What Is a Participating Policy? Definition and How It Works

What is a Participating Policy?

A participating policy is an insurance contract that pays dividends to the policyholder. Dividends are generated from the profits of the insurance company that sold the policy and are typically paid out on an annual basis over the life of the policy.

Most policies also include a final, or terminal, payment when the contract matures. An insurance dividend is not guaranteed and depends on the annual performance of the insurance company. A participating policy is also referred to as a "with-profits policy."

Understanding Participating Policies

Participating policies are typically life insurance contracts, such as a whole life participating policy. The dividend received by the policyholder can be taken in different ways: It can be used to pay the insurance premium; it can be left with the policy to generate interest like a regular savings account; or the policyholder can take a cash payment like you'd get from a dividend stock.

Participating Policies vs. Non-Participating Policies

Insurance companies' premiums are based on a number of things, including expenses. At first, non-participating policy premiums are usually lower than those for participating policies because of the dividend expense: Participating policies charge more with the intent of returning the excess. This has implications for the policy's tax treatment. The Internal Revenue Service (IRS) has classified the payments made by the insurance company as a return on excess premium.

For example, an insurance company will base premiums on higher operating costs and lower rates of return than are actually expected. By operating from conservative projections, the insurance company can better protect against risk. In the end, this is better for the individual policyholder because it helps offset their insurance company's insolvency risk, resulting in lower long-term premiums. 

Though the interest rates, mortality rates, and expenses that dividend formulas are based on change year to year, an insurance company won't vary dividends that often. Instead, it will alter dividend formulas periodically based on experience and anticipated future factors. These approaches apply to whole life insurance. Universal life insurance policy dividend rates can adjust much more frequently, even monthly.

While more expensive at first, participating policies can end up costing less than non-participating policies over the long term. With cash value policies, the dividend will typically increase as the policy’s cash value increases. The owner of the participating policy would then have more cash value available to cover their ongoing premiums versus a nonparticipating policy.

Is a Participating Policy Right for Me?

The question of whether participating policies are better than nonparticipating policies is a complex one and depends largely on your needs. Term life insurance is generally a nonparticipating policy with low premiums. It may suit you if you're interested in providing for your beneficiaries with lower or fewer premium payments.

Permanent life insurance can be either participating or nonparticipating. A non-participating policy may charge a lower premium for the same amount of coverage at first. However, with this type of policy, the profits aren't shared and no dividends are paid to the policyholders.

A participating policy likely will charge a higher premium at first. In exchange, it enables you as a policyholder to share the profits of the insurance company through regular dividends. This extra income could be used to reduce the long-term policy cost or build your savings, depending on your preference.

The type of insurance company you work with also matters. Mutual life insurance companies can only issue participating policies in most states. These policies allow a portion of the company's premiums to be paid out in the form of policy dividends as refunds, which makes those funds nontaxable as income.Alternatively, stock life insurance companies generally issue nonparticipating policies. They pay their profit dividends to their stock shareholders instead.

The Bottom Line

A participating policy is an insurance contract that pays dividends to the policyholder. Dividends come from the issuing insurance company's profits, and are typically paid out on an annual basis over the life of the policy. Several factors should be considered to determine whether a participating life policy is right for you, but in many cases, they may be more expensive at first than non-participating policies. On the other hand, receiving dividends helps many holders of participating policies pay their premiums or build savings in the policy for later use.