7.1 Dividend Options (Participating Policies)

Dividend Options on Participating Policies

A participating (par) policy is one that pays policy dividends to the policyowner. Dividends represent a return of overpaid premium generated when the insurer's actual experience (mortality, expenses, and investment earnings) is better than the conservative assumptions priced into the premium. Because they are legally a return of the owner's own money, the Internal Revenue Service (IRS) treats dividends as a nontaxable return of premium rather than as income.

Mutual insurers are owned by policyowners and issue par policies, so dividends flow to owners. Stock insurers are owned by shareholders and traditionally issue nonparticipating (nonpar) policies, paying shareholder dividends that are taxable income to investors. Exam traps often hinge on this distinction: mutual = policy dividend to owner; stock = shareholder dividend to investor.

Why dividends are never guaranteed

State insurance law prohibits insurers from guaranteeing dividends because they depend on future surplus, which cannot be promised. Illustrations must label dividend figures as non-guaranteed and show a guaranteed column alongside the projected column. A producer who tells a prospect that dividends are guaranteed has made a material misrepresentation and could face disciplinary action.

Dividends are typically first payable at the end of the first or second policy year and only while the policy is in force. They are declared annually by the insurer's board of directors based on the year's divisible surplus.

The five standard dividend options (CRAPO)

Memorize these with the mnemonic CRAPO:

Paid-up additions is commonly the default option chosen when the owner makes no election. Each PUA is fully paid-up permanent coverage that itself earns dividends, creating a compounding effect that grows both cash value and death benefit.

Worked numeric: accumulate-at-interest taxation

Suppose a par whole life policy pays a $300 annual dividend left to accumulate at interest crediting 4%. The $300 itself is a nontaxable return of premium. If by year-end the account holds $5,000 and earns $200 of interest, that $200 is taxable to the owner in the year credited and reported on Form 1099-INT, even if not withdrawn.

Contrast the one-year term option, sometimes called the fifth dividend option: it uses the dividend as a net single premium to purchase one-year term coverage. A frequent design buys term equal to the policy's current cash value, which can support an enhanced or economatic death-benefit design.

Scenario and trap

An owner of a par whole life policy wants to maximize total death benefit over time without paying extra out of pocket. The best election is paid-up additions, because each addition adds permanent death benefit and compounds. If the same owner instead wanted to shorten the premium-paying period, applying dividends to reduce premium lowers the cash outlay but does not build extra benefit.

Trap: Candidates confuse 'reduce premium' (offsets the current bill) with using dividends to make a policy paid-up early. Reducing premium does not retire the contract; it only lowers each payment. Also remember a nonpar policy cannot use any dividend option because it pays no policy dividends.

Dividends and the seven-pay test (modified endowment contracts)

Dividends used to buy paid-up additions can inadvertently push a life policy past the seven-pay test and turn it into a Modified Endowment Contract (MEC). The seven-pay test asks whether cumulative premiums in the first seven years exceed the net level premiums needed to make the policy paid-up in seven years. If PUA dividends are applied as additional premium, they count toward that limit.

Once a policy is a MEC, living distributions (loans, withdrawals, surrenders) are taxed last-in-first-out (LIFO) - gain first - and a 10% penalty applies before age 59 1/2. The death benefit remains income-tax-free. Because dividends themselves are a return of premium, taking them as cash rather than PUA avoids adding to the seven-pay premium total.

Choosing among options

Match the option to the owner's goal: a retiree who wants spendable money picks cash; a budget-conscious owner picks reduce premium; a saver who wants a guaranteed deposit account picks accumulate at interest; a legacy-minded owner who wants growing protection picks paid-up additions; and an owner who wants extra temporary coverage at low cost picks one-year term.

Producers should document the suitability of the recommendation and disclose that dividends are non-guaranteed. Owners may change the dividend option at any time by written request, and most insurers allow combining options (for example, part cash and part PUA).

Paid-up additions: the most-tested dividend option

The paid-up additions (PUA) option uses each dividend as a single premium to buy a small chunk of fully paid-up whole life. Each addition has its own cash value and own death benefit, immediately increases the total face amount, and itself earns future dividends, compounding the policy's growth. PUAs require no evidence of insurability, making them a valuable way to grow coverage for an insured who has become uninsurable.

One-year term and the fifth standard option

The one-year term (fifth dividend / additional term) option uses the dividend to buy one-year term insurance, often up to the policy's cash value, increasing the death benefit cheaply for a year. Some insurers limit it to the cash-value amount (a 'fifth dividend option' tied to loans). Contrast all five options by memory: Cash, Reduce premium, Accumulate at interest, Paid-up additions, One-year term — the CRAPO mnemonic — and note that only accumulate-at-interest produces currently taxable interest income.