Page 2: The basics of insurance dividends
Life insurers also classify their policyholders, and the amount you pay in premium and the amount you receive as a dividend depends on what class of policyholders you are in.
Policyholders are placed in rating classes according to physical characteristics, including age, sex, and medical history. If your life insurer has to pay out a higher-than-expected number of death claims in your class, you are less likely to get a dividend.
You might assume that younger folks would receive more in dividends than seniors because younger people are less likely to die. However, James Reiskytl, vice president of tax and financial planning at Northwestern Mutual Life Insurance Co., says premiums are calculated such that older people pay more in mortality and expense (M&E) fees — the cost the insurer charges you to assume the risk of insuring you — and thus get back a higher dividend because they pay more in premium. Thus, older people have the same chance of receiving the amount younger people receive, he says.
Still, it's possible that some policyholders will receive dividends when others won't, regardless of how much a particular group pays in M&E fees. Life insurers "don't want to reward a class [of policyholders] if there are a lot of unknowns and they have a poor track record," says Michael Bartholomew, senior counsel for the American Council of Life Insurers.
Those who own whole life and universal life insurance policies may receive dividends, while people who own term life insurance policies will not. That's because the cash value in a whole or universal life insurance policy is a fixed rate guaranteed by the insurer and funded through money in the company's reserves. In turn, the investment return on its reserves is one factor that determines whether the insurer will pay a dividend. Term life insurance policyholders do not receive dividends because there is no underlying cash value that earns interest.
Variable life and variable universal life insurance policyholders may receive dividends if there are a lower-than-expected number of death claims in their rating class and the insurer managed to keep down its expenses. However, these policyholders are less likely to receive dividends than whole or universal life insurance policyholders because earnings on the cash value — one factor life insurers use to determine whether they will pay a dividend — are not fixed or guaranteed. Instead, the cash value in variable policies is based on the performance of subaccounts, which are investment options that may include mutual funds.
Dividends and taxes
If your insurer issues you a dividend, you can take it in cash, buy additional insurance coverage, or apply the money toward your premium. For life insurance policies, you also can pay off loans you may have taken against your whole life policy.
In most cases, your dividends won't end up in Uncle Sam's pocket. Dividends from auto and homeowners insurance policies are tax-free.
Life insurance policy dividends are taxable only when the amount you receive in cash exceeds the amount of premiums you have paid. The dividends are taxable only if you take them in cash. If you use your dividends to buy paid-up additions to your policy, they are not taxable. Dividends also may be taxable if your life insurance policy is a modified endowment contract, which is a policy that's overfunded in order to build up greater cash value. Dividends on modified endowment contracts are taxable unless the money is used to buy paid-up additions to your policy. (For more on life insurance and taxes, check out Insure.com's Life Insurance & Annuity Tax Tool.)
An incentive to stay
Insurance companies often pay dividends to keep customers from defecting to other insurers, says Hartwig of the III. Insurers think a check at the end of the contract year — no matter how small — is incentive enough for policyholders to renew their coverage and not seek lower rates or better coverage elsewhere.
"At the end of the year, the last thing a person sees from their insurer is a check," he says. "That can go an awful long way in keeping that customer." Return to Page 1