What are life insurance policy options?

Life insurance policy options are features of your life insurance policy that require you to make a choice regarding some aspect of your insurance coverage. Options permit you to make various elections that may be advantageous to you as the policyowner. There are many different types of policy options. For example, dividend options permit you, the policyowner, to share in the profits of the insurance company. Nonforfeiture options allow you to receive at least a minimum value if you surrender your life insurance policy. Settlement options allow you to elect various ways to have your life insurance death proceeds paid out to your beneficiary. There may be more contractual options available to you, depending on your life insurance company and the specific policy you own. You should consult additional resources to determine the best combination of policy provisions, options, and riders for your specific situation.

Conversion option

If your term life insurance policy contains a conversion option, it can be converted to permanent, cash value life insurance without proof of insurability. The premium on your new permanent policy may be based on your attained age or your original age. If your attained age is used, the premium on the new policy would simply be based on your age at the time of the exchange. Using your original age, your premium on the permanent policy would be calculated using your age when you initially purchased the term policy.

Tip: Using your original age will typically result in a lower premium. However, you will likely be required to pay an additional sum to make up for the lower premiums you paid on the term policy. While this may sound like a drawback, it can actually be an advantage because these additional premiums will help your cash value grow more quickly.

Caution: There may be a time limit for exercising your conversion option. The time limit is typically based on the expiration date of the original term policy. For example, you may not be able to convert during the last three years prior to the expiration of the term policy or after you reach 75 years of age.

Dividend options

Life insurance policies that pay dividends are called participating policies, while life insurance policies that don’t pay dividends are called non-participating policies. Dividends are generally refunds of your premium payments. The amount of the dividend is based on many factors. If your insurance company has good mortality rates, good returns on investments, and minimal expenses, then it may share its profits with policyowners. However, dividends are not guaranteed.

There are many ways you can receive your dividends. You will typically be asked to make a choice when you apply for insurance coverage, but most insurance companies allow you to change your mind at any time.

Caution: Dividends in excess of premium payments are generally taxable as ordinary income. Dividends paid by mutual insurance companies do not qualify for capital gains tax treatment.

Cash dividend option

If you elect the cash dividend option, the insurance company will simply issue you a check for the amount of your dividend.

Reduction of premium dividend option

You may elect to use your dividend toward your life insurance premium. This option may be used if you are having difficulty paying your premium or if you simply don’t want to have to remember to make the premium payment. Because dividends are typically small in the beginning, you will likely be able to reduce (but not eliminate) your premium payments using dividends during the first 10 or 15 years of the policy. If your dividend is not enough to cover the premium payment, you will be required to pay the difference.

Accumulation at interest option

Your dividends may be left to accumulate with your life insurance company. The insurance company will invest your dividends and add interest earnings to the amount of your dividends. You may withdraw your dividends and interest as you see fit. However, the interest you earn each year is considered taxable income. You will receive a Form 1099 from the insurance company reporting the amount of interest earned at the end of each tax year.

Paid-up additions option

You may decide to use your dividends as a premium to purchase additional permanent life insurance protection. Because this one premium payment completely covers the cost of the additional insurance, this is called the paid-up additions option. The amount of additional insurance your dividend will buy depends in part on your attained age at the time of the purchase. If you choose this option, you typically do not have to provide proof of insurability every time a dividend is declared.

One-year term dividend option

Your dividend may also be used to buy one-year term insurance, with an amount usually limited to the cash value of your permanent life insurance policy. The balance of your dividend, if any, is yours to use as you wish. You typically do not have to provide proof of insurability every time you use your dividends to purchase term insurance.

Non-forfeiture options

Many years ago, if you allowed a cash value policy to lapse, you simply forfeited the accumulated cash value. Today, almost every state has laws requiring insurance companies to make your accumulated cash value available to you if you surrender the policy or allow it to lapse for any reason. There are three different nonforfeiture or surrender options from which you may choose.

Cash surrender value

When you surrender your life insurance policy, you may choose to simply receive its accumulated cash value in a single lump sum. Surrendering your policy, however, may trigger income tax consequences if the cash value exceeds your basis in the policy.

Extended term

Under the extended term insurance option, your cash surrender value may be used to purchase term insurance coverage in an amount equal to the original policy face amount. The length of the term insurance depends on your attained age and the amount of the cash value that is applied as a premium.

Reduced paid-up insurance

If you have a continued need for life insurance protection but you don’t want to continue paying life insurance premiums, you might choose the reduced paid-up insurance option. With this option, you use the cash surrender value of your life insurance policy to buy a reduced amount of paid-up single premium insurance. The amount of paid-up life insurance protection you could purchase would depend on your attained age and the amount of cash surrender value available.

Tip: Once you purchase paid-up insurance, you’ll never have to pay another premium on the policy.

Settlement options

At one time, all death benefits were paid out as a lump-sum cash payment. Over the years, life insurance companies have developed several other methods for distributing the proceeds of a life insurance policy. These various distribution methods are called settlement options. Insurance companies are not required to offer different settlement options, but most do. However, lump-sum payments are still the most common method of payout.

You may elect a settlement option when you purchase the policy. More commonly, however, your beneficiary will choose the settlement option after your death. There are also circumstances under which the beneficiary can withdraw all or part of the principal amount of the proceeds, effectively circumventing the settlement option altogether. Settlement options can also be combined in various ways to customize the payment of life insurance proceeds to your beneficiaries.

Interest option

This option is frequently called the interest-only option. Under this option, your life insurance company holds the life insurance policy death proceeds for a period of time. The insurance company invests the proceeds on behalf of the beneficiary and makes periodic interest payments to your beneficiary. Under the interest option, the policy can be arranged so that the beneficiary is allowed to withdraw the full amount of the principal at any time. However, the policy can also specify that the beneficiary cannot withdraw any of the principal at any time, or it may restrict withdrawals until a certain number of years have passed or until the beneficiary reaches a certain age.

If the beneficiary dies without withdrawing all of the principal, the remaining money will go either to the estate of the deceased beneficiary or to your contingent beneficiary (if one was named). If a settlement option has been selected for the contingent beneficiary, the insurance company will pay out the proceeds in the designated manner. If no settlement option was selected, the contingent beneficiary can choose how the proceeds will be paid out.

Fixed amount option

Also called the installment amount option, this settlement option is actually a form of annuity. It provides that your life insurance policy death proceeds are paid out to your beneficiary in fixed, periodic installment payments when you die. The periodic payment amount is established ahead of time, but the duration of the periodic payments is not. Payments continue until both principal and interest are exhausted. You may choose to give your beneficiary withdrawal rights or the right to increase or decrease the amount of the installment payments. The fixed amount option lends itself to flexibility for your beneficiary. However, the interest portion of the payments will be considered taxable income to the beneficiary.

Fixed period option

The fixed period option is also a type of annuity. Under this option, your life insurance policy death proceeds are paid out to your beneficiary over a fixed period of time. Your beneficiary may be able to receive the death proceeds monthly, quarterly, semiannually, or annually. However, the amount of each payment is not predetermined. At your death, the payment amount will be calculated based on the principal amount of the death benefit, the interest that will accumulate, and the length of time during which payments are to be made. The payment amount will be calculated so that the principal and interest are completely depleted during the specified period. Again, the interest portion of the periodic payments will be considered taxable income to the beneficiary.

Life income option

The life income option is actually an annuity in that it provides for installment payments over the entire lifetime of the beneficiary. These payments may be made in one of four different ways:

  • Straight life income–Installment payments of a fixed, predetermined amount are made to your beneficiary during his or her life. Upon the death of the beneficiary, no further payments are made.
  • Refund annuity–A life income is paid to your beneficiary. If the beneficiary dies before the entire death benefit has been paid out, a contingent beneficiary will receive the balance of the proceeds.
  • Life income certain–A life income is paid to your beneficiary, with a guaranteed minimum number of payments. If your beneficiary dies before all the guaranteed payments have been made, a contingent beneficiary will receive the remaining payments.
  • Joint and survivor life income–Two beneficiaries receive payments during the lifetime of the first beneficiary. When one beneficiary dies, the surviving beneficiary continues to receive smaller payments (usually two-thirds or one-half of the sum of payments being made to both beneficiaries) for the rest of his or her life.

Copyright 2006-2012 Broadbridge Investor Communication Solutions, Inc. All Rights Reserved.

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About The Author

Richard Eddy

Founder of Rates4Term.com and Cona Financial Group Richard Eddy has been assisting clients with their life insurance needs since 2005. He is an expert helping people find the right policy to fit their specific situation. In addition to insurance planning, he is also experienced in a wide range of financial planning topics including investment and portfolio analysis, tax planning, retirement planning and estate preservation strategies. You can call Richard toll-free at (877) 883-3561.