By law, life insurance companies must maintain a cash reserve against their obligation to pay death claims. Insurers do this by taking insurance premiums from policy holders, pooling them in the general account of the insurance company, and then investing them in a conservative portfolio of stocks, bonds, cash equivalents and treasuries. The value of this cash reserve grows over time, with investment returns, interest, and the contributions of new policy holders and annuity owners. It is the growth of this cash reserve, minus death benefits and annuity income paid out, minus taxes and expenses, that drives interest rate and dividend growth for life insurance policy owners.
Stock Companies vs. Mutual Companies
There are two major varieties of life insurance companies: Stock companies and mutual companies. Stock companies raise capital by selling stock to stock holders, who then own a share of the insurance company profits. Mutual companies are not owned by stock holders, but by the policy holders themselves. The difference is key: When a stock company makes a profit and does not need to reinvest the profits within the company, it issues its dividend to stockholders. Policyholders do not participate in the profits of the company and do not receive a dividend from stock companies.
In contrast, when a mutual company issues a dividend, it issues it to the policyholders It's policy holders, then, "participate" in the profits of the company. Their policies are called "participating policies."
Whole Life Insurance
Whole life insurance features a permanent death benefit, rather than a limited-term death benefit, and a level premium, guaranteed never to rise. The premium is set high enough for the company to guarantee a buildup of cash reserves, or cash value which will eventually equal the death benefit. At that point the policy is said to "endow" and the insurance company simply cancels the policy and issues a check to the policy owner. By law, modern insurance policies are structured to "endow" at age 121.
Whole life policies generally guarantee the owner a modest minimum interest rate, which is usually comparable to prevailing CD or money market rates. Participating whole life policies (also called "par whole life") also issue a non-guaranteed dividend to policy owners, which is credited to their cash value, and is frequently used to purchase small amounts of fully-paid up life insurance. In this way, both the cash value and the death benefit grow over time.
Stock company policies do not issue a dividend; their cash value grows with the interest crediting rate, while death benefits typically remain level. Premiums are typically lower with stock companies, though par whole life policies often show a lower net cost of insurance over a lifetime.
Universal life insurance
Universal policies do not typically earn a dividend. Instead, fixed universal life policies generally earn an interest rate in the cash value, while variable universal life policy returns depend on the performance of the funds offered within each policy's subaccounts, which are analogous to mutual funds, except that the insurance company owns the shares rather than the policy owner.
Term Life Insurance
Term life insurance does not earn interest directly, though the insurance company must still maintain a cash reserve against the potential liability of paying a death benefit on these policies as well. These reserves earn interest and dividends, though stock companies do not typically forward these to the policy holder. Some mutual company term policies are, however, eligible for dividends. These are typically credited to the investor in the form of a discounted premium.
Taxation of Dividends and Interest
Generally, the build up of cash value within a life insurance policy is free of federal income tax. However, if you surrender the policy, you could be liable for tax on the difference between your contributions and the cash value of the policy, if the difference is positive.