How Does Whole Life Insurance Work

Whole life insurance dividends have long mystified both consumers and agents. We know that once per year, the mutuals and other companies that issue participating whole life insurance release press releases to announce the dividend payout for the following year. And usually (but not always…New York Life…) the companies will typically release what this payout means to the dividend interest rate.

And it's this dividend interest rate that causes so much confusion across parties. So how does it work, and what does it mean? When a company pays a 6% dividend, what is it paying 6% on?

The Reserve

First, before we can tackle what exactly the company is paying the dividend on, we have to understand a crucial aspect to permanent (and level premium) life insurance, the reserve. A life insurance policy reserve is a cash position that can cover a policy's future benefits.

I'll use a really basic example commonly discussed with term insurance, and then expand from there.

Most of us have heard, at one time or another, that level term insurance can have a level premium (instead of the rising premium that old term insurance was notorious for) because the insurer overcharges you for the first many years, and then under charges you in later years. This very principal is a foundational concept to reserve building.

The excess premium collected from the insurer is used to develop the policy's reserve. In other words, the company takes the difference between the required premium (what it absolutely must collect under the old term model where premiums started really low and increased incrementally each year) and what it actually collects and saves that money to cover costs that will be incurred after the premium collected is no longer adequate to cover the costs of the insurance (i.e. once the insurer is undercharging you).

The reserving system is what get's cash value life insurance off the ground. And it's also what sets off the endowment aspect to whole.

Dividends are Paid off the Reserve

This simple statement tells us all we need to know, and we could honestly stop there if not for the fact that I'm assuming an incredible amount of additional knowledge regarding these products. This statement is one I could utter indefinitely and there's a good number of people who still would discount this statement and miss the point.

While we're at it, I should mention that the guaranteed rate on all whole life policies is also paid off the reserve of the policy.

So what Exactly is the Reserve on My Policy?

This is the million dollar questions and I'm going to disappoint all of you with my answer: we never really know.


It's true. If you remember all of that black box business about whole life insurance this is one of those perfect examples.

The company is under no obligation to disclose the exact number that is your policy's reserve. But this fact alone may not be such a big deal.

Thanks to the Standard Non-forfeiture Law (SNFL) a policy cannot have a reserve that is less than it'c current cash surrender value. So we'll always know that the reserve on a policy is at least the policy's cash surrender value.

So How does it Work?

Dividend interest rates are quoted in aggregate for yield on the reserve. That's an incredibly descriptive and yet dreadfully obscure statement, so let’s spend a little more time on this point.

The stated dividend yield (also known more commonly as the dividend interest rate) itself is a combination of the guaranteed rate plus the additional earnings on the policy's reserve made possible by the cash dividend that is paid to the policy.

This means, when we see a company quote a dividend rate of 6% (for example) what this means is you're receiving 2% from cash dividends paid on top of the 4% guaranteed rate (assuming the 2001 CSO where the statutory guaranteed reserving rate is 4% at the minimum, FYI there is now a revision allowing minimums to drop to 3.5%, which has already taken effect with some carrier's product and will become the norm likely next year–we'd encourage you not to drag your feet too long on your planned whole life insurance purchase).

So, generally speaking, when you look at a ledger for whole life insurance and look at the amount paid in dividends, it should come out to around 2% of the cash surrender value in a given year (keep in mind that some carriers quote cash surrender value and dividend payments oddly, e.g. sometimes reporting beginning of the year or end of the year numbers, forcing you to really pay attention and make sure you're using the right cash surrender value number from the correct policy year).

But what happens when the dividend comes out to another number? This can and does happen, and here's why.

When Dividends are Larger than we Expected

We shut up and don't complain, maybe someone made a mistake. 😉

Actually there is a perfectly good reason for a dividend being larger than just the percentage above the guaranteed rate applied to the cash surrender value and it has nothing to do with someone's making a simple arithmetic error (in fact calculation errors are extremely rare).

This goes back to the point about never knowing exactly what the reserve is. It can't be less than the cash surrender value, but it can be more. And this does happen to a policy when the policy is advanced in age. So while the insurer may not share the additional money they are setting aside for your policy with you. They are willing (due to legislative imperative) to pay you dividends based on this additional money.

When Dividends are Smaller than Expected

It's possible to see cash surrender in the first year of the policy (generally because one used a paid-up additions rider to get it there) and still receive no dividends. Why?

There are two pieces at play, that are so interlinked I won't bother discussing them separately.

It comes down to a practice among many (but not all) insurers known as the Contribution Principal. Put simply, it's a method of comparing profitability of a policy to all of the other policies in force. And not surprisingly, it's a practice where policies that bring in the greatest amount of money to the bottom line receive the highest dividends.

Long term, the contribution principal doesn't matter a whole lot. But in the short range, it can. Since insurers assume a certain degree off amortized acquisition expenses for all policies issued (yes even whole life technically speaking even whole life has a surrender charge, we just never let you know because we don't report any other values) those charges can prevent the payment of dividends because (according to the insurer) the issuing company is still in the red regarding the cost of acquiring you as a new customer.

Net vs. Gross

There's one other reason a dividend may be smaller than expected and it has everything to do with how the insurer reports dividend interest rates. Some insurers report the rate as a net rate, meaning it assumes all expenses that would deduct from the dividend have already been factored into the rate.

Others, however, report a gross rate–meaning expenses have yet to be deducted from the dividend payment and will be before you receive the final number. If an insurer uses a gross rate when they report the dividend interest rate, than you will not receive a payout that seems correct if you calculate the dividends received as a yield from the cash surrender value in the policy.


5 thoughts on “How Does Whole Life Insurance Work”

    • Hi Brad,

      At the moment, nothing we can hand you that would be of practical use for just anyone to pick up and use. Send us a quick note here and let us know a little more of what you’re thinking and we’ll see what we can do.

  1. Oh awesome post. I always knew there was a reason cash values couldn’t decrease but I didn’t know there was an actual term for it!

    You have added more terminology to my arsenal, and I thank you for it.

  2. Could these articles be more printer friendly. The left column isn’t necessary when printing and the tweet, like etc. relocate over article in print mode blocking the words.
    Love your columns and find them very helpful.
    Rick Coffey

    • Hi Rick,

      Ah a classical complaint about blog formats is their unfriendly nature to printers. Then you throw in a a couple of semi-tech savvy jerks who view the world through the lens of how they browse the internet (with fancy browser add-ons/extensions that can make any page printer friendly…sort of) and you find something we completely overlooked.

      Brantley is working on this for us. As well as about 15 other things, so if you don’t see anything within the next month, please remind us.



Leave a Comment