STUDY Chapter 5) Settlement options

Living Benefits

Aside from nonforfeiture options, which will be discussed in the next module, living benefits are options for using cash value in a life insurance policy.

Life Settlement

Life settlements work the same way as viatical settlements, in that a life insurance policy is sold to a third party in exchange for a large portion of the death benefit, except that the insured is not terminally or chronically ill.

Installment Refund

Refund life annuity in which the beneficiary receives the balance of premium minus benefits paid in installments.

Period Certain

Duration of time that annuity payments are guaranteed to be paid. Typically 5, 10, or 15 years.

Joint and Survivor

Life income settlement option which allows two or more individuals to receive income payments for their entire lives.

Annuities

A contract which protects against the risk or living longer than expected. Annuities provide a guaranteed life income to protect against the risk of depleting retirement funds.

Lump Sum; -Not taxable to beneficiary -Lump Sum = No Tax -Lump sum distribution is not taxed.

Cash payment, or lump sum payment, of the policy proceeds is still prevalent today. If the policyowner does not choose a settlement option for the beneficiary, the policy proceeds default to payment in lump sum. In this case, the beneficiary is permitted to choose a settlement option upon the insured's death. If the policyowner does select a settlement option, it cannot be changed.

All of the following is true regarding lump-sum payment of life insurance policy proceeds, EXCEPT: Select one: a. Distribution is taxed. b. Distribution is not taxed. c. The policyowner has the right to select the settlement option. d. Cash payment, or lump-sum payment, is still a common way of receiving life insurance policy proceeds.

Life insurance proceeds received in a lump-sum distribution are not taxed. The correct answer is: Distribution is taxed.

Indemnity

Means "to make whole". Insurance policies agree to provide payment of benefits to restore the insured's economic loss.

Transfer for Value Rule

The exceptions to this rule are: -Transfers to the insured, -Transfers to a business partner of the insured, or -Transfers to a corporation in which the insured is a stockholder or officer.

Straight Life

The most common type of whole life insurance sold. Coverage has a level face amount and level premiums payable over the entire life of the insured. Synonymous with continuous premium and ordinary life.

Policy Proceeds Paid Upon the Insured's Death

With the interest-only life insurance settlement option, installment payments are taxable because they are 100% interest earned on the principal, but the principal when paid out in a lump sum is not taxable.

Tax Treatment of Proceeds;

-Generally, life insurance benefits paid to a beneficiary are tax-free. -However, interest earned on reinvested policy proceeds is subject to tax, because installment payments contain interest, which is taxable. -Likewise, dividends are not taxable because they are a return of overcharged premium; however, if the dividend is reinvested with the insurer, any growth earned on the dividend (interest) is taxable.

Examples of terminal and chronic illnesses are cancer and AIDS.

-Is unable to perform at least two activities of daily living without assistance, -Has a disability, or -Is cognitively impaired and requires supervision to ensure health and safety.

Fixed-period Installments or Period Certain; -Fixed-period Installments use Annuities. -The amount of each installment is based on: +The length of the period, +The amount of the policy proceeds, and +The interest rate. -Depletes funds over a fixed period Example: $100,000 10 years= $10,000 20 years= $5,000/year

-Longer payment periods result in lower payments. -Income is guaranteed for the entire period specified, so if the recipient dies before the period ends, then a contingent beneficiary would continue to receive payments until the period lapses. -Fixed-period Installments use Annuities.

Life income

-There is some risk inherent in the life income option. -If the beneficiary lives well beyond their expected lifespan, the insurer must pay out-of-pocket after the principal has been depleted. -However, if the beneficiary dies earlier than expected, the balance of the principal is forfeited to the insurer.

Policy Proceeds Paid Upon the Insured's Death

-Policy proceeds that are reinvested and paid out to the beneficiary as an installment are subject to federal income tax, only up to the amount of each benefit that is interest (annuity rule - the portion of proceeds that formed the principal are not taxable, but the portion of proceeds that form interest are taxable).

Interest Only; -Temporary option until proceeds are paid out using one of the other settlement options.

-Sometimes the policyowner will specify the beneficiary's right of withdrawal of the principal, such as after a certain number of years or upon a certain age. -If the beneficiary dies before the funds are depleted, then a contingent beneficiary will receive payments.

Accelerated Benefits; The Health Insurance Portability and Accountability Act (HIPAA) of 1996 requires that proceeds from accelerated benefits are exempt from federal income tax.

Accelerated benefits allow policyowners to use their policy's death benefits tax-free while they are still alive, or if they are terminally or chronically ill. A terminally ill person must be expected to die within two years.

Life Income

-Because of the risk involved with the life income option, insurers provide additional options to ensure that part or all of the policy proceeds are disbursed. -These additional guarantees lower the amount of the payments.

Transfer for Value Rule

-If a life insurance policy is assigned for valuable consideration and the insured under the life insurance policy dies, the new owner of the policy will be responsible for paying taxes on the amount of proceeds paid (including premiums that were paid by the original owner) that exceed the valuable consideration.

Interest Only; -Temporary option until proceeds are paid out using one of the other settlement options.

-In many cases, the interest only option is used in tandem with other settlement options, especially in situations where more than one person is receiving payments from the policy proceeds.

Policy Proceeds Paid Upon the Insured's Death

-Lump sum proceeds paid to a beneficiary are exempt from federal income tax. If the policy contains a double indemnity rider or paid-up additions, those policy proceeds are also exempt.

1035 Policy Exchanges; -The gains on exchanges of life insurance policies, endowments, or annuities are, in most cases, subject to taxation.

-Section 1035 of the Internal Revenue Code allows for certain exchanges without recognizing a gain or loss for tax purposes. The following exchanges may occur without tax consequences: -Life insurance policies may be exchanged for another life insurance policy or endowment. -Endowments may be exchanged for another endowment. -Annuities may be exchanged for another annuity.

Interest Only; -Temporary option until proceeds are paid out using one of the other settlement options.

-The insurer retains the policy proceeds, which become the principal, and pays out only the growth on the principal to the beneficiary on a scheduled basis, such as monthly or annually. -The principal is paid out in cash or via another settlement option at some point in the future. -A minimum guaranteed interest rate is quoted to the beneficiary.

Viatical Settlement

When a terminally or chronically ill insured sells his life insurance policy to a third party in exchange for payment of a large portion of the death benefit.

Viatical Settlements; -Viatical settlements are completely separate from life insurance contracts. -HIPAA requires that proceeds from a viatical settlement are exempt from federal income tax.

-A terminally or chronically ill insured can sell their life insurance policy to a third party in exchange for payment of a large portion of the death benefit. -The insured may receive anywhere from 50% - 80% of the death benefit. -This may be a feasible option for insureds that need a large sum of money to pay medical bills prior to death.

There are five settlement options:

-Lump sum -Interest only -Fixed-period installments -Fixed-amount installments -Life income

Fixed-amount Installments; -Pays fixed amount until proceeds are exhausted. Example: $100,000 $5,000/year= 20 years $10,000/year= 10 years $20,000/year= 5 years -The length of time installments will be paid is based on: +The amount of the policy proceeds, +The amount of each payment, and +The interest rate.

-The fixed-amount installment option uses an annuity to pay the policy proceeds, but the payment amount is specified instead of the period of time. -Payments consist of principal and interest and are paid until the principal and interest reach zero.

Fixed-amount Installments; -Pays fixed amount until proceeds are exhausted. Example: $100,000 $5,000/year= 20 years $10,000/year= 10 years $20,000/year= 5 years -The length of time installments will be paid is based on: +The amount of the policy proceeds, +The amount of each payment, and +The interest rate.

-The larger the payment amount, the shorter time period payments will be received -More favorable interest rates will lengthen the payout period. -This settlement option guarantees that the entire amount of the policy proceeds will be paid out. -If the beneficiary dies before the balance reaches zero, then a contingent beneficiary will receive the remaining payments.

Endowment

An endowment policy is a whole life policy that will pay the face amount under one of two situations: 1.) if the insured is alive at the contract maturity date, or 2.) if the insured dies during the policy period. The policy cash value must equal the face amount by the end of the policy period.

Settlement options are the ways, other than lump sum, that life insurance policy proceeds are paid out to beneficiaries upon the insured's death or when the policy endows.

Before life insurance settlement options were introduced, the only payout method available was one lump sum cash payment. While still available, the lump sum payout may not be the best way to distribute policy proceeds, especially if the beneficiary does not manage money well.

Who may choose the settlement option for a life insurance policy? Select one: a. The insurer b. The policyowner c. The beneficiary d. The policyowner and the beneficiary

The policyowner chooses the settlement option. If the policyowner has not chosen a settlement option, the beneficiary may select the settlement option. The correct answer is: The policyowner and the beneficiary

Settlement Options

The ways, other than lump-sum, that life insurance policy proceeds are paid out to beneficiaries upon the insured's death or when the policy endows.

Life income

There are several versions of the life income option including the following. These will be discussed in greater depth in the annuities chapter. -Cash refund -Installment refund -Straight life -Life with period certain -Period certain -Joint and survivor

Insured's Estate

Upon the insured's death, life insurance and any accumulated dividends are includable in the insured's gross estate for federal estate tax purposes.

Cash Refund

Refund life annuity payout option in which the beneficiary receives the balance of premiums plus interest minus benefits paid in a lump-sum.

The introduction of settlement options made additional methods available for disbursing policy proceeds other than lump sum.

Settlement options allow the policy proceeds to be retained by the insurer and paid out gradually. Because the policy proceeds are reinvested, they earn interest, and the interest portion of payments is taxable.

Life Income Settlement Option

-Life insurance settlement option in which an annuity is used to pay the policy proceeds. -The beneficiary is provided a stream of income that cannot be outlived.

Fixed-period Installments or Period Certain; -Fixed-period Installments use Annuities. -The amount of each installment is based on: +The length of the period, +The amount of the policy proceeds, and +The interest rate. -Depletes funds over a fixed period Example: $100,000 10 years= $10,000 20 years= $5,000/year

-The fixed-period or period certain, installment option use an annuity to pay the policy proceeds to the beneficiary for a certain number of years. -Payments consist of principal and interest, and the principal reduces to zero by the end of the period.

Life Income

-The life income settlement option uses an annuity to pay the policy proceeds. -The beneficiary is provided with income that cannot be outlived; income is guaranteed for the beneficiary's entire life. -The amount of each payment depends on: -The beneficiary's life expectancy (age and gender), -The amount of the policy proceeds, -The interest rate, and -Any payout guarantees.

Policy Proceeds Paid While the Insured is Alive; -However, for chronically ill insureds there is a maximum amount, indexed annually, that may be tax-sheltered for an accelerated benefit.

-When a life insurance policy is surrendered for its cash value, taxes apply to any portion of the proceeds that exceed the cost basis. -Policy proceeds received as an accelerated death benefit or viatical settlement for chronically or terminally ill insureds are not subject to federal income tax.