Let’s look at an example.
The rate makers determine that John Doe’s policy will cost him $1.00 / year for the insurance he wants.
Now the insurance company recognizes that several factors may cause the $1.00 / year estimate to be wrong, such as high administrative cost, larger than expected death claims, or lower than expected earnings.
As a result they apply a fudge factor and bump the rate to $1.10 / year. This extra $0.10 is the capital that makes the system viable.
After a few years the directors call the accounts in and ask “How did we do on John Doe’s policy in comparison with the assumptions made by the actuaries and the rate makers?”
The accounts report “we have collected $ 1.10 in premium on John Doe’s policy and it has only cost us $0.80 to deliver the promised death benefit.”
As a result, the directors now have $0.30 to make a decision with.
Since the directors are smart people, they decide to place $0.025 into a contingency fund and return the remaining $0.275 as a dividend.
Since the dividend is not an actual “gain” but is rather a “return of premium”, the dividend is not considered a taxable event.
Unlike a dividend declared in a security which may lose its value as the stock rises or falls, a dividend declared in an insurance policy can never lose any of its value. Once a dividend is declared it is guaranteed – it can never loose its value.
If the owner will use the “dividend” to purchase additional Paid Up Insurance (No cost for acquisition or sales commission), the result is an ever increasing, tax deferred accumulation of cash values that support an ever increasing death benefit.
This pool of money has no real governmental strings attached as to how, when or why it may be used and can be passed on to the next generation with limited or no estate taxes.