the Interest Component
The principal portion of any settlement option — the death benefit itself — is received income-tax-free by the beneficiary. However, when the insurer holds proceeds and credits interest (under interest-only, fixed-period, or fixed-amount options), that interest is taxable as ordinary income in the year credited.
Under life income options, each payment is part principal (tax-free) and part interest (taxable), similar to an annuity exclusion. Choosing a settlement option instead of a lump sum therefore creates a small annual tax cost in exchange for structured income — a trade-off the producer must explain at the point of sale.
A beneficiary wants the highest possible monthly income for life and is unconcerned about leaving anything to heirs. Which settlement option fits best?
A beneficiary elects to receive $1,000 per month until the proceeds and interest are exhausted. Which settlement option is this?
Comparing the Standard Settlement Options
Settlement options control how the death benefit is paid to a beneficiary. Know the trade-off each makes between income size and duration:
| Option | How it pays | Longevity risk |
|---|---|---|
| Lump sum | Entire benefit at once | None — beneficiary manages it |
| Interest only | Insurer holds principal, pays interest | Principal preserved |
| Fixed period | Equal payments over a set number of years | Runs out at term end |
| Fixed amount | Set dollar amount until funds exhausted | Runs out when depleted |
| Life income | Payments for the beneficiary's lifetime | Insurer bears longevity risk |
Fixed period and fixed amount are the mirror image of each other: in fixed period you choose the time and the insurer computes the payment; in fixed amount you choose the payment and the insurer computes how long it lasts.
Life Income Variations and Taxation
The life income option converts the death benefit into an annuity on the beneficiary's life. Variants adjust how much protection the beneficiary's heirs get:
- Straight life income: largest payment, but stops at death with nothing to heirs.
- Life with period certain: payments continue to a contingent payee if the beneficiary dies within the guaranteed period (e.g., 10 or 20 years).
- Life with refund: guarantees at least the principal is paid out.
- Joint and survivor: continues (often at a reduced rate) to a second person.
Tax rule: the death-benefit principal portion is income-tax-free, but any interest the insurer credits while paying installments is taxable to the beneficiary. Under interest-only and installment options, the interest earned is reported each year.