A participating life insurance policy is a policy that receives dividend payments from the life insurance company. It is called participating because it is entitled to share or “participate” in the surplus earnings of the life insurance company. A nonparticipating policy does not have the right to share in surplus earnings, and therefore does not receive a dividend payment. If you want to owner a participating life insurance policy, you will probably need to buy whole life insurance.
The dividend payment actually has some tax advantages. Despite the terminology, instead of being classified as a dividend by the IRS a life insurance dividend is actually considered to be a return of premiums paid for tax purposes. Dividend payments are a share of surplus earnings. Because the premium from participating policies contributed to those earnings both directly (when premium payments outpace mortality expenses) and indirectly (with investment returns) a simple way to understand why the IRS considers the dividend to be a return of premium is to say that policy owners paid “too much”, or more than the life insurance company needs to operate. So when the company has more money than needed (after additions to reserves and contingency accounts), the premium is returned through the dividend.
Even though dividends are technically a return of the surplus earnings, it is not rare for them to be paid. Most major life insurance companies make a dividend payment to their policy owners every year, and policies are illustrated such that dividend payments are expected to be made into the future.
What Types Of Policies are Participating?
Whole life insurance policies are usually the only type of policy that is paid a dividend, and therefore is considered to be participating. This is true for an individual whole life insurance policy, and usually an ordinary whole life insurance policy (a whole life policy from a group plan). Some select few companies may have term policies that are participating. This is becoming slightly more common, but still is rare because term life insurance has no cash value.
Why Whole Life Is Participating- Roots In Mutual Companies
Whole life insurance is considered a participating policy for a couple of reasons. The biggest of these reasons is that in a mutual life insurance company (a common ownership structure for life insurance companies) the whole life policy owners are actually the owners of the company.
As owners of the company, they are deemed to have a right to participate in the profitability of the company. This is similar to how the owner of a share of a publicly traded stock has the right to participate in the earnings of the public company through price growth and dividends.
Some life insurance companies are not mutual companies, but have other ownership structures such as publicly traded corporation (known as a stock company). While the whole life insurance owners are not technically owners of the company, from tradition and for competitive purposes (why would someone buy whole life insurance from a company that doesn’t pay dividends) the whole life policyholders are still paid a dividend when they buy from a stock company.
A participating policy is usually advantageous to the owner because the surplus profits, and therefore dividend payments, have proven to be a stable. Owners have been growing their cash value and taking extra income from life insurance dividends for decades. Simply put, as a relatively safe investment with tax advantages, whole life insurance has been a very high performer.
Why Term Life Insurance Is Non participating
Term life insurance is not participating because term life insurance is really a “rented” life insurance policy. Term policy owners will not own the policy for the rest of their lives (unless they pass away pre-maturely during the specified term period).
Term life insurance also does not have a cash value. Whole life insurance dividends are paid out at a determined rate based upon the amount of cash value in a policy. Without a cash value account, the dividend rate is essentially applied to 0.
Looked at another way, the life insurance company makes money in large part from the cash under their management. Not only do life insurance companies have huge reserves in order to pay future claims, but they actively manage all of the combined cash values of every whole life insurance policy (as well as other premiums and payments collected that are not part of the cash value). In total, life insurance companies have massive amounts of cash on hand. Instead of letting the money sit in cash, life insurance companies typically invest this money in a portfolio of very secure fixed income securities, such as treasury bonds and notes. The interest earned from these fixed income assets comprises a major source of revenue for the insurance company.
Term policy owners are looking for inexpensive coverage. Here is a primer on the very basics of pricing term insurance: To make term coverage as affordable as possible, insurance companies basically calculate the mortality risk and apply a 0 sum insurance charge to cover claims (the amount of money the company needs to cover future claims and nothing more). In addition they charge enough to cover the administrative expenses (the manpower to process and underwrite the policy, plus printing costs, shipping costs, and other administrative costs), enough to pay the life insurance agent a commission, plus enough to make a small margin of profit.
At the end of the day, because term insurance owners are not keeping any money with the company in cash value (which the company uses to make more money), and because the margins are thin on term life insurance, and term life insurance is a short term “rental” it does not make sense to include term policies as participating policies or to give them an ownership stake in the company.
More recently, some term life insurance products are getting more complex. Some do have small cash values, and some are actually considered participating policies. This is more common with a form of term known as “term till” or “T- till” which is a term policy that lasts until the insured person reaches a specific age. This policies may be said to be a form of “permanent term” as usually they expire when the insured person reaches a very old age (i.e. age 100). Typically rather than being a level premium, the premium required to keep the policy in force will rise each year as the insured person gets older. This is not a type of life insurance as commonly owned as the most basic form of term life insurance, but it is worth mentioning.
Why Universal Life Is Nonparticipating
Universal life policy owners are not owners of the life insurance company. Universal life insurance policies are already paid interest on their cash value, and are not eligible for additional dividend payments. This is usually because of the way that life insurance companies invest the aggregate cash value in all universal life insurance policies. It is usually held under a separate investment umbrella than the general account of company. Excess earnings from the account with the money for universal life insurance policies actually is taken by the life insurance company and added to their earnings (which can then be shared with whole life policy owners). The universal life insurance policy owners are paid the market interest rate as it is defined in their policy. They are not entitled to any additional funds.
Why Variable Universal Life Is Nonparticipating
Variable universal life insurance policies do have a cash value account, but the cash value is not managed by the life insurance company at all. In contrary, the money is invested in variable sub-accounts, which are managed by third party fund companies. These sub-accounts are essentially mutual funds. Each sub-account has a stated objective, and the manager of the account actively invests in a portfolio of underlying securities that match the stated objective.
The policy owner has the option to the invest the money as they see fit. They can make trades between the sub-accounts, and they can allocate money to various funds in whatever way they decide. The performance of the policy will be dictated by the performance of the funds. The funds performance is affected by the underlying assets. For instance funds may be large cap stocks, mid cap stocks, small cap stocks, short term bond funds, mixed bond funds, treasury security funds, commodities funds, ect, and each fund will own assets within the asset class. Most variable sub-accounts act as a proxy for mutual funds which are available to the public, and they are managed by the same fund companies.
The life insurance company does not participate in earnings from these funds. Rather, they collect a small percentage fee based upon the total assets in the funds from the VUL policies, in addition to the insurance charges deducted from the policy. Because the owners are not actively invested in the life insurance company they deemed not to be able to take part in the earnings. VUL policies are not considered to have an ownership share, and therefore are nonparticipating policies in most all cases.
Is It Better To Have A Participating Policy
Since whole life insurance policies are participating policies, does this make them the “best” kind of life insurance to own? The answer to that is not so simple.
For instance, term life insurance is by far the least expensive form of life insurance for the amount of time that it is owned. The problem with term is that it expires and does not necessarily last for a whole lifetime. Term life insurance clearly has its place in the life insurance product lineup as it is a useful and cost effective solution for many life insurance owners. Term may be the best type of life insurance policy for many people, while other forms of insurance may be appropriate for others. Read on to learn why a participating policy may be the best choice.
Why A Participating Policy May be Best
For many people, a participating whole life insurance policy represents a very safe, very stable investment vehicle (while the insurance provides valuable financial protection). Many people who own whole life policies experience solid returns from them, and whole life insurance is widely considered in the industry to be one of the safest forms of investment. The dividend rate is responsive to market interest rates (when rates rise the insurance company makes more money and dividends rise). There are also tax advantages to dividend payments, because they are classified by the IRS as a return of premium rather than a source of income and therefore they are not taxed. The cash value in your life insurance policy is further protected both by the total assets of the life insurance company, as well as your State’s insurance regulations (up to a certain dollar amount).
When you account for the safety, stability, and tax advantages, a participating policy is often the best choice for many people who are not best suited for term life insurance.
Return Comes From Different Sources, There are Trade-offs To Each
Ultimately you can’t tell which type of policy will give the highest return on investment. A variable universal life insurance policy is invested in the equity and fixed income markets. Potentially the rate of return in these markets is much higher than the rate of return on a whole life insurance policy. As anyone who has invested in the stock market will tell you, it does not do with without risk, or ups and downs. The marketplace is risky, and even a high performing portfolio experiences the peaks and troughs of bull and bear market cycles. Some people may deem this risk too much for their life insurance policy.
Similarly a universal life insurance policy may end up outperforming a whole life policy depending upon interest rates. A universal life policy will adjust to interest rate changes more quickly than dividends adjust, and potentially either return could ultimately be greater.
A variable universal and universal life insurance policy also have other benefits, such as the flexible premium payment structure. You can add in extra money if you want to take advantage of your life insurance as an investment more than the planned premium. You can also not make payments for periods of time and let the insurance charges be paid from cash value. These benefits have value beyond participating in the life insurance companies profits.
Things Affecting The Dividend Payment
The law states that all life insurance dividend payments must be equitable. The amount paid to each policy owner must be commensurate with their contribution to profits (at least roughly). This is judged based upon the size of each policy. A policy with a higher cash value will pay a higher dividend generally speaking. During the early policy years, there are load charges which reduce the dividend. Generally these decrease every year until they cease at some designated policy age. The load charges are a way to account for the administrative expenses associated with opening the policy.
The dividend payment is a return of surplus profits. Surplus profits are the profits after all mortality expenses and operating expenses are paid, and after reserve funds and contingency accounts are appropriately funded. While the financial controls of life insurance companies are extremely tight (statistically based and very sophisticated), the possibility for certain expenses to higher than expected is possible.
For example, a natural disaster, terrorist attack, or disease could create a much high mortality expense than what was planned by the life insurance company. More mundane but equally possible a life insurance company’s underwriting department could be judging risk incorrectly and the actual rate of death is higher than anticipated. A higher than expected mortality rate would lead to lower than expected profits, and impact the dividend payment negatively. In the event of higher than expected mortality rates the company will also probably need to fund the reserves at higher rates, which further impacts the dividend payment rate.
Surplus profits are also influence by the rate of return of the investments an insurance company owns. If their fixed income portfolio is negatively affected by interest rate fluctuations (either affecting their interest rate of return or the value of the underlying assets), the company will have lower profits and therefore the dividend payments will likely be reduced.
As you can see dividend payments are not guaranteed. That being said, most major life insurance companies in the United States have a long history of making healthy dividend payments to their policy owners. Some have not missed a dividend payment in over 100 years. Dividends are not technically guaranteed, but they do have a high probability of being paid regularly. Ultimately the board of directors decides the rate of dividend payment to owners.
Owners Get A Say With Participating Policies In Mutual Companies
If you own a participating policy with a mutual life insurance company, you are an owner of the company. As an owner, you have ownership rights such as approving the board of directors. This may be a small benefit, but it’s nice to know that you have additional rights of ownership besides the dividend companies. Just like with stock ownership, participating policy owners “have a say” in the leadership of the company. Practically speaking, it is rare that mutual policy owners actually participate in the election of the board of directors. Even so, the option to do so does exist.
Participating Policies Are Useful
Having financial protection in the form of life insurance while at the same time being able to participate in the profitability of the company is very attractive to many people. Ultimately, the safety and tax advantages of a whole life insurance policy end up driving people to choose a participating policy. Ultimately, each person must weigh the pros and cons and decide for themselves. At Life Ant, we believe most people are best served owning a participating policy.