Participating policies and dividends

Where a dividend comes from

When an insurer prices a participating whole life policy, it makes assumptions about three things: how long policyholders will live, what its investments will earn, and what running the business will cost.

Those assumptions are deliberately conservative, because the premium and the death benefit are guaranteed and the insurer has to be able to honour them in bad conditions as well as good.

When reality turns out better than the assumptions, the surplus builds up in the participating account. Each year the insurer’s board decides how much of that surplus to distribute back to participating policyholders. That distribution is the dividend.

What it is not

It is not interest. You are not earning a rate on a deposit. You are receiving a share of a surplus that may or may not exist.

It is not a stock dividend. You do not own a piece of the company. Participating policyholders share in one specific account, not in the insurer’s overall profit.

It is not guaranteed. This is the point that matters most. The dividend is declared annually at the insurer’s discretion. Canadian insurers have long records of paying them, and dividend scales have also been reduced across the industry, most visibly during extended periods of low interest rates. A long history of payment is a reason for confidence, not a contractual promise.

The five options

You choose what happens to the dividend, and you can usually change it later.

Paid-up additions. The most common choice by a wide margin. The dividend buys a small amount of fully paid-up permanent coverage, which is added to the policy. Those additions have their own cash value and earn dividends themselves, so the effect compounds. Over decades this can grow both the death benefit and the cash value considerably.

Cash. The insurer sends you the money. Simple, and it gives up the compounding.

Premium reduction. The dividend is applied against your next premium, reducing what you pay out of pocket.

Accumulate on deposit. The dividend sits with the insurer earning interest. That interest is taxable annually, which makes this the least tax-efficient option.

Buy term additions. The dividend buys one-year term coverage. Less common and used in specific structures.

For most people building long-term value, paid-up additions is the default for good reason.

Premium offset, and the trap in it

At some point an advisor may explain that after a certain number of years the dividends could become large enough to cover the premium, so you stop paying out of pocket. This is called premium offset, and it is frequently described as premiums “vanishing”.

The mechanism is real. The description is misleading in one important way: it depends on the dividend scale holding at or near the illustrated level. If the scale is reduced, the dividends no longer cover the premium and payments resume, sometimes years after the owner had mentally filed the policy as paid for.

This has happened at scale before and it caused genuine hardship for people who had budgeted around it.

Two questions to ask about any offset proposal. Is the premium contractually limited, or only projected to stop? And what does the illustration look like if the dividend scale is reduced? Insurers are required to show reduced-scale scenarios, so ask to see them.

Reading a dividend illustration

Every participating illustration has a guaranteed column and a projected column.

The guaranteed column shows what the contract promises if no dividend is ever paid. The projected column assumes the current dividend scale continues indefinitely, which is not a forecast so much as an arithmetic extension of today’s conditions.

Read the guaranteed column first and decide whether the policy is worth buying on those numbers. If it only makes sense on the projection, you are buying an assumption.

Also worth noting: the dividend scale interest rate quoted in illustrations is not the return on your money. It is one input into how the participating account is credited, and the relationship between it and what actually lands in your policy is indirect.

Tax

Dividends on a participating life insurance policy are generally not taxed as they are credited, which is a meaningful part of the appeal. They do reduce the policy’s adjusted cost basis, which affects how much is taxable later if the policy is surrendered or money is withdrawn.

Dividends left to accumulate on deposit are different, because the interest earned on them is taxable each year.

The interaction between dividends, adjusted cost basis and eventual disposition is genuinely complicated, and the numbers matter. See tax on cash value and policy loans for the outline, and take the specifics to an accountant.