Commonly associated with permanent policies; dividends are declared when an insurance company receives the premium payment from a policy owner, invests the money, and then returns a portion of the money back to the policyholder.
After a policy is purchased, policy owners are given the opportunity to decide how their dividends will be rewarded, which can be done through a series of options.
The most common options are:
In this scenario, dividends are rewarded like ordinary corporate stocks, i.e., as cash payments. The insurer will pay dividends to the policy owner usually at the end of the first or second policy year.
Usually, most policy owners do not choose to take dividends this way because other options are much more convenient and/or favorable.
Reducing Subsequent Premiums
The policy owner can choose to have the insurer automatically, and at no charge, apply any dividends to reduce future premiums. As dividends increase, the policy owner’s required premium payments decrease.
If the insurer’s investment performs exceptionally well, at some point the dividends can equal or exceed the amount of premiums.
Leaving the Dividends with the Insurer at Interest
A policy owner can choose to leave the dividends to be retained by the insurer to accumulate and earn interest. The interest rate payable on the policy owner’s accumulated account is guaranteed to equal or exceed a specified minimum.
When the insured dies or the policy is surrendered, the policy pays the face value or the net cash surrender value, plus the value of this account. Interest earned on accumulated and retainer dividends are fully taxable to the policy owner as soon as the policy owner has the right to withdraw it, even if the policy owner elects not to withdraw it.
If the policy owner can only withdraw the interest on a specific date (usually the policy anniversary date), the interest is taxable in the policy owner’s taxable year in which the date falls.
Buying Paid-Up Additional Insurance
This option allows the policy owner to use dividends to purchase small amounts of completely paid-up (i.e., single premium) additional insurance coverage. The insurer will add the additional amount of coverage, which the dividend can purchase at the insured’s attained age.
This is purchased at net rates with no commission paid, no extra premiums, and requires no further evidence of insurability. Also, these paid additions can generate dividends on their own.
Buying Additional One-Year Term Insurance
With this option, dividends can be used to purchase as much one-year additional term insurance coverage as possible based on the insured’s age. Also, this option doesn’t have any commission paid and requires no evidence of insurability.
Repaying Policy Loans
This method allows dividends to be directly applied against any interest and/or principal of a policy loan before being used in one or more other dividend options.
In addition, most participating policies will pay a “terminal dividend” at the termination of the contract. The longer the policy has been kept in premium-paying status, the larger the terminal dividend will be.
Although most ordinary level-premium whole life policies have no explicit surrender charges, the terminal dividend is, in a sense, a form of surrender charge, since the insurer is withholding the policy owner’s money instead of paying it currently.
Those policy owners who terminate their policy in the first few years will receive a relatively small terminal dividend, while those who continue to pay premiums on their policies for a longer period of time receive a larger terminal dividend. The terminal dividend therefore rewards long-term policy holding and discourages early policy lapses.
(Tax Planning with Life Insurance Second Edition 2003/2004 Financial Professionals’ Edition—Published by Warren, Gorham and Lamont, RIA by Howard Zaritsky and Stephan R. Leimberg)