Dividends and Nonforfeiture Options
Dividends — Participating and Nonparticipating Life Insurance Policies
Participating life insurance policies, unlike nonparticipating policies, pay dividends. Operating a life insurance company is much like any other business — there are uncertainties as to payout, returns, and operating expenses. Consequently, a life insurer will calculate premium payments to cover the uncertainties. When the life insurer does better than expected, it returns part of the paid premiums to the insured. Because the IRS considers life insurance dividends to be a return of part of the premium, dividends are not taxable. The source of dividends arises because
- the actual mortality costs were less than projected
- operating expenses were lower than expected; or
- investment income was greater than expected
Since the source of dividends result from actual income minus actual expenses, dividends are not payable until at least a year has elapsed — whatever is stated in the policy — and is usually paid on an anniversary date of the policy.
Dividends can be received as cash, or the insurer can retain the dividends to earn interest, reduce premiums, or add paid-up additions or term insurance to the policy.
If the dividend is taken as a premium reduction, the insurer will send the insured the amount of the premium, the amount of the dividend, and the net amount due.
Most policies pay a minimum of interest on accumulated dividends, but may pay more if investments are doing better. The insured can withdraw the money at any time, or it will be added to the face policy if the insured dies, or the policy is surrendered for its cash value.
The major disadvantage of accumulated dividends is that taxes must be paid on the income every year, whether withdrawn or not — just like the interest earned on a savings account.
The insured can also use the dividends to buy small amounts of additional paid-up whole life insurance, which increases the face value of the policy. The advantage of increasing life insurance this way is that there is no expense charge for the additional life insurance — thus, the premium buys more life insurance than if sales charges and other expenses were deducted. The other advantage is that the insured does not need to prove insurability. Hence, this is a good option for someone in poor health who wants to increase their life insurance.
Eventually, the insured can convert to a single-premium life insurance policy if the legal reserve of the main policy and the paid-up policies is enough for the coverage desired.
Another possibility is to collect the face value as an endowment. If the legal reserves of the main policy and the paid-up policies equal the face value of the main policy, then the insured can collect that money as an endowment.
The dividend can also be used to buy 1 year term insurance. If the policyholder has borrowed against the policy, then part of the dividend can be used to buy term insurance equal to the face value of the policy. If the insured should die before paying back the loan, the beneficiary will still receive the full value of the policy.
A 2nd option for term insurance that very few companies offer is yearly, renewable term insurance. For a young person, a small dividend can greatly increase the death benefit. The amount of term insurance that can be purchased depends on the amount of the dividend, the age of the insured, and the insurer's rates.
Often, people stop paying premiums on their life insurance policies. For most types of insurance, the policy terminates after the grace period, but if the policy has cash value, then state law prevents life insurance companies from simply terminating the contract and keeping the cash value. Insurance companies can provide 4 different nonforfeiture options:
- paying the cash surrender value to the insured;
- convert the insurance to term life insurance;
- convert to a reduced paid-up insurance policy;
- convert it to an annuity.
If the policyholder does not choose an option, most insurance companies choose the term life insurance option.
If the cash surrender option is chosen, then the insured receives the cash value of the policy, which is taxed as ordinary income. The policy cannot be reinstated.
If the policy is converted into term life insurance (aka extended-term option), then it will have the same face value as the original policy, but the term will be determined by the cash value of the policy — the greater the cash value and the lower the face amount of the policy, the longer the term. A policy converted to term insurance can be reinstated under the reinstatement provision of the contract.
The cash value can also be used to pay for reduced paid-up insurance. The face value of the paid-up policy will be commensurate with the amount of the cash value of the policy, but will be less than the original policy. Under this option, the original policy can also be reinstated under the reinstatement provision.
Most insurance companies will also allow the insured to buy a single-premium, immediate annuity, which pays the policyholder an amount commensurate with the cash value of the policy and the policyholder's age for the rest of his life. There are 2 advantages to buying an annuity this way: there are no sales charges or other expenses, and the mortality table used in calculating the annuity payments is the same mortality table used for calculating life insurance premiums. Because life insurance mortality tables list shorter life expectancies than the mortality tables used in calculating premiums for annuities, the annuity payments are larger.