Policy Dividend Options

A dividend is an amount returned to a policyowner out of an insurance company's surplus funds. In a practical sense it is a return of premiums that exceed the insurer's expenses and mortality experience. Only certain types of insurance policies produce dividends. The policyowner decides in advance how he or she wants the dividend to be applied based on the options available through the policy.

Dividend Basics

Policy dividends are payable only with participating life insurance policies. They are most commonly issued by mutual insurance companies. A participating policy is one that participates in the insurer's divisible surplus, which is determined after accounting for liabilities (including death benefit payments), reserves, capital, and expenses. Participating policy dividends are effectively a return of unearned premium. As long as they do not exceed the total premiums paid by the policyowner, they are treated as a tax-free return of premium. (Since life insurance premiums are not tax deductible, it is only fair that a return of premium would be tax free.)

Dividends are not guaranteed. While insurers try to pay policy dividends consistently, they (and their producers) may not under any circumstances state or imply with certainty that policy dividends will be paid. This prohibition against guaranteeing policy dividends applies to producers, too

--Participating Policy= the owner is paid a dividend out of the insurance company's earnings that are available for distribution (the divisible surplus)

Dividend Options

Participating life insurance policies include provisions that enable the policyowner to choose how he or she wants to apply any declared policy dividends. These most common options, known as dividend options, are

-receiving the dividend in cash;
-applying the dividend to reduce the premium;
-leaving the dividends with the insurer to accumulate at interest;
-using the dividends to buy additional paid-up life insurance; and
-using the dividends to buy one-year term insurance.

Policyowners may change their selected dividend option at any time. However, if the new dividend option increases the pure insurance risk to the insurer (e.g., to the one-year term option), the insurer can require the insured to submit evidence of insurability.

Receive the Dividend in Cash

Under the cash dividend option, the policyowner simply elects to receive the dividend in cash. The insurance company sends a check for the amount of the declared dividend on the anniversary date of the policy. Policy dividends received in cash generally are not income taxable.

Reduce the Premium

Under the premium reduction option, the insurance company uses the dividend to reduce the next premium due. Suppose, for example, that the annual premium was $1,000 and the declared dividend was $250. In such a case, the policyowner choosing the premium reduction dividend option receives a premium notice for $750

Accumulate at Interest

Under the accumulation option, the insurer holds the dividends in an interest-bearing account for the policyowner. The policyowner can withdraw the accumulated dividends and interest at any time.

While dividends are generally not taxable, the interest earned on dividends held at interest is taxable income in the year credited. This holds true regardless of whether the policyowner withdraws the interest earnings or allows the interest to continue to accumulate.

Suspend Premiums

An option that is available to policyowners who have let their policy dividends accumulate at interest is to use the accumulated funds to suspend premium payments. The length of time for which premiums can be suspended is dependent on the value of the accumulated dividends (plus interest); the larger the account, the longer premiums can be suspended.

Buy Paid-Up Additions

Under the paid-up additions option, the dividend buys additional paid-up insurance of the same type as the base policy. For instance, a $300 policy dividend on a whole life policy would be applied to buy an additional amount of paid-up whole life insurance. (The premium rate for the paid-up additions is based on the attained age of the insured when he or she buys the addition.) As each year's dividends are applied to buy these paid-up additions, the age at which they are bought increases each year. And because the age increases, the premium rates for the additional insurance increase each year, too.

Paid-up additions are life insurance policies in their own right. As such, they are eligible for dividends and they each have a cash value that grows over time. Upon the insured's death, the total death benefit equals the face amount of the policy plus the face amount of the paid-up additions. Over time, the cumulative effect of these expanding policy values can greatly enhance the policy's total value—all for the same premium in effect when the policy was issued.

Buy One-Year Term Insurance

In addition to these four basic dividend options, various combination dividend options are available. Most of the combination dividend options involve one-year term life insurance. They are often referred to collectively as the fifth dividend option.

Under the fifth dividend option, policy dividends are used to purchase one-year term life insurance. Depending on the specific option selected, the term life face amount may equal the base policy's cash value or it may equal the amount bought with the dividend. If the first option ("equal to cash value") is elected, it is likely there will be some left-over dividend amount. In that case, the unused dividend can be applied to any of the other four basic dividend options. Whichever term life option is selected, the additional coverage is provided through a one-year term life policy that expires one year after issue.

Because the term life face amount consists entirely of pure insurance protection, it represents a greater risk to the insurer than any other dividend option. If the policyowner requests a change to this option after the policy is issued, the insured will be required to provide evidence of insurability.

-Combination dividend options= dividend option in which the declared dividend each year buys one-year term insurance. The insurance is bought in an amount equal to the policy's cash value. Also called combination dividend option.

-fifth dividend option= declared dividend each year buys one-term insurance. The insurance is bought in an amount equal to the policy's cash value. Also called combination dividend option.

Paid-Up Insurance

A less common dividend option, the paid-up insurance option, lets the policyowner use the dividends to pay up the life insurance policy early. A policyowner who chooses this option could pay up a whole life policy several years early, depending on the policy. After the policy is paid up, the policyowner does not owe any more premiums and the policy benefits continue in force.

key points

-Policy dividends are payable only with participating life insurance policies.
-Participating policy dividends are effectively a return of unearned premium.
-While insurers try to pay policy dividends consistently, they (and their producers) may not under any circumstances state or imply with certainty that policy dividends will be paid.
-While dividends are generally not taxable, the interest earned on dividends held at interest is taxable income in the year credited.
-Paid-up additions are life insurance policies in their own right. As such, they are eligible for dividends and they each have a cash value that grows over time.

on test

-Paid-up additions= the best. small portion of premium will add to death benefit and raise cash value.
--ex. facemount= 50,000 premium 61.95
+paid up additions 24,000 = 74,000 total face amount
-cash value 15,000 + paid up additions 10000= 25000 total cash value

quiz

Question 1
Which statement about the accumulation dividend option is NOT correct?

Participating policy dividends are not generally taxable.
The policyowner can only withdraw the accumulated dividends and interest on the policy's anniversary date.
The insurer credits a rate of interest to the dividends as they remain on deposit with the insurer.
The dividends are retained in the insurer's general account.
Participating policy dividends are not generally taxable. However, the interest earned on the dividend is taxable.
Question 2
Most of the combination, or "5th," dividend options involve which of the following?

one-year term life insurance
one-year permanent insurance
renewable term insurance
extended-term insurance
Combination dividend options involve one-year term insurance.
Question 3
In addition to the four basic dividend options, various combination dividend options are available. Most combination dividend options involve which of the following?

additional insurance (determined by the dividend amount) of the same type as the base policy
term life insurance in $1,000 increments
one-year term life insurance
permanent life insurance in $1,000 increments
The declared dividend each year buys one-year term insurance in an amount equal to the policy's cash value-not additional insurance (determined by the dividend amount) of the same type as the base policy.
Question 4
Gloria chooses to take her life insurance policy dividends in cash. The insurance company sends a check for the amount of the declared dividend on the anniversary date of the policy. What is the tax consequence to Gloria for receiving cash dividends?

Her dividends are only income tax-free if Gloria is over age 62 ½.
Her dividends are not income taxable.
Her dividends are fully taxable.
Her dividends are tax deferred.
Policy dividends are received tax free.

Question 1
What type of life insurance company is owned by the policyowners?

*mutual company
stock company
universal insurance company
privately-traded company
There are no "universal insurance" companies; the term refers to a type of life insurance.
Question 2
What type of life insurance policy distributes its surplus after the company accounts for liabilities, reserves, capital, and expenses?

commercial insurance
industrial insurance policy
non-participating policy
*participating policy
A participating policy is a life insurance policy that participates in the divisible surplus of the insurer. The divisible surplus is the part of an insurance company's earnings available for distribution to policyowners.
Question 3
Sue's annual premium is $1,500 and the declared dividend was $200. If Sue chooses the premium reduction dividend option, she will receive a premium notice for which of the following?

$1,700
$1,500
*$1,300
$200
Under the premium reduction option, the insurance company keeps the dividend and uses it to reduce the next premium due. Sue's next premium notice will be for $1,300.
Question 4
What type of life insurance company is owned by its stockholders?

mutual company
*stock company
universal insurance company
privately held company
Stock companies are owned by stockholders, just like other public companies.

Question 1
Which one of the following most correctly describes a life insurance policy dividend?

an amount paid to insurance company stockholders annually if profit margins are met
*an amount returned to a policyowner out of an insurance company's surplus funds, effectively representing unused premiums.
a distribution of insurer profit to those holding stock in the company.
an insurer's revenues in excess of costs
A policy dividend is not an insurer's revenues in excess of costs.
Question 2
Laura has selected the paid-up additions dividend option with her participating whole life insurance policy. In Laura's case, which of the following types of life insurance best describes the type of product that will be purchased with policy dividends?

level premium whole life insurance
one-year term life insurance
level premium term life insurance
*single premium whole life insurance
Paid-up additions do not purchase term insurance.
Question 3
Which statement regarding life insurance policy dividends is NOT correct?

If dividends issued to a participating policyowner do not exceed the policyowner's total premiums for the policy, then they are not taxable.
Participating life insurance policies include provisions that enable the policyowner to choose how he or she wants to apply any declared policy dividends.
Dividends are generally received income tax free.
*Dividends are guaranteed.
Dividends are generally received income tax-free
Question 4
Which type of life insurance company pays dividends to its stockholders?

*stock company
privately traded company
mutual company
universal insurance company
Stock companies pay dividends, when declared, to their stockholders.