When actuaries construct an insurance policy, a primary concern is making sure the company can deliver the benefits promised by the contract. It’s not insurance if the policy owners can’t count on receiving a benefit. To ensure their ability to deliver promised benefits, insurance companies conservatively price their offerings, giving themselves a financial cushion against unexpected occurrences, such as higher-than-anticipated claims or lower-than-projected returns from their invested reserves.
This conservative pricing may result in excess capital for the insurance company; actual claims and expenses are less than projected, or investment returns are higher. Policy owners may receive a portion of this excess as dividends.1 This is a common feature of whole life insurance policies, and while dividends are not guaranteed, most life insurers pay them regularly.
Policy owners may choose to receive a dividend as a cash payment, or apply it against current premiums, reducing out-of-pocket payments. To enhance policy benefits, they may elect to add the dividends to existing cash value accumulations, buy paid-up additional insurance, or obtain additional one-year term insurance.
Dividend options give policy owners ways to adjust their life insurance program. One possibility is called “premium offset”. If a policy consistently exceeds its guarantees and pays dividends, it is possible that, at some point, accumulated dividends may be sufficient to keep the policy in force without requiring additional premiums (to “offset” the premiums).2 Done correctly, this option could be a substantial benefit. But mismanaged, a decision to offset premiums can lapse a policy and obliterate all benefits.
The Difference between Guaranteed, Projected and Actual Performance
When someone contemplates the purchase of a whole life insurance policy, an illustration of benefits and cash values will typically be presented. Since insurers have a long history of regular dividend payments, regulators allow them to publish projections of policy performance that include the payment of dividends, even though they are not guaranteed. An illustration will include both guaranteed and projected performance numbers for the anticipated life of the policy. These numbers, and the differences between them, are intended to give consumers some perspective on the minimum benefits they are guaranteed, and what might be expected to occur if dividends are paid.
A standard whole life policy has a premium schedule intended to last for an insured’s lifetime (typically, to age 100, or in newer contracts, to 120). Many of these projections will acknowledge the possibility that accumulated dividends could be used to offset premiums at some point in the future. Some projections might indicate that dividends could offset premiums in very short time frames, such as 7, 10 or 15 years, especially if the owner makes “extra” premium payments during this period.
But while these illustrations may reflect historical performance and/or reasonable assumptions about the future, the policy’s actual performance will not match the illustration. And as each year passes, the initial illustration will be increasingly less accurate. Going forward, actual performance will probably exceed the guarantees, because the guaranteed values assume the worst-case scenario every year. But whether actual performance is higher or lower than the projections will vary year-by-year.
Even if a policy in the early premium-paying years outperforms projections, there’s a potential problem with electing to offset premiums: the length of time dividends must replace premiums. Suppose a 45-year-old makes 10 years of payments, and then at 55 decides to use dividends to offset premiums. A reasonable life expectancy is age 85, which means relying on the 10th-year projection to be accurate for at least 30 years (if not longer). What if, after 20 years of offsetting premiums, dividends decline dramatically? A projection at age 75 could reveal that resuming the payment of premiums is required to keep the policy in force. If premiums aren’t paid, the policy may lapse, resulting in the forfeiture of all benefits.
This worst-case scenario has precedent. Because interest rates were exceptionally high in the 1980s, then steadily declined to historic lows over the past three decades, some premium offset scenarios have failed. Relying on overly optimistic initial projections, some policy owners stopped paying premiums, only to find years later that their policies were under-funded and in danger of collapsing. A significant amount of litigation against agents and insurance companies ensued.
There are whole life policies that can achieve guaranteed paid-up status in a period shorter than age 100. Common policy types include 10-pay and 20-year plans, or paid-up at 65. Unlike the offset scenarios referenced above, policy owners do not have to hope future dividends will cover the cost of maintaining the policy. Once the scheduled premiums have been paid, the benefits are contractually guaranteed3; a policy owner can be assured that no future premiums will be required. But the annual premiums will also be higher than a standard whole life schedule.
Policy owners may find benefit in buying, or altering, their whole life policies to guaranteed paid-up status. Premiums can be re-allocated to other financial products or added to discretionary income. The higher premiums that accompany a guaranteed paid-up schedule also typically accelerate cash-value accumulations. In a retirement scenario, the combination of a paid-up policy and substantial cash values may permit the policy owner to make systematic withdrawals from the paid-up policy– often on a tax-favored basis.4
Knowing What You Can and Can’t Do
The illusion in projected offset scenarios is that paid-up status can be achieved with a premium offset; it can only be accomplished with a paid-up whole life policy at a predetermined age or year.
That said, once a whole life policy, which matures at age 100 or right around age 100, is established and has accumulated cash value, policy owners may be able to safely offset premiums on an intermittent basis. If a business owner hits a cash flow crunch, or an individual loses employment, the offset option makes it possible to keep the policy in force with no out-ofpocket expense, and premiums can be resumed at a later date. In these instances, a brief period of dividends substituting for premiums will not jeopardize the policy’s in-force status (although it will diminish cash value accumulations).
Psst…If Your Eyes Are Glazing Over, Just Read This
Dividends, and their impact on guaranteed, projected, and actual policy performance, can seem like bits of financial trivia. But dividends offer policy owners flexibility in maintaining or enhancing their whole life benefits. Every review of your life insurance program should include a discussion of how dividends are being applied.
1 Dividends are not guaranteed. They are declared annually by the company’s Board of Directors.
2 The premium offset year is not guaranteed and relies on dividends and the surrender of paid-up additions to pay the policy’s required premium. There is no guarantee that dividends will be paid or that paid-up additions will exist in the policy.
3 All whole life insurance policy guarantees are subject to the timely payment of all required premiums and the claims paying ability of the issuing insurance company. Policy loans and withdrawals affect the guarantees by reducing the policy’s death benefit and cash values.
3 Policy benefits are reduced by any outstanding loan or loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any outstanding loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under 59½, any taxable withdrawal may also be subject to a 10% federal tax penalty.