A Description of the Dividend Option Referred to as Paid-Up Permanent Additions

Dividends are a feature found in "participating" life insurance policies. Aside from their other insurance or investment characteristics, those policies are entitled to share in the insurer's financial successes. They're usually offered by mutual insurance companies, which are owned collectively by their policyholders in the same way farmers' cooperatives or credit unions are owned by their members. Companies issue dividends based on the relationship between their payouts for the year, the profitability of their investments, and the level of expenses they've experienced. Dividends create a tax benefit for the insurer, so they're often paid even in mediocre years.

Dividends can be used in several ways. They can be paid out in cash each year and used to pay bills or fund other investments, or left to accumulate within the policy and increase its cash value. One common alternative is purchasing additional coverage with the dividends. Your main policy is usually bought with regular payments, like a house. The additional coverage is bought outright for a single payment, like a deck or a shed. Because those additional amounts are paid for, they're referred to as paid-up additions to the policy.

Paid-up additions are a popular option in permanent insurance policies because of their cumulative effect. Each addition increases the policy's value, which means it will attract a slightly larger dividend the following year. If the dividends are consistently turned into paid-up additions, those annual increases in policy value and dividend share become substantial. Over a period of decades, if the company's finances and dividends remain stable, they can double or even triple the policy's values.

There are drawbacks to this approach. In his book "Life Insurance: A Consumer's Handbook," author Joseph Belth points out that the cost for paid-up insurance can sometimes be higher than with ordinary coverage. It's also possible to generate higher returns by reinvesting the dividends in a more conventional investment vehicle, rather than the insurance policy. However, this type of permanent policy is often used by investors to generate long term, tax-sheltered growth. Paid-up dividends can contribute strongly to that strategy.