Settlement and Nonforfeiture Options Worked
A life policy ends in one of two ways. Either the premiums stop and the owner takes something out, or the insured dies and the beneficiary takes the proceeds. Each ending offers a menu: nonforfeiture options for the lapsing owner, settlement options for the beneficiary. A producer who can only recite the menu cannot help a client choose. The numbers behind each option are worked below, so that you can compute a payment, compare two options and say plainly what each one gives up. Every name and dollar figure is invented for the example, including the interest rates and the policy tables, and none of them is a statutory figure.
Settlement Options at Death
What Michigan Requires of the Claim and the Table
A policy that becomes a claim by death must provide that settlement is made on receipt of due proof of death, or not later than 2 months after receipt (MCL 500.4030). The policy must also contain a table showing the amounts of the installments in which its proceeds may be payable (MCL 500.4032). That table is the working tool of this section. It is how an agent turns a face amount into a monthly check without guessing.
An insurer may hold the proceeds on terms agreed in writing with the insured or the beneficiary, and it need not segregate the money from its general assets (MCL 500.4054(1), (2)). A policy may also provide that benefits payable to a beneficiary other than the insured are not subject to the claims of that beneficiary’s creditors and cannot be transferred, commuted or encumbered (MCL 500.4054(3)). The consequence is practical. If the owner chose installments with that protective clause, the beneficiary cannot later trade the remaining payments for a lump sum, and a creditor of the beneficiary cannot reach them.
The examples assume proceeds of $100,000, a guaranteed interest rate of 3% a year (0.25% a month) and payments at the start of each month. Real policies also pay excess interest above the guarantee when the insurer’s earnings allow it. The excess is not promised, so the examples leave it out.
Interest Only
Under the interest option the insurer keeps the $100,000 and pays the interest. At 3% that is $3,000 a year, or $250 a month. The principal is untouched, so the beneficiary can ask for it later or leave it for the next generation. Nothing is being liquidated, which is the option’s point and its limit. A beneficiary who needs $1,000 a month cannot live on $250.
Fixed Period
The fixed period option fixes how long the money lasts and lets the payment fall where the arithmetic puts it. Each payment is the proceeds divided by the present value of one dollar paid monthly for the period. For 20 years (240 payments) at 0.25% a month, that divisor is 180.7617 and the payment is $100,000 divided by 180.7617, or $553.21.
| Period | Monthly payment | Total paid | Interest included |
|---|---|---|---|
| 10 years | $963.20 | $115,584.00 | $15,584.00 |
| 15 years | $688.86 | $123,994.80 | $23,994.80 |
| 20 years | $553.21 | $132,770.40 | $32,770.40 |
Totals are the payment rounded to the cent times the number of payments.
A longer period lowers each check and raises the interest the beneficiary collects, because the insurer holds more of the money for longer. If the beneficiary dies mid-period, the remaining payments go to the contingent payee named for that purpose. The period is certain; the payee’s life is not part of it.
Fixed Amount
The fixed amount option reverses the question. The beneficiary chooses the check, and the insurer works out how long it lasts. Take $800 a month. The first payment leaves $99,200, which earns a month of interest, and so on. The proceeds run out after 150 payments: 149 payments of $800 and a final one of $488.98. That is 12 years and 6 months, and the beneficiary receives $119,688.98 in all.
Raise the check to $1,200 and the proceeds last 94 payments: 93 at $1,200 and a last one of $360.26, which is 7 years and 10 months. The lower limit matters as much as the upper one. A fixed amount at or below the monthly interest ($250 here) would never exhaust the principal, and insurers set a minimum payment for that reason.
Life Income
A life income option pays for as long as a named person lives, so the insurer must price the risk that the payee lives longer than average. It does that with a mortality table, and the result appears in the policy’s installment table as a monthly payment per $1,000 of proceeds. The table for this example policy reads as follows for a payee aged 65.
| Option | Monthly payment per $1,000 |
|---|---|
| Life income only | $5.73 |
| Life income, 10 years certain | $5.52 |
| Life income, 20 years certain | $4.90 |
Ruth Alvarado, age 65, is the beneficiary of $100,000. The payment is the number of thousands times the table figure.
- Life income only: 100 times $5.73 is $573 a month.
- Ten years certain: 100 times $5.52 is $552 a month.
- Twenty years certain: 100 times $4.90 is $490 a month.
The price of each guarantee is visible in the table. Ruth gives up $21 a month, or $83 for the 20-year version, to guarantee that her payments will not stop before a set date. Suppose Ruth dies four years (48 months) after the first payment. Under the life-only option the insurer owes nothing more, and the money Ruth did not live to collect stays with the insurer. Under ten years certain, 72 payments remain, and they go to her contingent beneficiary: 72 times $552 is $39,744. Under twenty years certain, 192 payments of $490 remain, or $94,080.
The break-even is the other side of the choice. Dividing the $100,000 by $573 gives about 174.5 months, or 14.5 years, which carries Ruth to roughly age 79.5. The comparison ignores interest on the payments, so it is a rough guide rather than a result. If Ruth lives past it, the life-only income has paid out more than the lump sum, and the insurer has taken the risk that she would; if she does not, the reverse is true. Nobody knows which, which is why the choice is about what Ruth needs to be protected from. Outliving her money argues for life income. Leaving something to her family argues for a certain period.
Joint and Survivor
When two people are named as payees, the insurer can pay until the second of them dies. Ruth and her sister Inez, age 62, are named jointly as beneficiaries. The installment table pays out as follows per $1,000, with the amount stated for the case where both are alive.
| Option | Monthly payment per $1,000 |
|---|---|
| Joint and survivor, 100% to the survivor | $4.57 |
| Joint and survivor, two-thirds to the survivor | $5.15 |
| Joint and survivor, 50% to the survivor | $5.50 |
On $100,000 the payments are $457, $515 and $550 while both sisters live. At the first death the survivor receives 100%, two-thirds or half of that amount. A joint and survivor option pays less than a single life option at the same age because it pays for longer: the insurer must keep paying until the last of two lives ends. Reducing the survivor’s share raises the payment while both are alive. Whether the survivor can live on two-thirds of the income is the question to settle before the election, since an election generally cannot be changed afterward.
Taxation of Installments
Life insurance proceeds paid by reason of death are generally excluded from the beneficiary’s gross income (IRC 101(a)(1)). When the insurer instead holds the money and pays it later, the amounts held are prorated over the period of payments. The prorated part is excluded, and the rest, which is interest, is included in gross income (IRC 101(d)(1)). In the usual fixed period case, the excluded part of each payment is the proceeds divided by the number of payments.
For the 20-year fixed period, the exclusion is $100,000 divided by 240, or $416.67, in each $553.21 payment. The taxable part is $136.54 a month. Under the interest-only option the principal is not being paid out, so all of each $250 payment is interest and is taxable. For a life income option the proration runs over the period the payments are expected to last rather than a fixed number of payments. The insurer reports the split, and the producer’s job is to say that part of each payment is taxable and to refer the client to a tax adviser.
Nonforfeiture Options at Lapse
The Michigan Rule
Each life policy must contain a provision for nonforfeiture benefits and cash surrender values (MCL 500.4024). The standard nonforfeiture law sets the timing (MCL 500.4060(2)).
- After a premium default, the company must grant on proper request, made not later than 60 days after the due date of the premium in default, the paid-up benefit stipulated in the policy, effective as of that due date (MCL 500.4060(2)(a)).
- If the owner elects nothing, the benefit named in the policy takes effect (MCL 500.4060(2)(c)). The owner may elect another available option within the same 60 days.
- After premiums have been paid for at least 3 full years on ordinary insurance, the owner may instead surrender within 60 days of the due date and take a cash surrender value in place of the paid-up benefit (MCL 500.4060(2)(b)).
- Once the policy is paid up, or continued under a paid-up benefit that took effect on or after the third anniversary, the owner may surrender within 30 days after any policy anniversary for a cash surrender value (MCL 500.4060(2)(d)).
- The company must reserve the right to defer paying a cash surrender value for 6 months after demand (MCL 500.4060(2)(h)).
The sixty days run from the premium due date. The grace period gives one month of continued insurance after that date (MCL 500.4012(a)), so the election window outlasts the grace period by about a month. An owner who has missed the grace period has not yet lost the right to choose. Take a premium due March 1 and unpaid. Insurance continues through the grace month ending March 31. The 60 days after the due date end April 30, so a client who calls on April 20 can still elect reduced paid-up insurance, extended term or, after three full years, cash. A client who calls on May 2 has only the stipulated benefit. The producer’s first question on any lapse call is the due date of the missed premium, because every deadline counts from it.
Checking an insurer’s figure takes one line. Multiply any quoted paid-up amount by the table’s single premium rate and the product should equal the cash value being used. Multiply the extended term amount by the term rate for the stated duration and it should come to the same figure. A quote that fails the check is a quote to question before the client acts on it.
One Cash Value, Three Results
Priya Venkataram bought a $100,000 ordinary life policy at 35. After 10 years she stops paying. The policy’s table shows a cash value of $13,500 at the end of the tenth year, which is $135.00 per $1,000 of face amount. She is now 45. The three options spend the same $13,500 three ways.
Cash surrender pays $13,500. The coverage ends and nothing further is owed.
Reduced paid-up insurance buys a smaller whole life policy with the money as a single premium. The policy’s table gives the single premium for whole life insurance at attained age 45 as $293.55 per $1,000 of coverage. The amount of paid-up insurance is the cash value divided by that rate: $13,500 divided by $0.29355 per dollar, or $45,989. Priya owes nothing more and holds $45,989 of whole life coverage for the rest of her life. It keeps its own cash value and can be surrendered later.
Extended term insurance keeps the full $100,000 and buys as much time as the money allows. The table gives the single premium per $1,000 of term insurance at age 45 for each duration.
| Term | Single premium per $1,000 |
|---|---|
| 20 years | $58.30 |
| 25 years | $85.34 |
| 30 years | $118.93 |
| 32 years | $134.12 |
| 33 years | $142.04 |
The $13,500 buys term insurance on $100,000 at $135.00 per $1,000. That lies between 32 and 33 years, and the policy interpolates between them: the extra $0.88 is 0.11 of the $7.92 step to 33 years, and 0.11 of a year is about 41 days. The extended term runs 32 years and 41 days, to Priya’s age 77. If she dies at 60, her beneficiary collects $100,000. If she is alive at 77, the coverage has ended and there is nothing left.
| Option | Death benefit | How long | Cash left |
|---|---|---|---|
| Cash surrender | None | Ends now | $13,500 paid |
| Reduced paid-up | $45,989 | For life | Cash value continues |
| Extended term | $100,000 | 32 years and 41 days | None at the end |
Choosing
The options answer different needs. Extended term suits the insured who has a large short-lived need, such as a mortgage or children at home, and who cannot afford further premiums. Reduced paid-up suits the insured who wants something to leave at any age, such as final expenses. Cash suits the owner who no longer needs the coverage, or who needs the money, and who knows the coverage is gone. A policy states which benefit applies automatically when nothing is elected, and many name extended term; Michigan lets the policy stipulate it (MCL 500.4060(2)(a), (c)).
A Policy Loan Changes the Result
A loan reduces the cash value available. If Priya had borrowed $3,000, the value that buys either benefit is $13,500 minus $3,000, or $10,500. Reduced paid-up insurance falls to $10,500 divided by $0.29355, which is $35,769. For extended term, the same cash value buys term insurance at $105.00 per $1,000, which lies between 28 and 29 years and works out to about 28 years and 15 days. Forms differ on whether a loan shortens the extended term or reduces the amount insured, so a producer should not promise either. The policy must explain how paid-up additions and indebtedness alter the nonforfeiture values (MCL 500.4060(2)(f)).
A loan is also why a lapse can surprise an owner with a tax bill. If a policy ends with a loan outstanding, the loan is treated as an amount received, and any part above the owner’s premiums paid is taxable income.
Lesson summary
- A policy must contain a table of installment amounts, and settlement on a death claim is due on proof of death or within 2 months after it (MCL 500.4030, 500.4032).
- The insurer may hold proceeds on agreed terms, and a creditor-protection clause makes installments non-transferable to the beneficiary’s creditors (MCL 500.4054).
- The fixed period option sets the time and computes the payment. The fixed amount option sets the payment and computes the time, ending with a smaller final check.
- Life income options are priced from a table per $1,000: a certain period or a survivor share lowers the payment, and a survivor option pays less than single life because it pays longer.
- Interest in installments is taxable, and the principal part is prorated and excluded.
- The owner has 60 days from the due date to elect among nonforfeiture options, and the stipulated paid-up benefit applies if the owner elects nothing.
- Cash value after the third full year buys cash, reduced paid-up whole life or extended term at the same face amount for a computed time. A loan reduces the cash value that is available.