Where it comes from. New York's Department of Financial Services describes dividends on participating whole life as representing "the favorable experience of the company," resulting "from excess investment earnings, favorable mortality and expense savings." The insurer compares what it charged with what claims, costs and investment returns turned out to be, and decides at its discretion how much of the difference to return. The formula an insurer uses to set the year's dividends is its dividend scale, and the scale can change from one year to the next.
It is not guaranteed, and the disclosure rules are written around that fact. NAIC's Life Insurance Disclosure Model Regulation treats a dividend as one of a policy's nonguaranteed elements, those that are "subject to company discretion and are not guaranteed at issue," and requires any reference to one to state "that the item is not guaranteed and is based on the company's current scale of nonguaranteed elements." Its companion, the Life Insurance Illustrations Model Regulation, bars an insurer or producer using an illustration in a sale from stating or implying "that the payment or amount of non-guaranteed elements is guaranteed," and requires the numeric summary of a sales illustration to show a midpoint column that pays dividends at half the illustrated scale. These are model regulations, so they bind only in the states that adopt them. A policy loan can lower the dividend too, and where it would, the disclosure model requires a statement saying so wherever the nonguaranteed elements are described.
The dividend options. NAIC's glossary and New York's regulator between them list the usual choices: take the dividend as cash, apply it to the premium, leave it on deposit with the insurer, use it to buy an increment of paid-up insurance (often called paid-up additions), or use it to buy one year of term insurance. The policy states which options it offers, and an illustration must show the dividend option it assumes. The choice changes what the policy becomes over time: cash and premium reduction leave the coverage where it was, while paid-up additions add fully paid coverage, raising the death benefit and, because paid-up insurance carries cash value of its own, the policy's cash value.
The tax treatment. Section 72(e) of the Internal Revenue Code treats a dividend on a life insurance contract as an amount not received as an annuity, and IRS Publication 550 states the result for a contract that is not a modified endowment contract: a dividend paid out is "a partial return of the premiums you paid," not included in gross income "until they are more than the total of all net premiums you paid for the contract." A dividend the insurer keeps to pay premiums is not taxable either. What is taxable is the interest an insurer credits on dividends left on deposit, which Publication 550 treats as interest income and the insurer reports on Form 1099-INT. A modified endowment contract follows different distribution rules, so the return-of-premium treatment cannot be assumed there.
Why the dividend column matters in a sale. On a participating policy the illustrated columns rest on the current dividend scale, and they are the columns that make one policy compare well against another. The insurer sets that scale every year for decades after the sale. Reading an illustration well mostly means reading the guaranteed column and the midpoint column alongside the illustrated one, rather than the illustrated one alone.
