California Life and Health Insurance Practice Exam

How is a life insurance policy dividend legally defined?

1. A return of excess premium and taxable

2. Payment of claim and non-taxable

3. A return of excess premium and not taxable

4. Taxable gain on the investment

The correct answer is: A return of excess premium and not taxable

A life insurance policy dividend is legally defined as a return of excess premium and is not taxable. Life insurance dividends are typically issued by mutual insurance companies to policyholders when the company experiences better-than-expected financial performance, such as lower-than-anticipated mortality costs or higher investment returns. These dividends represent a distribution of surplus profits and are considered a return of the policyholder's own funds rather than earned income. The reason dividends are not taxable is that they are not considered income. Instead, they are seen as a return of premiums that have already been paid. Thus, policyholders do not pay taxes on these dividends unless they exceed the total amount of premiums paid into the policy, which could then create a taxable event. Understanding this distinction is important for policyholders when considering the overall taxation of their investments and returns.