A $1,000,000 death benefit with a $340,000 loan against it pays $660,000. The carrier settles the loan out of the proceeds first and sends the rest. There's no negotiation and no separate bill to the estate.
The accrued interest goes too. A loan balance is principal plus whatever interest has been added since you last paid. So the number coming off the death benefit on the day of the claim is bigger than the number you remember borrowing. On a loan carried fifteen years at 5% with no payments, the balance roughly doubles.
This is the part that surprises families rather than the part that surprises the policyholder. The person who took the loans knew about them. The beneficiary was told the policy was for a million dollars.
Whether it matters depends on the policy's job. Say the design was always about tax-advantaged retirement income, and the death benefit was the cost of admission. Then a reduced payout is the intended outcome. The money that came out during life is where the value went. If the policy is the family's protection plan, a large loan balance is eating into the thing the policy exists to do.
On an increasing death benefit design, option B, the payout is the face amount plus the account value, and the loan reduces the total. On a level design, option A, the death benefit stays flat while the account value grows inside it. So the loan comes off a fixed number and the proportional bite is larger.
Two ways to keep the gap from widening. Pay the annual loan interest out of pocket instead of letting it capitalize, which costs real dollars each year and freezes the balance where it is. Or add coverage so the net death benefit after the loan still lands where the family needs it, which costs more in insurance charges and requires you to be insurable when you do it.
There's a version of this that ends worse than a reduced payout. If the loan grows large enough against cash value, the policy can lapse while you're alive. A lapsed policy with a big loan creates a taxable gain, with no death benefit and no cash to pay the tax. An overloan protection rider exists to stop that, and it comes with conditions and usually a charge. How the tax lands in that scenario is a CPA question, and it's one to ask early.
Check the net death benefit on your annual statement, not the face amount. It's the number after the loan, and it's the only one your family will ever see.