What Is a Participating Life Insurance Policy?

Life insurance provides financial protection for loved ones after the policyholder’s death. Various types of life insurance policies exist, each designed to meet different financial needs and goals. Among these, participating life insurance stands out as a distinct type of permanent life insurance. This category of policy offers lifelong coverage and the potential for additional financial benefits beyond the guaranteed aspects of the contract.

Core Concepts of Participating Life Insurance

A participating life insurance policy is a type of permanent life insurance that allows policyholders to share in the financial performance of the issuing insurance company. This means that policyholders may receive a portion of the insurer’s surplus in the form of policy dividends. These dividends reflect the company’s favorable financial results and are distributed to eligible policyholders.

Participating policies are typically offered by mutual insurance companies. A mutual insurance company is distinct because it is owned by its policyholders, rather than by external shareholders. This ownership structure means that the company’s primary objective is to serve the interests of its policyholders, and any profits generated can be returned to them. In contrast, non-participating policies do not offer this dividend feature, providing only guaranteed benefits at a generally lower premium. It is important to understand that while participating policies offer the potential for dividends, these payments are not guaranteed and can fluctuate based on the insurer’s annual performance.

The Source of Policy Dividends

The surplus that generates policy dividends for participating life insurance policies arises from an insurance company performing better than its financial assumptions. Insurance companies set premiums based on projections for mortality, expenses, and investment returns. When actual experience is more favorable than these initial assumptions, a surplus can develop.

One contributing factor is favorable mortality experience, which occurs when the actual number of policyholder deaths is lower than the company had projected. This means the insurer pays out fewer death benefits than anticipated, contributing to a surplus. Another factor is lower-than-expected expenses, where the company’s operational costs are less than what was originally budgeted. Finally, higher-than-expected investment returns play a significant role, as the company’s investments, such as bonds and stocks, yield more than the assumed rates. These combined factors create the divisible surplus from which dividends are paid.

Life insurance dividends are generally considered by the Internal Revenue Service (IRS) to be a return of premiums paid, and therefore are typically not taxable income up to the amount of premiums paid into the policy. However, if the dividends received exceed the total premiums paid, the excess amount may be subject to taxation.

How Policyholders Receive Dividends

Policyholders with participating life insurance policies have several options for how they can utilize the dividends distributed by the insurance company. Each option provides a different financial benefit and can be chosen based on an individual’s current financial goals and needs. These choices offer flexibility in managing the policy’s value and ongoing costs.

One common choice is to receive the dividend as a direct cash payment. The insurance company issues a check to the policyholder, providing immediate liquidity that can be used for any purpose. Another popular option is to use the dividend to reduce future premium payments. The dividend amount is applied directly to offset the cost of upcoming premiums.

Policyholders can also choose to use their dividends to purchase Paid-Up Additions (PUAs). PUAs are small, single-premium policies that add to the policy’s existing death benefit and cash value. These additions are fully paid for and do not require further premium payments, and they themselves can also generate future dividends, creating a compounding effect. A final option allows policyholders to leave the dividends with the insurer to accumulate at interest. In this scenario, the dividends are held in an interest-bearing account, and the interest earned may be taxable as ordinary income when withdrawn. This option allows the policy’s value to grow over time, similar to a savings account.