Dividend payments are a feature of whole life insurance policies. The dividend payment is a way for whole life policy owners to take part in the money an insurance company makes in profit. Dividends are paid annually, and policy owners have a choice of how to use their dividend payment. Dividends get preferred tax treatment and the size of the payment fluctuates based on a variety of factors. Dividends are illustrated in a whole life insurance illustration but are not guaranteed to be paid. Typically, dividend payments start at the first policy anniversary and grow larger over time.
Why Companies Pay Dividends
The tradition of paying dividends on whole life insurance policies started because life insurance companies were originally organized as mutual companies. With a mutual company, the policy owners are also the owners of the company. By purchasing life insurance, clients were also purchasing ownership shares. Since these companies made money, they would distribute profits to the owners of policies in the form of dividend payments.
The dividend payment can be thought of as interest earned for keeping cash value in a whole life insurance policy. Dividend payments are made once per year to policy owners, who have different options regarding how to utilize these payments. The size of the dividend payment depends on a number of factors, but the amount is mostly influenced by the amount of cash value in a policy and the life insurance company’s financial performance during the year. The dividend payment is usually made on the policy anniversary.
How Dividend Payments can be Used
A policy owner has four options for using the dividend payment. Each option has merits and drawbacks and may affect both the long term rate of return on a whole life insurance policy as well as the death benefit ultimately paid to beneficiaries. Each owner should carefully consider their options, the effect on the policy, and the tax consequences of their decision closely. Keep in mind that an agent can easily run different scenarios for using the dividend payment so that you can compare the options against each other.
These are the four options for using dividend payments. The way a dividend is used can usually be changed easily by the policyholder at any time. Check with your insurance company regarding rules for changing dividend options. For an in-depth discussion of the investment implications of various dividend choices, look at our discussion of life insurance as an investment.
Paid Directly To Owner
A dividend payment may be paid out directly to the policy owner each year. This can be used for any purpose, such as to supplement income or retirement income. Dividend payments help owners to realize an investment return from the policy without accessing cash value and reducing the death benefit. It is important to note that taking dividend payments directly does not reduce the death benefit or face amount of the policy like a partial surrender or withdrawal will. Dividends are separately viewed as a rebate of premiums paid.
Used To Reduce Premium Payments
The dividend can be directed towards reducing premium payments. As the dividend payment grows over time, the owner will be obligated to pay less and less for premium payments out of pocket. Eventually, the dividend payment can usually pay the entire premium and the policy becomes self-sustaining. At this point, the excess (if any) over the premium payment due can be used for any of the other dividend options. Using the option to reduce premium makes sense for people looking to reduce their costs who also do not need the death benefit to grow over time. If used to pay premiums the dividend is generally not taxable. Similarly to reducing premiums, dividends can also be used to pay off outstanding loans on a life insurance policy.
Used To Buy Paid-Up Additional Life Insurance
The dividend payment can be directed towards the purchase of additional paid-up whole life insurance. This has the dual advantage of both increasing the death benefit available for beneficiaries, and increasing the growth rate of the dividend payment through the higher guaranteed minimum cash value growth (paid-up whole life insurance still has guaranteed cash value growth). Some owners elect to do this for the duration of the policy, and others elect this option for a period of time to achieve higher future dividend payments and insurance coverage and then direct the dividend payment to other uses. Using dividends to purchase additional paid-up life insurance is a great way to compound the growth of the policy and to increase your tax-deferred growth if you are using the policy as an investment.
Dividends can be Stored in Cash and Accrue Interest
The fourth way that dividend payments can be used is to store them as cash in the policy. This cash will accrue interest at the prevailing rates offered by the life insurance company. This is a way to compound the growth of your financial returns, without having to purchase additional paid-up life insurance. The cash can be withdrawn easily if you wish to access it. Life insurance companies offer this option because they invest the cash that you store with them. They receive a higher rate of return than they pay to you. This can be a winning scenario for both owners and life insurance companies, but higher rates of return are generally available to owners if they search them out. One advantage is that historically speaking, cash is extremely safe with life insurance companies.
Tax Treatment of Life Insurance Dividends
Life insurance dividends do benefit from some tax advantages over interest earned in other non-qualified investments. The IRS views life insurance dividends as a return of premium, or put another way as a rebate. Because it is considered as such, dividends are generally not taxable until the total dividends paid out exceed the total premium paid out of pocket by the owner. If the dividend payments exceed the premium paid into the policy, the dividends become taxable as income. Tax laws are tricky though, and always there are exceptions to these rules. Other factors like withdrawals or partial surrenders can affect the calculation, and if the policy is a modified endowment contract or MEC, dividends are taxable regardless of the amount of premium paid. Always check with a tax professional if you need advice on your specific situation.
The preferential tax treatment of life insurance dividends helps make whole life insurance a better investment and more appealing for this purpose than it otherwise would be. Over time, a policy owner can take out of a policy the entire amount that they paid in premiums, and still have life insurance coverage, if done correctly.
Factors Influencing Size Of Dividend Payment
The dividend payment is calculated based upon a number of factors, which can vary slightly from company to company. Generally, there are a few common factors taken into account when determining the dividend payment for any given policy.
- The year beginning cash value of the policy (net of loans).
- Year-end cash value of the policy (net of loans).
- Actual mortality and expense rates experienced by the company over the course of the year.
- Company financial performance.
- Amount of profit the company decides to retain in cash reserves for the year.
- Prevailing interest rates (which influence company performance significantly).
Policy Cash Value Effect On Dividends
When determining the dividend payment, the higher the cash value of a policy the more the dividend payment will be, all else being equal. The insurance company will take into account any loans against the policy value when calculating the dividend payment, so beware of the effect of loans. Generally, more growth of policy value through premiums also leads to a higher dividend payment.
Mortality Rates Experienced Effects on Dividends
The mortality and expense charges experienced by the life insurance company reflect the quality of underwriting accuracy over time. Severely misjudging risk is one of the greatest impediments to the long term financial stability of a life insurance company. Every year the company can expect a certain percentage of their insured persons to pass away, resulting in death claims. If fewer people pass away than statistically expected based on underwriting risk class and expected mortality rates for each class, the company will end up retaining more money than they expected. Owning a policy from a company with strict underwriting standards and a favorable mix of risk classes can lead to actual mortality rates being lower than anticipated.
A lower than expected mortality rate will lead to a higher dividend payout, all else being equal.
Financial Performance of Company Effect on Dividends
The financial performance of the company ultimately plays a major role in the size of dividend payments. Financial performance is influenced by multiple factors, which include factors that are part of the dividend calculation. Financial performance depends upon the amount of money paid out in claims over the course of a year, the sales of the company, the amount of total premiums paid to the company compared to the amount expected to be paid, and prevailing interest rates as these strongly affect the amount of money earned on company reserves, which are massive in terms of total assets.
All else being equal, higher company performance will lead to higher dividend payments made to policy owners.
Amount of Money Retained In Reserves Effect on Dividend Payments
Life insurance companies are required by law to keep a certain amount of money in cash reserves. This minimum is called the reserve requirement, and these calculations are very complex. Insurance companies are required to keep this large cash reserve base in case death claim payouts are much higher than expected over a given time period, due to a large scale disaster or poor underwriting for instance. The reserve helps ensure that the company will be able to stay in business and meet all claim obligations over time. A company may decide to retain more money than required by law in reserves.
Generally, if a life insurance company decides to keep a higher amount of money in cash reserves for the year dividend payments will be lower with all else being equal.
Prevailing Interest Rates Effect on Dividend Payments
This can ultimately affect the dividend payment in two ways. The first is higher interest rates lead to higher returns on the cash reserve account. If cash reserves are earning more than needed, the surplus can be paid out in the form of dividends to policyholders.
The second way that interest rates affect dividend payments is from a competitive standpoint. If prevailing rates are high, but the amount earned on the cash reserve account is comparatively very low, people will be less likely to invest in a whole life insurance policy. To some extent, life insurance companies must keep dividend rates competitive given the current interest rate environment in order to retain and attract new business. Life insurance companies must also keep dividend rates competitive compared to other industry competitors.
Higher dividend payments will be paid when interest rates are higher, generally speaking, though life insurance dividend rates are notoriously slow to adjust both higher and lower which is in part a reflection on the duration of their bond holdings in the cash reserve account.
Keep in Mind Dividends are Not Guaranteed
While most major life insurance policies have a very strong track record of paying out dividends each year, they are not contractually obligated by the life insurance policy or obligated by law to make a dividend payment. Many large companies have been paying dividends for over 100 years consecutively and barring a substantial financial disaster will continue to do so. Life insurance companies continue to pay dividends because it is a feature that helps them to sell policies. Even companies that are not organized as a mutual company pay dividends on whole life insurance because they need to put out a competitive product to the mutual companies.
When you review a whole life insurance illustration, you will notice that it shows two sets of numbers. One is the growth rate of the policy given certain assumptions about the dividend payment rates in the future, and another is the guaranteed minimum assuming that no dividends are paid. It is important to understand that the life insurance company is only contractually obligated to the minimum values.
Dividends Make Whole Life Insurance Extremely Valuable
As can be seen, the payment of dividends from whole life insurance makes whole life an attractive product for those people looking for long term coverage. Dividends are useful in a number of ways, and when managed properly can provide substantial tax-deferred growth in policy value as well as provide a high supplement to the income of the policy owner without affecting the death benefit of the policy.
To compare the cost of whole life insurance for yourself or another, use the Life Ant quote comparison tool.
