What Is Commutation?

Commutation refers to the right that a beneficiary has to exchange one type of income for another. Commutation is offered to beneficiaries of annuities and life insurance policies so that they might receive a lump-sum payment instead of a series of future payments.

When this happens, the net present value (NPV) of all remaining payments is computed into a single payment that is given to the beneficiary.

Key Takeaways

  • Commutation allows the recipient of an obligation, such as an annuity or insurance policy, to change how they would prefer to receive their payment.
  • Beneficiaries may choose to swap a lump-sum pau put for a series of ongoing cash flows, or vice-versa.
  • A commutation arrangement can actually help an insurer save on loss adjustment and administrative expenses and create underwriting gains.

Understanding Commutation

Commutation can provide a larger sum of money to a beneficiary who needs it now. This can be a tremendous help for those who need cash to pay for medical or other bills that cannot wait. However, this right must be accorded to the beneficiary in the policy. The insured will also benefit from a higher level of certainty in their financial life by settling for a certain immediate amount rather than an uncertain future amount. The insured will also stand to save on administrative costs associated with monitoring and collection activities on the part of the insurer.

For the insurer, a commutation can help bring about a clean break in the relationship between the insurance company and the insured, which can help them demonstrate improvements in financial performance over time while eliminating the unknown factors that may be involved with a long-drawn-out settlement period, which may encounter unforeseen risks. Allowing recipients of an obligated payment to select how they would like to receive their funds can also reduce an insurer's burden since some people will choose one form over the other based on their personal circumstances. As a result, they can save on both allocated and unallocated loss adjustment expenses and even mark a marginal gain in the underwriting spread.

Commutation in Practice

Often, a disabled individual will convert their workers' compensation periodic payment claim for life into a single lump-sum payment. A liability claim may be resolved with a structured settlement, wherein the risk bearer provides a fixed series of future value payments to the claimant by way of a structured settlement provider at a discounted current cost paid to that structured settlement provider. To avoid a long, drawn-out runoff of a claim, a reinsurer may ask to commute its obligations to a ceding insurance company. To raise cash, companies under supervision, rehabilitation, or liquidation may commute liabilities with their reinsurers.

The insurer and insured both hope to somehow improve their financial standing as an outcome of a commutation. Both parties consider the differences between them, with regard to the ultimate claim and expense liability, timing recognition, tax position, and accounting treatment, and these differences become factors under consideration in the course of a commutation negotiation.