Life insurance dividends are a part of a class of life insurance polices known as ‘participating’. They’re participating because dividends are how you participate in the investment performance of the company. These polices are almost always whole life, so for practical purposes dividends are seen on participating whole life policies.
What are dividends? The life insurance company takes your policy and the rest of the block and makes assumptions on investment returns, admin costs, and mortality. At the end of the year they compare their actual performance with expected, and if things are positive they issue a dividend – a share in those over-estimated profits. (Note, this is a huge oversimplification, but it’s the way it’s technically supposed to work, so good enough for understanding the concept). In the end what this means is that if you have a participating policy, ever year you’re expected to receive some amount of money from those profits.
Important, red flag, warning, caveat emptor. Dividends are not guaranteed. Not only are they not guaranteed, they’re subject to vagaries in company management. “It’s Thursday, you’re ugly, this interferes with my bonus payment” are all valid reasons for a life company to not pay dividends. This lack of guarantees is important to appreciate as life insurance advisors have a tendency to over emphasise the lack of guarantees. When I started in life insurance back in 1986, advisors would say things like “the life insurance company has never decreased dividends”. Which was true until it wasn’t. Now that life companies HAVE decreased dividends some advisors will say “no company has ever failed to pay a dividend”. Also true right up until a company does this. Life companies take particular care to stabilise dividends so dividend decreases are possible but perhaps not probable – but just keep it in mind as you evaluate the importance of dividends in your life insurance purchase.
Next, what do you do with this infusion of cash every year? There’s 5 things you can do. You’ll pick one of these 5 choices upfront when you purchase the policy and in most cases that choice is locked in.
- Pay in cash. Just like it sounds. They simply issue you a cheque for the amount of the dividend. This would be one of the more rare options.
- On deposit. Similiar to 1, the life company will just deposit your dividends into an internal account where it accumulates with a minimal amount of interest. Again, not a common choice.
- Paid up additions. More common, and a really interesting choice. Each year your dividend will automatically purchase a small sliver of single premium fully paid up life insurance that gets added to your death benefit – basically your life insurance policy will increase every year. Two interesting results. First, this allows your coverage to automatically increase roughly in line with inflation. Secondly if you should ever become uninsurable this is the only way you’re likely to get more life insurance in the future (because these paid up additions increase your coverage without a medical exam).
- Reduce your premium. Your dividends can be used to reduce your premiums. Over time your dividends can (maybe…) get high enough that they equal your premium – at that point the dividends pay your insurance costs. This is called a ‘paid up policy’ because there are no more premiums. See the lack of guarantees above – these policies may not become paid up as quickly as intended, or may become ‘un-paid up’.
- Enhanced whole life. This is a fairly complex option. The purpose here is to get more life insurance at a lower price. A whole life policy is combined with term insurance; the dividends pay the term insurance and any leftover purchases paid up additions (as above). The paid up additions eventually replace the term insurance, leaving you with policy that is all whole life. Between the complexity of the interactions, the increasing costs of the term insurance portion, and the lack of guarantees on the dividends, be cautious with these policies – they do not always perform as expected.