When the proceeds of a life insurance policy are payable in a lump sum, the company�s liability under the policy is fully discharged with the payment of such sum. If, however, the company retains the proceeds under one of the optional methods of settlement, its liability continues beyond the maturity of the policy and must be evidenced by some sort of legal document. That document is the settlement agreement.

The settlement agreement contains the designation of the various classes of beneficiaries and a detailed description of the manner in which the proceeds are to be distributed. During the early development of deferred-settlement arrangements, settlement agreements were tailored to fit the insured�s exact specifications and were typewritten in their entirety. As the requests for deferred settlements multiplied, it became necessary, for reasons of economy and administration, to standardize the various arrangements and privileges that the company would make available. As a result, the modern settlement agreement is composed primarily of preprinted provisions, some of which are general in scope and apply to any option that might be elected, and some of which pertain to only one specific option. All of the rights, privileges, and restrictions that the company is willing to make available are included and become effective by appropriate action of the policyowner (usually by making a check mark in a box opposite the provision in question). The only portion of the agreement that must be filled in concerns beneficiary designations and any modifications of the printed provisions that are acceptable to both parties. A specimen settlement agreement of the type generally used today is shown at the end of this chapter.

The typical settlement agreement is one entered into between the insurance company and the insured, or policyowner, to control the distribution of the policy proceeds to third-party beneficiaries after the insured�s death. Depending on company practice, the agreement may be a basic part of the insurance policy, or it may be separate and distinct from the policy. It can be drawn up at the time the policy goes into effect or at any time prior to the insured�s death. Although the insured can revoke the agreement at any time and substitute a new agreement, he or she can revoke the beneficiary designation only if such right has been specifically reserved. The policyowner may or may not give the primary beneficiary the right to set aside the prior agreement after the insured dies. Upon the insured�s death, the insurance company�s obligation under the original contract terminates, and it assumes a new obligation, which is defined by the terms of the settlement agreement.

The insured may also enter into a settlement agreement with the insurer to provide payments to himself or herself from a surrendered policy�s cash value. If the agreement relates to the proceeds of an endowment policy, it can be entered into at the policy�s inception or at any time prior to the policy�s maturity.

If the insured did not elect a deferred settlement or did elect one but gave the primary beneficiary the right to set it aside, under the rules of most companies the beneficiary may elect a settlement option and enter into an agreement with the company to govern the distribution of the proceeds. The beneficiary is usually given 6 months after the insured�s death in which to elect a settlement option, provided the check proffered by the insurer in full settlement of the death claim has not been cashed. Insurers pay interest on the portion of proceeds still held by the insurer after the insured dies. The interest starts accruing from the date of death (even if the election of the specific option is made long after the insured dies) and continues accruing until the underlying proceeds are distributed to the beneficiary.

When a beneficiary elects the settlement option or when the policyowner elects a deferred settlement for his or her own benefit, a spendthrift clause cannot be included in the settlement agreement (if it is included, it will not be enforceable). A spendthrift clause states that the proceeds will be free from attachment or seizure by the beneficiary�s creditors. This clause may properly be embodied in a life insurance policy or settlement agreement procured by one person for the benefit of another, but it cannot be incorporated into an agreement at the behest of the party for whose benefit the agreement is being drawn up. This offers an argument for having the insured elect the settlement option on behalf of the beneficiary, especially if the beneficiary has credit problems (or may be expected to have them in the future).

Under the rules of many companies, a settlement agreement entered into between the company and the beneficiary must provide that any proceeds unpaid at the time of the beneficiary�s death will be paid either to his or her estate in a lump sum or in a single sum or installments to irrevocably designated contingent beneficiaries. In other words, the beneficiary cannot designate revocable contingent beneficiaries.

Companies that impose this limitation fear that designating revocable contingent beneficiaries to receive proceeds that are already in existence at the time the designation is made might be construed as a disposition of property to take effect at the primary beneficiary�s death. If the beneficiary�s action should be so construed, the settlement agreement would be ineffectual as to the residual proceeds unless the agreement had been executed with all the formalities of a will�which, of course, is not the practice. Some insurance companies, however, feel that such a construction of the settlement agreement is a remote contingency and they therefore permit the beneficiary to designate contingent beneficiaries with the right of revocation.

As pointed out earlier, the liability of the insurer at the maturity of a life insurance policy is generally stated in terms of a single-sum payment. In making other modes of settlement available, the company promises a set of installment benefits, based on various patterns of distribution, that have a present value precisely equal to the lump-sum payment. The policy contains tables that show the amount of periodic income that will be payable under the different options for each $1,000 of proceeds left with the company. Under each option a specified rate of income per $1,000 of proceeds is guaranteed in the policy; these are referred to as contract rates. It is important to note that insurers can and often do credit investment earnings in excess of the guaranteed rate to the funds supporting settlement options.

From time to time, a company will modify the actuarial assumptions underlying the benefits provided under the optional modes of settlement, which means that the amount of periodic income per $1,000 of proceeds will change. Historically, because of declining interest yields and growing longevity, these modifications have produced lower benefits per $1,000 of principal. Such benefit modifications are, of course, reflected only in those policies and settlement agreements issued after the change. The benefits under existing agreements cannot be modified without the specific consent of the policyowner. (Consequently, insurers rarely take steps to modify existing settlement agreements.) In order to distinguish the rates of income available under existing policies and settlement agreements from rates that are applicable to contracts currently being issued, the latter are referred to as current rates. For policies and agreements issued since the latest rate changes there is, obviously, no difference between the contract and current rates. For all others, however, the distinction can be significant.

Contract rates are always available to the policyowner, except for options that can be "negotiated"�that is, options not contained in the original policy. If a policyowner wants the proceeds to be distributed in a manner not provided for in the original policy and his or her request is granted, the benefits will almost invariably be based on the rates in effect at the time the option was requested. Thus if a policy does not contain all the options that the applicant thinks he or she might want to utilize, the applicant should try to have them added to the policy by endorsement at the time the policy is issued or as soon thereafter as possible.

Under most companies� rules a beneficiary who is entitled to a lump-sum payment can choose to leave the proceeds with the company under the interest option or elect one of the liquidating options at contract rates. Contract rates are usually available to the beneficiary if a liquidating option (any option other than the interest option) is elected within a specified period after the insured�s death�usually somewhere in the range of 6 months to 2 years. If within the 6-month period, the beneficiary elects the interest option, he or she can switch to a liquidating option at contract rates up to 2 years after the insured�s death. Moreover, if�during the prescribed period of 6 months to 2 years�the beneficiary elects to have a liquidating option go into effect at some specified date beyond the 2-year period, contract rates will apply. On the other hand, if the beneficiary requests a change of option after the permissible period, the requested benefits will be made available only at current rates, if at all.

It is important to grasp the rationale of the restrictions on contract rates. They are not designed primarily to prevent an indefinite projection of contract rates into an uncertain future. Rather, they are intended to protect the insurance company from adverse mortality and financial selection. For example, if a beneficiary could elect a life income option at any time, his or her attitude toward that right would be influenced by the condition of his or her health. If, after the insured�s death, the beneficiary�s health deteriorated, he or she would not consider a life income option appropriate, unless it were the cash refund type. On the other hand, if the beneficiary�s health over the years were excellent, he or she might elect a life income option. Since beneficiaries as a group could be expected to react in this manner, without a time limit or option selection the company would find itself with an undue proportion of healthy annuitants.

Likewise, if a beneficiary has the choice of withdrawing the proceeds and placing them in some other type of investment or leaving them with the company to be liquidated under one of the installment options, he or she would probably place the investment burden on the insurer if it provided a higher return than could be obtained in the open market. The reverse would be true if the market yield were higher than that provided by the insurer. While the behavior of one or a few beneficiaries has little impact on the insurance company, the adverse action of tens of thousands could be financially devastating to the insurer.

As stated earlier, the beneficiary may be given the right to withdraw all or a portion of the proceeds held by the insurer under a deferred-settlement arrange-ment. If the beneficiary can withdraw all of the proceeds at any one time, subject only to a delay clause, he or she is said to have an unlimited right of withdrawal. However, if the privilege is subject to restrictions, it is generally identified as a limited right of withdrawal.

The right of withdrawal may be limited as to the following:

The first two types of limitations are imposed by the insurers to control the cost of administration, while the last three are imposed by the policyowner (often a parent of the beneficiary) to prevent dissipation or too rapid exhaustion of the proceeds by the beneficiary. The right of withdrawal can usually be invoked only on dates when regular interest or liquidation payments are due. Most companies permit withdrawals on any such dates, but some restrict the privilege to a stated number of withdrawals per year, such as three, four, or six. Although some insurers have no minimum requirement, the minimum amount that can usually be withdrawn at any one time ranges from $10 to $1,000.

Most policies reserve the right to delay cash withdrawals under settlement options for a period of up to 6 months. This is a counterpart to the delay clause required by law in connection with loan and surrender requests.

The policyowner may provide that the right of withdrawal will be cumulative. This means that any withdrawable amounts that are not withdrawn during a particular year can be withdrawn in any subsequent year, in addition to any other sums that can be withdrawn pursuant to the terms of agreement. Thus if the settlement agreement permits the beneficiary to withdraw up to $1,000 per year in addition to the periodic contractual payments and provides that the right will be cumulative, the beneficiary�s failure to withdraw any funds during the first year would automatically give him or her the right to withdraw $2,000 during the second year. No withdrawals during the first or second years would bestow the right to withdraw $3,000 during the third year, and so on. A noncumulative right of withdrawal, whether exercised or not, expires at the end of the period to which it pertains. Most limited rights of withdrawal are noncumulative.

A right of withdrawal is included in a settlement agreement in order to provide flexibility. It can be invoked to obtain funds for unexpected emergencies or to meet the problem of a rising price level. It is especially desirable during the period when the beneficiary is caring for dependent children. In most cases, however, the right should be hedged with reasonable restrictions in order to prevent premature exhaustion of the proceeds.

The right of commutation is related to the right of withdrawal. To commute, in this sense, is to withdraw the present value of remaining installment payments in a lump sum. The term is properly applied only to a right attaching to proceeds distributed under a liquidating option. Hence it does not apply to proceeds held under the interest option. For all practical purposes, however, the right of commutation is identical to an unlimited right of withdrawal.

The right of commutation is not implicit in an installment arrangement; in order to be available, it must be specifically authorized in the settlement agreement. Commutation is specifically and intentionally denied the beneficiary in the spendthrift clause that is sometimes made part of the settlement agreement.

To hold down the cost of administering proceeds under deferred-settlement arrangements for which there is no specific charge, life insurance companies will not accept a sum less than a specified amount (such as $2,000 or $10,000) under a settlement option and will not provide periodic installments in amounts less than $25 or $50. If the proceeds of a policy are split into two or more funds with different options, the foregoing requirements apply to each fund. The minimum- payment requirement also applies to each beneficiary. Thus a policy large enough to satisfy the requirements if payable to the widow(er) alone might have to be paid in a lump sum if several children become payees as contingent beneficiaries.

These requirements are usually referred to in the policy as rules subject to change. Because of the anticipated variation, the specific dollar amounts are rarely stated in the policy.

There is usually a special requirement for proceeds held under the installment amount option. Most companies will not make monthly payments of less than $5 or $6 per $1,000 under this option. The requirement is sometimes stated as a percentage; the minimum is usually 4, 5, or 6 percent liquidation per year. This special rule is designed to assure liquidation of all proceeds and interest within a reasonable period of time.