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As described previously, mutual insurers issue participating or par insurance policies and, as such, provide their policy owners the opportunity to receive dividends. Mutual companies can issue only participating policies.
An insurance dividend is not considered taxable income because it's a return of an overpayment of premium. Therefore, insurance dividends are tax-exempt. During the sale of insurance, producers cannot inform an applicant that dividends are guaranteed. Most states require a policy that provides a choice of dividend options to include a statement that dividends are not guaranteed. A producer is allowed to provide illustrations or documentation to an applicant that verifies the payment of dividends in previous years by the insurer.
The source of funds from which policy dividends are paid includes mortality, interest, and expenses. At the end of each year, the insurance company will review the money it received (premium payments), the gain (interest) generated by that money, the annual operating costs (loading expenses), and the claim expenses paid out (mortality). The mutual insurer that experiences excess surplus after paying claims and other operating expenses pays dividends to its policy owners.
Dividends typically become payable after the first or second policy year and are generally paid on policy anniversary dates. The policy owner may inform the insurer of the dividend option they select. This option will remain the same until the policy owner requests another option.
If a policy owner is entitled to a dividend, they can choose to receive the dividend as Cash, Reduction of Premiums, Accumulation at Interest, Paid-Up Permanent Additions, Paid-up Policy, or One-Year Term. An easy way to remember these options is the acronym CRAPPO.
If the policy owner is entitled to a $50 dividend, they may request that the insurer send the payment directly to them. Again, received insurance dividends are tax-exempt.
If the policy owner's annual premium is $250, and they discover they're entitled to a $50 dividend, they may choose to direct the insurer to retain the dividend and subtract that amount from the upcoming premium. The policy owner then pays $200 for the year's premium. This dividend option assists the policy owner whose primary objective is to conserve cash, since the policy owner is not required to remit the entire annual premium. The premium reduction option may be the dividend option used by the policy owner to minimize their current outlay of funds.
Under this option, the policy owner directs the insurer to retain the $50 dividend in a designated account. When this occurs, the insurer must pay interest on the dividend(s) it holds. Although the dividend is tax-exempt (not taxable), any interest earned on dividends left with the insurer is taxable as ordinary income in the year in which the interest is credited, regardless of whether the policy owner receives it. When death occurs, the life insurance policy pays out the face amount plus any dividend accumulations. In the event of a policy surrender, the cash value and accumulated dividends will be paid to the policy owner.
Also known simply as paid-up permanent additions, the policy owner may elect to use the $50 dividend to purchase additional permanent whole life insurance. The amount that can be purchased will be based on two criteria: the current age of the insured, and the dividend amount.
The insured is not required to prove insurability. Since there's no investigation to determine the insured's health and no agent to whom commissions are paid, the operating expenses or load charge for issuing PUAs is substantially lower than for issuing other insurance coverages. The dividend amount is the premium used to purchase a small amount of permanent paid-up life insurance. In other words, the dividend is used to purchase a small face amount of single-premium life insurance. Each paid-up addition also has cash value. Therefore, this option provides an increase in the policy owner's cash value. If this option is used, it increases the total death coverage to its maximum.
Do not confuse the dividend option, "Paid-up Additions," with the non-forfeiture option, "Reduced Paid-up Insurance." Paid-up additions increase the death benefit rather than reduce it. With a reduced paid-up option, the face value is REDUCED to the amount that the policy's present cash value could afford if it's used to purchase a single-premium policy.
Although uncommon, a policy dividend may be used to pay up a policy earlier than expected or as originally planned. In such cases, policy owners continue to pay their normal premium and use the dividends as additional payments toward the overall cost of their insurance. The option was designed for use with adjustable life insurance contracts. The option is analogous to making additional mortgage payments to pay off their mortgage early.
Don't confuse paying a policy up using dividends with the reduced paid-up non-forfeiture option. With this dividend option, the policy (including the original face value) remains fully intact. With a reduced paid-up option, the face value is REDUCED to the amount that the policy's present cash value could afford.
The $50 dividend can be used to simply purchase any type of term insurance that the insurer offers. The one-year term option is the dividend option that provides the policy owner with a different type of life insurance (i.e., term life insurance) than that which is provided by the primary policy (i.e., whole life), paying the dividend.
This option may be used to purchase as much term insurance as possible up to the base policy's cash value. Any excess dividend portions may be applied to any of the other dividend options. It may also be used to provide a face amount of life insurance equal to the amount of a policy loan taken against the cash value of the whole life policy.
For example, the policy owner with an outstanding loan can use this option to buy more life insurance just in case the insured dies before the loan is repaid.
The one-year term insurance dividend option requires a specific application and the issuance of a separate rider. If this option had been selected since the policy's inception, proof of insurability is typically not required. However, if the policy has been in force for several years with a different dividend option, the insurer may require evidence of insurability.
| Option | Description | Details |
|---|---|---|
| Cash | Request the insurer to send payment directly | Dividend is tax exempt |
| Reduced, reduction, or suspension of premiums | Retain the dividend and subtract from the premium | Pay $200 for the year's premium |
| Accumulate at interest | Retain the dividend in a designated account | Interest earned is taxable |
| Paid-up additions | Use dividend to purchase additional insurance | Increase in cash value and death coverage |
| Paid-up Policy | Use dividends to make additional premium payments | Shorten the length of the premium-paying period |
| One-year term insurance | Use dividend to purchase term insurance | Requires specific application and separate rider |