This concept primarily related to the topic of life insurance. Both types of insurance policies, term and cash value, can act as either participating or non-participating (par or non-par, respectively). Most policies are par policies.
Insurance companies will charge higher than necessary premiums with the intent of returning the excess. Excess premiums are charged because the insurance company will operate based on more conservative estimates. For example, they will base premiums on higher operating costs and lower rates of return than are actually expected. This allows the insurance company to better protect against non-diversifiable (highly correlated) risk. In the end, this is better for the individual in that their insurance company bears less insolvency risk, and their expected costs are lower, resulting in lower premiums in the long run. Par policies are essentially a form of risk sharing where the insurance company shifts a portion of risk to policyholders.
Though the factors and assumptions (interest rates, mortality rates, expenses) that dividend formulas are based on change year to year, the insurance company will not vary dividends from year to year. Instead, they will alter dividend formulas periodically based on experience and anticipated future factors. The previous statements apply to whole life insurance. Universal life insurance policy dividend rates can adjust much more frequently, even monthly.
Return of excess premiums through dividends to the policyholder are not taxable because, unlike with investments, they are not earnings but return of excess premium payments. There are different ways in which these dividends can be utilized. Two of the most common ways are to apply them towards the cost of the future premiums (lowering premium payments), or to use them to increase the face value of the policy (paid-up additions).
Insurance companies charge premiums that are estimated to meet expenses. Non-par premiums are usually lower than premiums for par policies.
Par policies can end up costing less than non-par policies if maintained long-term. With cash value policies, the dividend will typically increase as the policy’s cash value increases.
Insurance agents will show “illustrated dividends” when selling policies. Illustrated dividends are current or expected dividend rates. Though these tables may be attractive, keep in mind that they are for illustrative purposes only and actual experience may differ.
There exists an argument on risk bearing with participating whole life policies. In the article detailing whole life insurance I stated that, from the perspective of the policyholder, whole life policies are essentially risk free because the insurance company bears all risk. Above I stated that with participating whole life policies the insurance company shifts some risk to the policyholder. The simple answer is that dividends for whole life policies reflect long-term trends in interest rates, costs, and expenses. This long-term affiliation has a dulling effect on changes in these trends, making dividends less volatile. Essentially, with participating whole life policies a risk does exist, but this risk is relatively insignificant.