Every year, usually sometime in November, life insurance companies that sell participating whole life insurance report their plans to pay dividends to policyholders. When the insurance companies talk about it, they often refer to as their whole life insurance dividend rates.
Generally, the companies make their announcements by noting the sum of dividends–expressed in dollars–they intend to payout to those holding a whole life policy.
Many also note the effective dividend interest rate the payout represents.
For a long time now, many have offered up the dividend interest rate out as some sort of metric that showed an insurers victory or defeats through the year.
There are definitely too many people out there who believe that a higher dividend interest at one company manifests some superiority over another company with a lower whole life insurance dividend rate. Others make a more insidious claim comparing the dividend interest rate to various yields on investments and suggest that because of a higher dividend interest rate, whole life insurance is always the better choice.
All of this is wrong. It’s important to understand how wrong it is. Plus, I wanted to tease out a more important and better question.
Should we just get rid of talking about whole life insurance dividend rates altogether?
The Purpose Of Whole Life Insurance Dividend Rates
The dividend interest rate reports the input of a single variable used by the life insurer to calculate the dividend paid to each policyholder. All dividend payments use three basic components:
- Investment income
- Underwriting Profit (Mortality)
- Operational Expense
To expound a bit on each…
Investment Income
This is the income that the insurer generates from investing the money it collects from the policyholder.
In other words:
Policyholders pay a premium → Insurer takes premium and places the funds into various income-producing investments → Insurer books this investment income as a component to its cash flow.
At the end of the year, the portion of investment income attributable to profitability will go to policyholders.
While not universally true, most insurers generate the largest portion of their cash flow and profitability from investment income.
Underwriting Profit
Whenever a life insurance policy exists, the insurer assumes the risk of paying out the death benefit associated with the policy. As a result of this assumed risk, the insurer must charge appropriate expenses to the policyholder and hold funds necessary to pay the death benefit should the policyholder die.
When policyholders don’t die and insurers don’t have to pay a death benefit the insurer generally benefits by keeping at least a portion of the funds set aside to cover the death benefit. This results in an underwriting profit to the insurer.
While underwriting profits were generally a smaller component of life insurer profitability, low-interest rates following the 2008 financial crisis have led this piece of the dividend equation to play a larger role in delivering value to policyholders in recent years.