How Do Life Insurance Payouts Work?

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Americans have invested heavily in life insurance policies of all types. Term insurance, convertible term life and cash value policies of every variety have trillions of dollars stored up in them, and together they constitute one of the economic backbones of the United States. And why is this? To get the death benefit payout, of course. The whole point of having life insurance is to protect your heirs, leave a legacy for your beneficiaries and provide peace of mind.

Of course, many people also buy permanent life insurance in order to build up the cash value in the policy so that they can use it at some point in the future. But how can you access this money? What’s the procedure for receiving the death benefit once the insured has passed away? Here are the answers.

How life insurance payouts work

Life insurance can be paid out in several different ways: single lump-sum payment, annual payments, annuity payments, and accelerated death benefits.

Single lump-sum payment

By far, the most common way that the face value of the policy is paid out is as a single lump-sum payout. This means that the beneficiary or beneficiaries will get all of the money immediately.

Annual payments

Another way that life insurance policies can pay out is with a series of annual payments that last for a certain period of time, such as five or ten years. Interest is generally paid on the amount that remains with the life insurance company until the full face amount, or death benefit, has been paid out.

And while the face amount of the life insurance benefit is nontaxable, the interest income that is earned on the unpaid amount is counted as taxable income. This means that you will pay tax on this interest at your top marginal tax rate.

Annuity payments

Some life insurance policies also allow the face amount to be paid as an annuity over the remaining life expectancy of the beneficiary. An annuity is a series of payments that are designed to last for the lifetime of the recipient.

This can give the beneficiary some time to mature and be better able to handle their benefit more wisely. Or it could be paid in installment payments over a long period of time, such as 50 years, depending upon the age of the beneficiary. There can also be a period certain if the insured chooses this option. Or payments can be made for the rest of your life if you choose a straight life option. This alternative is similar to Social Security.

Accelerated death benefits

Many life insurance policies today also offer accelerated death benefit riders that allow the insured to access some or all of the death benefit while they are still living. Riders are additional features added to a life insurance policy that provide additional benefits, often at an additional cost.

Riders are generally activated when the insured becomes permanently unable to perform at least two of the activities of daily living (ADLs). The six activities of daily living are:

  • Toileting
  • Eating
  • Bathing
  • Dressing
  • Transferring (from a chair to a bed, etc.)
  • Continence.

There are accelerated death benefit riders for long-term care, disability, and chronic or critical illnesses. In some cases, a medical exam may be required to qualify for these benefits. It all depends upon what the original application dictates.

Accelerated death benefit riders are rapidly gaining in popularity because unlike traditional long-term care policies, somebody is guaranteed a benefit when a long-term care accelerated benefit rider is attached to a life insurance policy.

If the insured never needs to use the rider, then they can access the cash value in the policy for any reason. If they do not do that, then the beneficiaries will get the entire death benefit.

With a traditional long-term care policy, if you end up not needing any form of care, then you’re out that money that you paid into the policy. And accelerated benefit payouts are always tax-free, just like the death benefit.

Parties involved in paying out a life insurance policy

Life insurance generally has two or three separate parties involved in a given policy, broken down as follows:

1. Policy owner

The owner of the policy is the party responsible for paying the life insurance premiums and keeping the policy in force. The owner has the power to change the beneficiary or modify the policy in other respects as the rules allow. The owner can access the cash value in the policy if any type of permanent insurance is used.

2. The insured

The insured is the person whose death will trigger payment of the death benefit. The insured must be a human being and cannot be a trust, corporation, or partnership because those entities have no life expectancy, and that is necessary in order for the life insurance company to calculate the amount of the premiums that will be required.

In many cases, the owner (policyholder)  and the insured are the same person. There can also be more than one insured on a policy, such as a married couple. The policy would then pay out when the second person passes away.

3. Life Insurance beneficiary

This is the party that will receive the death benefit once the insured passes away. It can be a natural person or a business or nonprofit entity, and there can be more than one beneficiary.

Most policies allow the owner to name the primary and secondary beneficiaries along with contingent beneficiaries and co-beneficiaries, where two parties each receive a portion of the death benefit at the same time. The primary beneficiary of a life insurance policy is responsible for reporting the death of the insured to the life insurance company.

4. Death benefit

The death benefit is the face amount of the insurance policy; they are one and the same thing. The larger the death benefit, the greater the cost of the policy. As mentioned previously, the death benefit is the main reason why most people buy life insurance.

The death benefit is always tax-free to the beneficiaries, except in rare instances where a corporation owns the policy and deducts the cost of the premiums as they were made. But any death benefit that is paid to a beneficiary where a natural person was the owner is never reported on the beneficiary’s income tax return.

Three generations of a family celebrating after grandparents receive their lump-sum life insurance payout.

For large policies, some life insurers will give the beneficiary a checkbook or even a credit card that they can use to spend the death benefit. The cash that is retained in the meantime by the life insurance carrier will earn taxable interest.

The death benefit can also increase beyond the face amount that was purchased in some circumstances. For example, someone who dies in an accident can trigger an accidental death benefit that is twice the amount of the original face value of the policy.

5. Life insurance company

A life insurance company can be viewed as a fourth party involved in any life insurance policy. It is the financial institution that issues and underwrites the policy and collects the premiums that are paid to keep the policy in force. It also pays the death benefit to the beneficiaries upon the death of the insured. There is also a contestability period during which the insurer can investigate and/or deny claims based on their findings.

Life insurance companies are rated according to their financial strength, with the most stable carriers getting the highest ratings. Life insurance companies are always required to have a certain amount of cash reserves on hand. They also calculate the amount of the premium payments based on the life expectancy of the insured using their actuarial tables.

Types of life insurance

The plethora of insurance products that are available in the marketplace today can be divided into four basic categories: term, whole, universal, and variable. Each policy type has its own set of characteristics.

Term life insurance

Term life insurance policies are the simplest type of life insurance available in the marketplace today. A term life policy does not have a cash value component, but simply pays a death benefit upon the death of the insured.

As their name states, term policies only remain in force for a certain period of time, which is called a term. Terms can last for anywhere from 5 to 30 years in most cases, and the longer the term, the more expensive the policy will be.

Term insurance is much cheaper than any type of cash value life insurance, but it becomes prohibitively expensive when you reach your later years. Term insurance is an ideal choice for a young married breadwinner with a family to support. A large term coverage amount can provide financial protection for the family of the breadwinner if something were to happen to him or her.

There are several types of term insurance.

  • Level term insurance keeps the premium the same throughout the duration of the term.
  • Decreasing term insurance has a level payout with a diminishing death benefit over time.
  • Convertible term insurance can be converted into a smaller amount of paid-up permanent life insurance at any time. It is also often possible to add a return of premium rider to a term policy, so that the insured can recoup his or her premiums at the end of the term if they are still living.

Many financial planners tell their clients that they should buy term insurance while they are young. Term insurance is relatively cheap at this point, and it allows the insured to get a much larger death benefit for the same price as a permanent policy can provide. Many planners, therefore, feel that this type of insurance is the best life insurance. But if the insured person will be facing estate taxes when they die, then most planners will recommend a permanent policy.

Whole life insurance

Whole life insurance policies are the oldest form of life insurance in existence. These policies pay a relatively low rate of return in the form of policy dividends, which are really a partial return of the premiums paid to keep the policy in force. Whole life policies generally have fixed premiums that do not change.

Universal life insurance

Universal life insurance is more flexible than whole life insurance and usually pays a higher rate of interest than whole life insurance. The amount of the premiums that are paid are usually flexible.

There is another type of universal life called indexed universal life. The interest that they pay is not based on prevailing interest rates as with conventional universal policies. Instead, they pay interest based on the performance of an underlying financial benchmark index such as the Standard and Poor’s 500 Index.

Variable Life

Variable life insurance is the riskiest type of life insurance that you can buy. The premiums that are paid into the policy are invested in a selection of mutual fund subaccounts that invest directly in the stock, bond, and real estate markets.

What's your life insurance policy worth?

It is possible to lose money in this type of policy if the markets perform poorly. Most variable policies today are also universal life insurance policies. The life insurance death benefit for these policies will also rise and fall along with the cash value.

How life insurance claims work

When the insured or insureds on a policy have passed away, then the beneficiaries must notify the insurance company of their death(s) in order to receive the life insurance proceeds.

The insurance company will require a certified copy of the death certificate that has been signed by a physician along with a request for benefits. (Every life insurance company has its own proprietary request for benefits claim form.) The death certificate must give the cause of death in order for the insurance carrier to process it. The life insurance company may also require the beneficiary to furnish a copy of the policy in some cases.

Once the death claim has been filed and all necessary documentation has been received by the life insurance company, most states will allow the company 30 days to process the claim.

At the end of that time, the life insurance company must pay the claim, deny the claim or request additional information. If the carrier denies the claim, then in most cases they must include an explanation of why they did so. Most carriers will pay out their claims within 30-60 days.

Cash value payout options

If the owner of a permanent life insurance policy wishes to access the cash value in the policy, then there are generally three ways that he or she can do that, listed as follows:

1.  Cash out the policy and let it lapse

Afterward, the remaining cash surrender value can be collected after all fees and penalties (if applicable) have been paid. This method of accessing the cash value in the policy is generally discouraged by most financial planners and life insurance agents. The reason for this is because it results in lost insurance coverage and is usually the most expensive way to access the cash value.

2.  Take a straightforward withdrawal out of the policy’s cash value

It is possible to simply take a direct withdrawal from the cash value in the policy. The insured will leave enough cash value in the policy to keep it in force. The death benefit will be reduced accordingly.

3.  Take out a loan from the cash value

This can be advantageous for borrowers who have poor credit because there are no underwriting requirements for this type of loan. The borrower is essentially borrowing from him or herself in this case. However, the loan will charge interest, and the amount of any outstanding unrepaid loans will be deducted from the death benefit if the insured dies before the loan is repaid.

The life settlement option

If you are age 60 or older and have a permanent or convertible term life insurance policy that you no longer want or need, you may be able to sell it to a life settlement company and receive at least two to three times the amount of the cash value in the policy.

The life settlement company will assume the responsibility of paying the annual premiums for the policy and will then collect the death benefit when you pass away. Just be sure that your family members, loved ones, or other beneficiaries will be able to do without the death benefit when you pass.

A well-structured life insurance settlement can provide you with a tidy sum of money that you can spend however you wish. The amount of money that you receive will depend upon how much life insurance you have along with several other factors, such as your current health condition.

Get a free valuation of your life insurance policy

There are several different payout options that you can use to access both the cash value and the death benefit in a life insurance policy. Consult your financial advisor or life insurance agent or broker to find out more about how you can access the cash value or collect the death benefit from your own life insurance coverage. If you are looking to buy a policy, then you can also get life insurance quotes online from many different sources.

Want to see how much you could get with a life settlement? Try our free life settlement calculator.

Author:
Chris Granwehr is the Founder of Dawn Life Settlements and a former senior manager with Mason Finance, an industry-leading life settlement provider in California. He's a member of the Life Insurance Settlement Association, and he has a passion for empowering customers financially through a faster, easier life settlement system.