A profitable insurance operation produces a company with increasing surplus. The board of directors must determine how to allocate newly earned surplus among several competing needs. The most important of these are as follows:

Unless the board of directors takes specific action, contributions to surplus remain in the company�s surplus account. This increases the company�s net worth (defined as the difference between the total assets and the total liabilities) and strengthens its financial position. From the surplus account, monies can be used to pay off debts or to pay the expenses associated with writing new business. Financing company growth undoubtedly presents the life insurer�s largest internal demand for capital, regardless of whether it is a mutual or a stock company.

The shareholders in a stock company expect financial rewards for their investments. Rewards can take the form of dividends on the stock increases, increases in the market price per share, or some combination of the two. Only a portion of an insurance company�s profits is normally distributed to stockholders in cash. The remainder stays in the company�s capital account to finance the acquisition of new business and to provide a financial buffer against adverse contingencies. Such additions also tend to increase the share price of the company�s stock.

A portion of the earnings from an insurance operation (stock and mutual companies) results from the company�s deliberate overcharge for its participating products. The policy dividend refunds this amount to the customers who paid the higher price for participating insurance. It is important to differentiate between stockholder dividends and policyowner dividends.

No predetermined relationship exists between the surplus gains in a particular year and the dividends returned to policyowners. The gains enhance the appropriate surplus account as they accrue, and at the end of the calendar year the directors of the company, based on information then available and in light of a number of factors, decide what portion of the total increases in surplus should be distributed in dividends the following year and what portion should be retained as an increase in contingency reserves. The board of directors earmarks the amount as divisible surplus, and paying that sum becomes a formal obligation of the company. Once set aside by action of the directors, the divisible surplus becomes a liability and is no longer part of the company�s surplus.

The decision to set aside funds for dividends requires an insurance company�s managers to balance the need for a general contingency fund against the advantages of pursuing a liberal dividend policy. In any well-managed company the share of the total surplus to be distributed always involves careful consideration of the impact on the company�s safety cushion. In some companies the importance attached to this component of financial operations is such that needed surplus is decided upon first, and the remainder becomes the divisible surplus.

The apportionment of the divisible surplus among the various groups of policyowners is a complex matter and one that should measure up to a set of guiding principles established over many years. The system of distribution should be reasonably simple in operation, equitable, flexible, and understandable by policyowners and the agency force.

Simplicity. For practical reasons the method of distribution should be simple. A complicated formula is troublesome, expensive, and difficult to explain to policyowners and others. A small increase in accuracy may also be more apparent than real. Complicated refinements have only minor significance and are of questionable value.

Equity. The distribution of surplus should be equitable by allocating dividends to each policy on the basis of the proportion it has contributed to the insurer�s surplus. Policies cannot be considered individually but must be dealt with on the basis of groups or classes, and the system of computing dividends or other distributions of surplus should be one that aims at approximate equity between classes and among individual policies within classes.

Flexibility. To say that the system of distribution must be adaptable to changing conditions is merely an extension of the statement that the method must be equitable. An insurer attains flexibility by separately recognizing as many sources of surplus as possible, using a formula that permits proper adjustments to the factors involved, and avoiding arbitrary expedients in annual adjustments to dividend scales.

Comprehensibility by Policyowners and Agents. This is a minor consideration, but policyowners occasionally ask about their dividends, particularly if a company has reduced its dividend scale. Such an inquiry may be addressed to the home office or to a field representative. In the interest of good public relations, the formula should afford policyowners an understandable explanation. Certainly the field force should have a general understanding of the sources of surplus and how they combine to produce a dividend scale.

The minimum objective of most companies is to continue the current dividend scale. This usually implies a larger absolute distribution of surplus each year than that of the preceding year. Current additions to surplus historically have been sufficient to support the existing dividend scale. In years when adverse fluctuations in experience do not produce gains, the company may draw on funds accumulated in previous years to avoid reducing the scale. Similarly, in a year when additions to surplus are more than adequate to support the existing dividend scale, the excess often is added to existing surplus in order to avoid the expense and other complications of changing the scale. If, however, a significant disparity develops between the funds needed to maintain the existing scale and those currently available for distribution, and if the disparity is expected to continue over a long period, the board of directors must consider a change in the scale.

Determining whether a change in mortality or interest rates is permanent or temporary normally requires several years. The nature and magnitude of modifying the dividend scale will reflect the directors� judgment about the duration and future course of the relevant trends.

In most states divisible surplus must be apportioned and distributed annually. However, sufficient theoretical and practical justifications exist for some degree of deferral that most states permit limited departures, under proper safeguards, from the general requirement of annual distributions. These departures take the form of either extra dividends or terminal dividends.

Extra Dividends. Extra dividends may follow one of two patterns. One is a single payment made after a policy has been in force a specified number of years, usually 5. Another is periodic additional dividends distributed at stated intervals. The single extra payment is usually a substitute for a first-year dividend. From a practical standpoint, this procedure has some distinct advantages and can be justified to some extent on equitable grounds. It reduces the strain of initial expenses and deters voluntary terminations during the early years. It also serves as a special system to assess a larger part of excess first-year expenses against policies that cancel during the first few years.

Periodic extra dividends, at every 5th year for example, have little justification in theory. Perhaps the only valid reason is that regular dividends are calculated on such a conservative basis that additional surplus remains even after annual dividends are paid. Extra dividends, while improving illustrative net-cost figures over a period of years, are paid only on those policies that remain in force. This is particularly true of a special dividend payable only at the end of 20 years. The 20-year extra dividend is further suspect when used to improve a company�s showing in net-cost comparisons.

In Canada companies issue policies under which dividends are apportioned only every 5 years, but the amount of surplus set aside for deferred dividends during each 5-year period must be carried as a liability until paid. Under Canadian practices, it is customary for the company to pay an interim dividend when a policyowner dies during the period of deferral but not upon lapse or surrender.

Terminal Dividends. Terminal dividends refer to special dividends paid upon termination of a policy through maturity, death, or surrender. Such dividends are normally paid only after the policy has been in force for a specified period of years. Surrender dividends are usually a percentage of the surrender value, while mortality and maturity dividends may be a percentage of the face amount of the policy or of the reserve, the percentage varying by plan and duration.

Terminal dividends are available only from companies that subscribe to the philosophy that a withdrawing policyowner should receive back all or a portion of his or her contribution to surplus. Those companies that do not provide terminal dividends�and they are in the majority�either feel that each policyowner should make a permanent contribution to the company�s surplus or they view any attempt to allocate the contingency fund to individual policies or classes of policies as impractical. However, the Standard Nonforfeiture Law requires the payment of surrender dividends whenever the rate of interest used in the calculation of reserves is more than .5 percent less than the rate used in the calculation of surrender values.

A terminal dividend payable at death should not be confused with a postmortem dividend. A postmortem dividend is payable at death and covers the period between the preceding policy anniversary and the date of death. It may be computed in various ways, but the most common practice is to provide a pro rata portion of the dividend that would have been payable for the full year. Most companies pay postmortem dividends and add the amount to the death proceeds under the policy. A few companies pay the full dividend for the year, thus giving effect to the arbitrary assumption that a company pays death claims at the end of the year. The loss of interest involved in this assumption is charged to surplus.