Policy Dividends

Policy Dividends are a feature of participating life insurance policies, typically issued by a mutual insurance company. Think of them not as a dividend in the way you'd get from a stock, but more like a refund. Because a mutual insurer is owned by its policyholders, when the company performs better than its conservative estimates, it shares that success by returning a portion of the premiums paid. This financial outperformance comes from three main sources: earning more on its investments than anticipated, experiencing fewer death claims than projected, and keeping its operating expenses lower than budgeted. This surplus is then distributed among the eligible policyholders. Essentially, the insurer is saying, “We charged you a bit too much for your coverage based on our cautious forecasts, so here's some of your money back.” This return of premium is a hallmark of a financially healthy and well-managed mutual insurer.

Policy dividends are not guaranteed, but for well-established mutual insurers, they have often been a consistent feature for over a century. The size of the dividend pool is determined annually by the company's board of directors based on its financial results.

The surplus that funds policy dividends is primarily driven by three key areas of the insurer's performance:

• Investment Earnings: Your premiums don't just sit in a vault. The insurance company invests them in a conservative portfolio of assets (mostly bonds, but also stocks, real estate, etc.) held in its general account. If these investments generate returns higher than the minimum rate needed to meet future obligations, it contributes to the surplus.
• Mortality Experience: Insurers employ actuaries who use mortality tables to predict how many death claims they will have to pay in a given year. If, thankfully, fewer policyholders pass away than predicted, the company pays out less in benefits, creating a surplus.
• Operating Expenses: This is simple business efficiency. If the company manages its costs—salaries, office space, marketing, commissions—better than it budgeted for, the savings add to the surplus.

It's crucial to understand that policy dividends are treated very differently from stock dividends for tax purposes. A dividend from a stock like Apple or Coca-Cola is a distribution of profit and is considered taxable income. A policy dividend, however, is viewed by tax authorities (like the IRS in the U.S.) as a return of your own money—an overpayment of premium. Therefore, policy dividends are generally not taxable. The only exception is if the total dividends you've received over the life of the policy exceed the total premiums you've paid into it.

For a value investor, looking at an insurance policy isn't just about the death benefit; it's about understanding the financial engine you are buying into.

A long and stable history of paying dividends is a strong indicator of a company's financial discipline, prudent underwriting, and successful investment management. While past performance is no guarantee of future results, consistency here suggests a company that is managed conservatively for the long-term benefit of its owners—the policyholders.

Only “participating” policies are eligible for dividends. If you want the potential to receive them, you must buy the right kind of policy.

• Participating Policies: These are primarily sold by mutual insurers. They have slightly higher initial premiums, but you get to “participate” in the company's success through dividends.
• Non-participating Policies (Non-Par): These are typically sold by a stock insurance company, which is owned by shareholders. Their goal is to generate profits for these external shareholders. Non-par policies often have lower initial premiums, but they do not pay dividends to policyholders.

If your policy pays a dividend, you typically have several choices for what to do with it:

• Take the Cash: Receive a check from the insurer.
• Reduce Your Premium: Apply the dividend to your next premium payment, lowering your out-of-pocket cost.
• Accumulate at Interest: Leave the dividends with the insurer to collect interest, similar to a savings account.
• Buy Paid-Up Additions (PUAs): This is often the most powerful option for long-term value creation. You use the dividend to purchase a small, fully paid-up block of additional life insurance. This new block increases your total death benefit and your policy's cash value, and it is also eligible to earn its own dividends in the future, creating a compounding effect.

Legendary value investor Warren Buffett built much of Berkshire Hathaway's empire on the back of the insurance business. He loves insurance because of the “float“—the massive pool of premium money that insurers collect upfront and can invest for their own benefit before they have to pay claims. Companies like GEICO are core to Berkshire's success. The principles that allow a mutual insurer to pay dividends—conservative underwriting, operational efficiency, and smart long-term investing—are the very same principles Buffett champions. While his companies are stock-owned, the underlying financial discipline is identical. Seeing a mutual company consistently pay dividends is seeing the principles of value investing in action, rewarding the policyowners for the company's prudent management.