An Expert Explanation of Participating and Non-Participating Life Insurance Policies

Because insurance companies must guarantee death benefits and a minimum schedule of cash values in most policies (except variable life policies), they must be conservative when estimating the values of the various premium pricing factors (interest, mortality, expenses, lapse rates, and risk loading factors) used to compute the required premiums under any particular premium payment plan of insurance. 

In the case of nonparticipating policies, all elements— premiums, death benefits, and the schedule of cash values —are guaranteed and fixed. If a company’s experience is more favorable than assumed with respect to any or all of the pricing factors, the premiums in excess of the amount needed to pay the company’s obligations add to the company’s profit or surplus. However, competitive pressures within the industry as well as from alternative investments have made such entirely guaranteed but nonparticipating policies unattractive in the marketplace. Now most policies issued are participating in one way or another, meaning that they share the benefits of the company’s favorable mortality, investment, expense, or lapse experience with the policy owners. 

In what are called traditional participating life insurance products (typically, but not exclusively issued by mutual rather than stock insurance companies), policy owners participate in the favorable experience of the company through dividends. Life insurance dividends are not like stock dividends, which represent a return on investment. Instead, they are more like a return of investment and are generally treated for tax and other purposes as a nontaxable return of prior overpayment of premiums. 

Insurers typically give policy owners of participating policies a number of options as to how they may use dividends, such as to reduce current premiums, to buy paid-up additional insurance, to buy additional one-year term insurance, to repay policy loans, to increase policy cash values and to shorten the premium paying period, or to accumulate at interest. In any case, dividends reduce the overall cost of insurance and make participating life insurance policies more attractive and competitive with alternative investments. 

Purchasers of participating policies are presented with a schedule of projected dividends when they buy the policy. Basically, the projected dividends generally reflect the company’s best estimate of the values of the various pricing factors as compared with the conservative assumptions built into their premium calculations. But in contrast with quoted premiums, death benefits, and cash value schedules, dividends are not guaranteed. Insurers cannot guarantee dividends because the dividends depend on the insurers’ actual experience relative to their conservative pricing assumptions. The insurers cannot know their performance until the experience actually unfolds. 

In relatively recent years, a new type of participating life insurance, generically called current-assumption life insurance, has become popular. In contrast with traditional participating policies, these types of policies do not pay dividends. Rather, if the company’s experience is more favorable than assumed in its premium pricing computations, the favorable experience is reflected directly in the amounts credited to the policy’s cash values. In other words, if the company’s experience is favorable, cash values grow larger and more quickly than shown on the schedule of guaranteed minimum cash values. 

Depending on the type of policy, the policy owner may have several options as to how they may use these additional cash value increases. In some cases, policy owners may withdraw the additional cash value without otherwise affecting their death benefits, premium payments, and minimum guaranteed cash values; the insurer may permit policy owners to reduce the level of future premium payments while maintaining the same face amount of coverage; the insurer may allow policy owners to increase the face amount of coverage while maintaining the same premium level; policy owners may keep the face amount and the premium payment level the same but shorten the required premium-payment period; or they may choose some combination or variation of these options. 

Purchasers of current-assumption policies are presented with an illustration of projected premiums, cash values, and death benefits that use the company’s current assumptions regarding the various premium pricing factors as well as an illustration showing the minimum guaranteed values based on the current premium and the statutorily mandated conservative pricing assumptions. Similar to projected dividends with traditional participating policies, the projected cash values and any projected death benefit increases above those shown using the required conservative pricing assumptions are not guaranteed. In many cases, even the premiums and the term of the policy are not guaranteed. If the company’s experience turns out less favorably than currently assumed, the policy owner may have to pay premiums for a longer period than anticipated or pay increased premiums in order to maintain the face amount of coverage. Alternatively, the policy owner may have to accept a reduction in the face amount of coverage or a shortened term of coverage. 

Variable life policies are the ultimate in participating policies, at least with respect to investment performance. The policy owner bears (almost) all the investment risk and reaps all the investment rewards from the underlying investments; the insurer provides no minimum interest guarantee with respect to cash values. In most cases, the policy owner may choose to invest premium dollars among a number of mutual fund-type investments. As in other types of policies, the insurer guarantees that mortality charges will not exceed certain maximums and that the death benefit will not fall below a certain minimum, regardless of the investment performance of the underlying assets. However, the insurer makes no assurances regarding cash values. Depending on the type of variable life policy, favorable investment performance may increase the face amount of coverage or the insurer may give policy owners a number of flexible options similar to those described above for certain current-assumption policies.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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