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A “dividend” on a life insurance policy is unlike the dividend you receive on a share of stock or a stock mutual fund. For tax purposes dividends are considered a return of a portion of the premiums paid for the policy. Basically, the insurance company receives the premium payments and invests them. If mortality and expense experience is favorable (i.e., the company keeps expenses down and the investments do well), the company declares a dividend, which returns a portion of the surplus to policy owners.

Only participating policies pay dividends. Basically, these policies are priced to pay dividends. In effect, the company charges a higher premium, and then returns a portion of it to policy owners. Dividends have always been a controversial topic within the life insurance industry. There is no need to get into the details here, but you should understand what a dividend is and what it is not. In Great Britain, life insurance policies are sold “with profits” (i.e., with dividends), and “without profits” (i.e., no dividends). As you might expect, policies that pay no dividends are less expensive. However, both in the U.K. and in the U.S., over long periods of time the participating life insurance policy issued by a reputable company stands a very good chance of outperforming a nonparticipating policy. The key words are “over long periods of time.” Although both term and permanent policies can be participating, as a practical matter dividends are suitable only for permanent policies, with their long in-force horizons.

Typically, when the policy is purchased the policy owner is allowed to elect their form of dividend option and most insurers allow the dividend option to be changed once the policy is in-force. The policy owner can also elect a combination of options. The most common dividend options are:

 Payment in cash - the insured may choose to receive policy dividend as cash payments like dividends on ordinary corporate stock. If this option is selected, the insurer will pay dividends to the policy owner in cash usually beginning at the end of the first or second policy year.