If you’re using a good noise-cancelling headset in the cockpit, it will kill the ambient noise pretty effectively, so the headphone simulation setting does work. Not sure it’s 100% accurate, but it works well. The shocker though is if you switch to an external view, you’re suddenly blasted with loud engine sounds, so that’s not so good.
Personally, I use the Communications setting. I’m fortunate that I use a Steel Series Arctis 5 headset. It offers me 2 discreet audio out channels - Game and Voice. And there’s a volume dongle with it that allows me to balance the volume between the two channels. I have the sim audio through the Game channel, and ATC through the Voice channel, and I can easily balance the volume between both. I tend to lean a bit towards the Voice volume to give me a similar effect to Headphone Simulation, only it gives me control of the volume of the ambient sound. And when I switch to external views, I don’t get blasted by loud engines.
But if I’m home alone with no one to bother, I tend to use the same setting, but running the ambient sound on my 5.1 system. If I press my subwoofer up against the base of my desk, it causes my whole desk to rumble, adding extra depth of immersion.