6.3 Settlement Options
Key Takeaways
- Settlement options decide how the death benefit is paid out: lump sum, interest only, fixed period, fixed amount, or life income.
- Interest only pays just the earnings while the insurer holds the principal; fixed period and fixed amount liquidate principal plus interest over different variables.
- Life income options pay for the payee's lifetime; life with period certain and joint-and-survivor variations guarantee payments or extend them to a second person.
- The straight life income option pays the largest monthly check but stops at death with nothing left for heirs.
- Interest credited on settlement options is taxable income, but the death-benefit principal paid to a beneficiary is generally income-tax-free.
Settlement options are the methods by which the death benefit (or a maturing cash value) is paid out instead of, or in addition to, a single check. Either the owner selects an option in advance or the beneficiary chooses one at the time of claim. The exam expects you to match each option to how it treats principal and interest and to recognize the income trade-offs.
When the owner locks in an option before death, the beneficiary cannot change it — a useful control when the owner doubts the beneficiary's ability to manage a large lump sum. When the option is left open, the beneficiary has a facility of payment style choice at claim time. Knowing who holds the choice is a common exam distinction.
The Standard Menu
| Option | How It Pays | Principal vs. Interest |
|---|---|---|
| Lump sum | Single payment of the full benefit | Entire principal at once |
| Interest only | Insurer holds the proceeds and pays the earnings | Principal preserved, interest paid |
| Fixed period | Equal payments over a set number of years | Liquidates principal + interest; time is fixed |
| Fixed amount | A chosen dollar amount each period until funds run out | Liquidates principal + interest; amount is fixed |
| Life income | Payments for the payee's lifetime | Annuitizes the proceeds |
The lump sum is the default and is generally received income-tax-free. The other four are deferred options that let the beneficiary spread the money out.
Fixed Period vs. Fixed Amount
These two are mirror images and are a classic exam comparison.
- Fixed period: you fix the number of years; the insurer solves for the payment size. A larger benefit or a shorter period means bigger checks.
- Fixed amount: you fix the dollar amount of each payment; the insurer solves for how long the money lasts.
Worked example: A $120,000 benefit is left under a fixed-period option of 10 years. Ignoring interest, that is roughly $1,000 per month ($120,000 / 120 months); credited interest pushes it slightly higher. Under a fixed-amount option of $1,500 per month, the same $120,000 (plus interest) would instead last a little under 7 years before exhausting.
Life Income Variations
Life income options annuitize the proceeds and pay for as long as the payee lives. They differ in what protection they add against an early death of the payee.
| Variation | Description | Payment Size |
|---|---|---|
| Straight life income | Pays for life; nothing remains at death | Largest monthly check |
| Life income with period certain | Pays for life but guarantees payments for, say, 10 or 20 years to a beneficiary | Smaller than straight life |
| Life income with refund (cash/installment) | Guarantees at least the principal is returned | Smaller still |
| Joint and survivor | Pays over two lives; continues (often at 50%-100%) to the survivor | Smallest, spread over two lifetimes |
Exam trap: Straight life maximizes the monthly income precisely because it provides no guarantee to heirs — if the payee dies after one payment, the insurer keeps the balance. Adding any guarantee (period certain, refund, or a second life) lowers each payment.
Taxation of Settlement Options
The principal portion of the death benefit is generally income-tax-free to the beneficiary. However, when the insurer holds the money and credits interest under any of the deferred options (interest only, fixed period, fixed amount, life income), that interest is taxable as ordinary income in the year it is credited.
- Under interest only, every payment is taxable interest because principal is untouched.
- Under fixed period and fixed amount, each payment is part tax-free principal and part taxable interest.
- Under life income, an exclusion-ratio approach treats part of each payment as a tax-free return of principal and part as taxable interest until the principal is recovered.
This is why a beneficiary who needs all the cash and wants no tax usually takes the lump sum, while one who wants spread-out, partly guaranteed income chooses a life income or fixed option.
Worked exclusion-ratio example: A $100,000 benefit is annuitized under a life income option with an expected return of $160,000 over the payee's life expectancy. The exclusion ratio is $100,000 / $160,000 = 62.5%. Of each payment, 62.5% is a tax-free return of principal and 37.5% is taxable interest, until the full $100,000 of principal has been recovered.
A beneficiary wants the largest possible guaranteed-for-life monthly check and is not concerned about leaving anything to heirs. Which settlement option fits best?
Under the fixed-amount settlement option, which variable does the beneficiary fix and which does the insurer determine?
Interest-Only and Life Income Compared
| Option | Principal | Income Length | Risk to Beneficiary |
|---|---|---|---|
| Interest only | Stays with insurer | Until withdrawn | Lowest; principal preserved |
| Fixed period | Liquidated over set years | Set number of years | Outlives the period |
| Fixed amount | Liquidated by chosen amount | Until funds exhausted | Outlives the funds |
| Life income | Annuitized on the beneficiary | For life | None (cannot outlive it) |
Under interest only, the insurer holds the proceeds and pays only the interest, preserving principal for a later need. Life income converts proceeds into payments the beneficiary cannot outlive but stops at death unless a period-certain or refund feature is added.
A beneficiary wants payments that are guaranteed to continue for as long as she lives, no matter how long that is. Which settlement option fits?
Taxation of Settlement Options
Life insurance death proceeds are income-tax-free, but when proceeds are paid over time, the interest the insurer credits is taxable to the beneficiary as it is received the original death benefit (principal) remains tax-free.
Under a lump sum, the entire amount is tax-free. Under interest-only or installment options, each payment is part tax-free principal and part taxable interest. With a life income option, an exclusion-ratio-like split applies, treating the return of principal as tax-free and the interest as taxable.
Exam Tip: Death benefit = tax-free; interest earned on deferred payouts = taxable. A lump-sum payout avoids the taxable-interest issue entirely.