Whole life insurance dividend season is right around the corner. During this time, major life insurers who issue whole life insurance will announce the dividend scale for 2022. For most of these insurers, they will mention the dividend scale, which is a cryptic datapoint often misused by agency marketers as well as insurance agents in an attempt to liken the scale to investment yield.
In some essence, they are correct in terms of their allusion. This scale does reference the rate of return achieved on an investment. The problem is that agents and markets often suggest this is your effective return on your whole life insurance policy. This is false. The scale is a vague reference to the return achieved by the insurance company and the input variable it uses in a longer calculation to tabulate the total payable dividend to each policyholder.
This calculation boils down to three components:
- Underwriting Profits
- Portfolio Profits
- Operational Expenses
When you buy whole life insurance, the insurance company offers you a policy and it makes assumptions about all three of the above variables. When any or all of these variables end up being more favorable than assumed, the resulting excess cash feeds the payable dividend to each policyholder. If any of these variables turn out less favorable, the shortfall subtracts from the payable dividend.
Let's understand these three components a little better, for clarity's sake.
Insurers pool applicants in categories that make broad assumptions about their life expectancy. They can't predict who within the group will die when, but they can predict how many people categorized correctly will die each year. This is the entire purpose of the underwriting process–to categorize applicants accordingly to their risk of dying.
Underwriting profits come about whenever the pool of policyholders experiences fewer deaths than assumed. This is good for the life insurer because it pays out fewer claims, but it also has a tendency to produce additional future income as those still-living policyholders often continue to pay premiums for their life insurance.
When insurers receive premiums from policyholders, they take the majority of those premiums and invest them. This asset pool is the mechanism insurers will use to build guaranteed features of a life insurance policy. When an insurer is capable of producing returns on these assets that exceed the obligations they have to policyholders through the guarantees provided within insurance contracts, the insurer produces portfolio profits. For years, this was the primary driver of insurer profits. However, the current interest rate environment puts many insurers in a place where this component no longer serves as its single largest profit source.
Insurance companies, just like any other business, cost money to operate. There is staff, utilities, expenses associated with notifying policyholders about their policies, etc. Insurers make an assumption about their operational expenses through normal budgeting practices. When the insurer operates under budget, there is yet one last source of profits achieved by the insurance company.
Arriving at the Dividend Interest Rate
Each year, the insurance company determines how much of its profits it can pay to policyholders. With this information, the insurance company calculates the dividend scale for the coming year. Sometimes the scale remains the same, other years it goes up or down depending on the total amount of payable profits to policyholders.
For years, life insurers made a big deal out of their dividend announcements. The end of the year was a big time for insurers to announce to the world that they had profits, they were going to share those profits with their policyholders, and they liked to report the new dividend interest rate.
Announcing the dividend interest rate was always a strange practice. It's a data point..yes. But a datapoint that is pretty useless to you and me. Useless because it requires we know other information about the insurance companies formula for paying dividends in order to make any sense of it in real dollars. This information–I assure you–will never be in the hands of either you or me.
Still, insurers reported their new dividend scale for the coming year because they learned that some people might misinterpret what this data meant, and those same people would draw incorrect conclusions about what this announcement meant that overstated the significance of what the insurance company was doing when it paid dividends to policyholders.
How the Dividend Interest Rate Works
While there is no unified approach, most insurers use the dividend interest rate in the same manner. The number represents a gross payout to the policyholders based on the insurance contracts' reserve. The reserve is another obtuse component of the insurance contract, but you can think of it as being closely related to the cash value of the whole life policy. I say gross payout because the dividend interest rate uses the guaranteed interest payable under the contract as a component.
An example will explain this more quickly than any attempt I can make to enlighten you:
Assume that an insurance company announces that it will pay $200 million in dividends to policyholders this year. It also announces that this payment represents a dividend interest rate of 6%. Also assume that the whole life policy has a 4% guaranteed rate–note that I specifically did not say a 4% guaranteed interest rate, more on that later.
Functionally, what this bit of information means is that the insurer will pay each policyholder a dividend that is 2% of the his/her policy reserve. Why 2%? Because 6 – 4 = 2. I know you're still confused.
The dividend interest rate is a gross number that incorporates the guaranteed component as part of its reporting. I know it's weird, but it's what the insurance industry does. So when the insurer announces its dividend interest rate, you must subtract the guaranteed rate of a whole life policy to arrive at the non-guaranteed component of cash value growth–for all regular dividend-paying whole life policies, the dividend is the only source of non-guaranteed growth in cash value.
Now to be fair, there is a somewhat justifiable reason for this awkward reporting. When an insurer issues a whole life contract, it is guaranteeing a certain accumulation of cash value in exchange for the payment of premiums. That means it must take the premiums it collects and turn them into value on the policyholder's behalf and it must achieve a rate of return on those dollars that can keep pace with the guaranteed rate of accumulation promised in the insurance contract. When it exceeds this benchmark, a dividend could be payable. This is an isolated example the portfolio profits explained above.
Still, though, this sort of reporting obfuscates the impact changes in the dividend have on policies and has a serious potential to cause people to misinterpret the magnitude of a dividend change.
Dividends are a Significant Reason People Buy Whole Life Insurance
I argue that dividends are a key motivation for a whole life insurance purchase. For the many clients that we have who use whole life insurance as a means to accumulate wealth, dividends are an incontrovertible component of the insurance contract–without them, the whole life doesn't get off the ground.
The guarantees offered by whole life insurance are significant when considered in the context of the length of time an insurance company is obligating itself to carry through such a promise. Still, if we assumed only the guarantee would materialize, we pretty confidently have better options.
For this reason, people spend a lot of time thinking, worrying, and talking about dividends.
Dividends not only play a crucial role in creating the future cash value one might intend to use for retirement income, paying for college, or financing various investment activities, they can also play a critical role in other objectives one might have for their policy. These objectives include strategies like:
- Paying the premium due on the policy
- Supporting a term life insurance rider attached to the policy
- Creating additional death benefit to keep up with a growing death benefit need
So the focus on dividends is front-and-center of the cash-focused whole life buyer, but it is also commonly near front-and-center for less cash-focused purchases.
The Rate of Change and the Magnitude of the Rate of Change
We began arguing back in 2012 that the best we can do with the dividend interest rate data is make observations about the rate of change over time with respect to the portfolio profits component of the dividend calculation. Some people are tempted to compare the dividend interest rate reported at one company to the rate reported by another company. This is a meaningless comparison. We don't know the other variables for the calculation, so one cannot compare this numerical data point among insurance companies and make any meaningful observation.
In other words, the 6% DIR at one company is not necessarily less than the 6.5% DIR at another. We do not know what each company is multiplying the DIR by to arrive at the final dividend payment.
But we can look at the change and make observations about how much the dividend changes year-over-year. But the way we are tempted to do this–and even the way we have done this for years–will usually understate just how significant the change is.
I'll start this final point with a question. What is the percentage change for a dividend interest rate falling from 6% down to 5.75%
Remember that the dividend interest rate is a component of both the guaranteed accumulation rate payable on the policy and the dividends paid due to portfolio profits. We have to subtract the guaranteed rate from the dividend interest rate to look at the actual impact on dividends.
If you ignore this last point and use the formula for percentage change on my above question, you'd first subtract 5.75 from 6 and arrive at 0.25. You'd then divide 0.25 by 6 and tell me the change is 0.04167 multiply that by 100 and declare that the change is 4.17%–I'm rounding.
But if you take into account the fact that the guaranteed component will never change and must be subtracted, our math changes a bit. We first subtract the guaranteed rate–4% was the prevailing rate prior to recent legislation changes, but since no product has come out yet that has also been through a dividend change, let's use 4% since something like 95% of all in-force whole life policies likely have a guaranteed rate no lower than this amount.
6 minus 4 is two and 5.75 minus 4 is 1.75. The difference from the first step of the percentage change calculation doesn't change, it's still 0.25. But the numerator does change, it's now 2 instead of 6 and this leads to a very different quotient, 0.125. Multiply by 100 and now we arrive at the real difference of 12.5%, which is also known as more than 3 times the amount we thought.
This impact is substantial and can have significant consequences on policy performance. This change not only affects cash value accumulation for those seeking to build their wealth through life insurance cash value but also death benefit-focused goals as mentioned above.
So when dividends change, we have to be a little more careful to evaluate the impact of those changes on policies. This is especially crucial for in-force policies and the significance of this grows with the age of the policy. The further removed we are from a time of prevailing higher dividend rates, the more critical it is for us to re-evaluate a policy now facing a different dividend rate environment. It's too easy to underestimate the impact by using nominal figures.