When a life insurance contract is drawn up between an insurance company and an individual, the insurance company is taking upon itself the contractual commitment to provide a death benefit at a level premium over the lifetime of the contract. This guaranteed premium and coverage may cover a period of time extending for 100 years or more.
Since these contractual agreements are so important to the consumer and the insurance company, it is critical that premium being charged is as accurate as possible.
Since the premium is based on assumptions projected into the future, i.e mortality rates, interest rates, expense ratios, etc, these premiums have to be skewed to the conservative side of projections. Consequently, the amount charged up front is going to be more than the actual mortality and current expenses. This leaves excess dollars which the insurance company holds in reserve for future use.
Having these excess funds to work with, insurance company will invest them with the intent of making a profit from them. If they are successful in doing so, the insurance company will then make sure their reserves are sufficient and then pay the rest to their clients in the form of a dividend.
The client’s share of the dividend will be based on the amount of guaranteed cash value in any individual policy.
The dividend can be used by the client to reduce premium, buy paid-up additions, accumulate at interest, or be paid out as cash–a nice but uncertain way of growing a fund for retirement.