Most whole life policies are participating policies, which means that the policy can and usually does pay annual dividends. All whole life and term policies sold by mutual insurers are participating policies. Some stock insurers also sell participating policies. Participating whole life insurance policy premiums are based on conservative assumptions. Because the insurer’s actual operating experience is expected to result in lower costs or higher rates of return on assets than are assumed in the premium calculation, the insurer generally pays a portion of the profits to policyholders in the form of policyholder dividends.
These dividends are treated are treated as a return of premiums and therefore you are not taxable to the policyholder. Insurers generally do not vary dividends with year to year fluctuations in operating experience; instead policyholder dividend formulas are changed periodically based on the long run term changes in interest rates, expenses and mortality costs.
Thus when participating whole life policies insurers typically use conservative assumptions with the anticipation that dividends will be positive. If insurers instead determined premiums using assumptions that were closer to what actually expected, premiums and expected dividends would be lower. Why do insurers follow the conservative approach? The main factors affecting policyholder dividends are changes in interest rates and aggregate mortality experience. Because these factors cause profits on individual policies to be highly co-related, the uncertainty associated with these factors is costly, if it is not impossible to diversify away. The use of conservative assumptions along with paying policyholder dividend shifts some of this correlated risk to policyholders.
For example, if a highly contagious and deadly disease occurred or if returns on insurer to bear more of this correlated risk. The problem is that insurers then would need to hold much more capital to achieve the same level of insolvency risk. The costs of holding this capital would increase expected prices for life insurance. In summary, policyholder dividends are one method of allowing insurers and policyholders to share correlated risk.
Policies usually provide several options for the use of dividends. For example, whole life policyholders often have a choice as to whether dividends are used to increase the policy’s face amount or pay part of the nest premium due. When selling whole life insurance policies, agents present a table of illustrated dividends, net premiums if the policyholder uses the dividends are used to increase the policy’s face amount. Illustrated dividends usually reflect what the insurer is currently paying on comparable policies. It is important to note, however that these illustrations are not guaranteed. Illustrated dividends typically increase over time. The main reason for this increase is that most insurer dividend formulas reflect a credit for greater than assumed investments returns that is approximately proportional to the policy’s cash value. As the guaranteed cash value grows over time, so does the illustrated dividend.
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