A “dividend” on a life insurance policy is unlike the dividend you receive on a share of stock or a stock mutual fund. Essentially, they are funds earned from life insurance policies; however, not all policies earn dividends.
For tax purposes, dividends are considered a return of a portion of the premiums paid for the policy.
Basically, the insurance company receives the premium payments, invests the funds into the stock market and then pays a dividend, which is based on the performance of the investment.
If mortality and expense experiences are favorable (i.e., the company keeps expenses down and the investments do well), the company declares a dividend, which returns a portion of the surplus to policy owners.
Only participating policies pay dividends, which are priced to do so. Because of this, the company charges a higher premium; but, hopefully, returns a portion of it back to the policy owner.
Dividends have always been a controversial topic within the life insurance industry, but it is advised to have a basic understand of what there are and how they function in order to determine if they are right for you.
In the U.K., life insurance policies are sold “with profits” (i.e., with dividends), and “without profits” (i.e., no dividends). As you might expect, policies that pay no dividends are less expensive.
However, both in the U.S. and U.K., over long periods of time the participating policy issued by a reputable company stands a very good chance of outperforming a nonparticipating policy.
Although both term and permanent policies can be participating, as a practical matter dividends are suitable only for permanent policies, with their long in-force horizons.
Typically, when the policy is purchased, the policy owner is allowed to elect a form of dividend options, and most insurers allow the dividend option to be changed once the policy is in-force. The policy owner can also elect a combination of options.
Usually, dividends are paid on the anniversary of the policy and one year after the dividend in earned, which can be rewarded in a variety of ways.
One of the common methods is to use the dividends to purchase paid-up additions to the policy, which also earn dividends. It is also fairly common to use dividends to reduce future premiums.