Policy dividends & returns

Dividends are sometimes associated with a life insurance policy. Unlike a dividend you receive on a stock or mutual fund, a dividend paid on a life insurance policy is considered a return of premiums you previously paid. Dividends on stocks and mutual funds are a distribution of profits to shareholders. Insurance companies typically add interest to existing cash values or use them to purchase “paid up additions” of insurance. In these situations the dividends maintain tax-deferred status.

Only mutual life insurance companies pay dividends to policyholders when the insurer's investments perform better than expected. Other forms of permanent life insurance - universal life, variable life, and variable universal life insurance - invest the excess, increasing the cash value of your policy.

One way to compare permanent life insurance policies is to evaluate their investment returns. Remember that permanent life insurance policies place a portion of your premiums into savings instruments, or investment subaccounts. Depending on the type of permanent insurance you choose, the investments may be safe, low-yielding investments such as a money market account. Conversely, they may include riskier investments, including stock, bond, and mutual fund subaccounts.
In general, whole life and universal life insurance policies invest premiums in less risky securities.

Indexed universal life is unique, and invest premiums in less risky instruments, typically high quality investment grade bonds.  A portion of each dollar is used to purchase options to an index, such as the S&P 500. This affords the owner of an indexed universal life insurance policy the opportunity for higher returns, which are linked to the performance of a share market index. It should be understood that your life insurance policy guarantees are never at risk of loss. In particular years you will have gains in your cash value, but in years of negative index performance, the interest credited to your cash value would be zero.
Variable life and variable universal life insurance policies invest in riskier securities.

You can even consider the death benefit of your life insurance policy to be a cash inflow. It may seem odd to include an investment that pays you after you die but, after all, that's the purpose of buying an insurance policy: providing income for your beneficiary that replaces your lost income.

A policy's rate of return can be calculated using the internal rate of return. The internal rate of return is the interest rate that equates the cash outflows and inflows of a policy. If you are calculating a return for a period longer than a year, the future-year cash flows are discounted to present value. Present value is the value of the investment measured in today's dollars.

For example, say you pay annual premiums of $2,000 for the first nine years on a 10-year term life policy. You die at the beginning of the tenth year of the policy and your beneficiary collects a death benefit of $100,000.

Your policy has earned an internal rate of return of 33.6%. This is an annual rate of return. However, if the policy lapses before you die, your policy return is zero.

The calculation works a little differently for a permanent life insurance policy. In addition to the death benefit, your invested premiums earn a rate of return every year. (You don't have to wait until you die to earn a return.)