If you’ve read previous posts on this blog, you’ll notice a continued trend of life insurance companies lowering their dividend scale. Unwary consumers may not see the impact of this on their life insurance policies immediately, but it can have large and catastrophic effects. I’m going to cover life insurance policy dividends in four steps; how they’re calculated, how they are applied to your polices, the consequences of all these lowered dividend scales, and the actions a consumer can take.
1) How life insurance policy dividends are calculated – the important thing with dividends is that they are not guaranteed. Technically each year the insurance company looks at your policy and others in the same block and determine how profitable it’s been compared to the original estimates. They take into account things like mortality, expenses, and interest on investments. If things go well, a dividend may be paid. If things aren’t going so hot, the original dividend scale may be cut back or reduced (which is what’s happening across the industry now). However even the way the dividend is calculated each year is not guaranteed. In the end, it’s up to senior management to approve the actual dividends paid – and if they decide they’re going to cut dividends without explanation or simply because their original estimates were terrible, they can and will.
2) Life insurance policies with dividends – life insurance policies that pay dividends are called ‘participating policies’. Each year the insurance company declares a sum of money called the dividend, and applies it to your policy. There are 5 ways this can be applied to your policy: in cash back, savings on deposit, paid up additions, reduce your premiums, and enhanced term insurance. That’s all very interesting, but here’s effectively what’s supposed to happen with many participating policies. A base amount of insurance is purchased (this is the portion that produces the dividends) plus an additional amount of term insurance. The term insurance has increasing premiums so we don’t want it around forever. Each year when the dividend is paid, various combinations of paying the term insurance premiums and buying a sliver of paid up additions happens. The paid up additions are basically mini whole life policies with a single premium (paid for by the dividend). Each year as there are more paid up additions, less term insurance needs to be purchased. The intent typically is to have the policy become paid up – the term insurance has been completely replaced by the paid up additions. With no more term insurance, the dividends on the base whole life policy plus the dividends on the paid up additions (remembering the paid up additions have no further premiums, but do create dividends) are enough to cover the cost of the life insurance. Voila, life insurance with no more premiums at some time in the future.
3) Consequences of lowered dividend scales – there are a variety of effects this can have on your policy, depending on which dividend option you selected. But for many policies, the lowered dividends means less paid up additions, which means it’ll be a longer period until the policy becomes paid up. In layman’s terms if you thought you wouldn’t have to pay life insurance premiums at some point in the future, think again.
4) Actions you can take – the very first thing you should do if you have a participating life insurance policy is to call the insurance company and speak to customer service. You need to ask for an ‘inforce policy illustration’. This illustration will project your policy features based on today’s current estimated dividend scale. It will likely look a lot worse than the one you got with your policy. And bear in mind – the projections are based on what they think is going to happen as of today – it’s still not guaranteed, and could still be even worse than what is shown with today’s numbers.
The solution to these problems vary based on the individual policy, however the basic premise is to consider replacing the insurance policy with a fully guaranteed life insurance policy that doesn’t rely on dividends. By cancelling the policy you should likely see some amount of cash value refunded to you as well. Be very very careful though – there simply is no simple answer as to whether this is a good idea or not. You’ll need to compare the current pricing of a new life insurance policy with the amount of after tax cash value from the existing policy. The taxes and cash value (and current insurance premiums) vary wildly by policy so we can’t generalize and need to look at each policy on a one-up basis.