Understanding Life Insurance
Appendix C: Enhanced Whole Life
The whole life we described above would more appropriately be called guaranteed whole life. Premiums are assumed to be level and guaranteed for life, with cash surrender values if you cancel. There are however a number of common variations to whole life worth mentioning.
Quick Pay
Some companies offer a guaranteed quick pay option. These policies are the same as the guaranteed whole life, except that premiums are level for 10, 15, or 20 years, and then guaranteed to be 0 forever after. If looking at quick pay policies, be cautious as there are both guaranteed and non-guaranteed options available.
Participating Whole Life
Some whole life policies are called participating becuase they offer ‘dividends’. These dividends are not guaranteed (and thus, effectively, the coverage and the premiums are not guaranteed), they are evaluated annually by the insurance company. Technically the company looks at a block of policies and reviews investment earnings, mortality costs, and administration costs and if they’re all favourable, will issue a dividend. In practice they do that then add in a health dose of ‘how do we feel about paying the dividend this year’. The point is, be cautious about claims of dividend payments – they are not guaranteed and anything can (and does) happen.
So the company issues a dividend on your policy – an amount that’s returned to you. What happens to that money? There’s 5 choices that you can choose from when you purchase one of these policies:
- Cash: They just send you the dividend. This is rarely used.
- Accumulation with interest: They deposit the dividend into an investment account on your behalf where hopefully it earns interest. Again, this option is rarely used.
- Reduce premiums: they simply deduct the amount of the dividend from your next premium.
- Paid up additions: Your dividend automatically purchases a small sliver of whole life insurance that has a single premium (thus the paid up term) that gets added to your base policy. So you may start with a $50,000 policy, then your first paid up addition would increase your coverage to $50,100, and so on.
- Enhanced Whole Life. Described in detail below
Enhanced Whole Life
This option is common but is complex enough to require a bit of explanation. The purpose is to decrease the cost of whole life insurance by counting on future dividends (which as noted, are not guaranteed).
Enhanced whole life actually consists of both term and whole life insurance, and later, whole life and paid up additions; the policy composition changes over time. It works as follows.
Lets say you purchase a $100,000 enhanced whole life. You would actually have a policy that’s split say $25,000 whole life and $75,000 of one year term – making for a cheaper policy than a typical whole life, but with less cash values.
In year 2, the company issues a dividend that is used to purchase a paid up addition (a small sliver of whole life insurance). That paid up addition replaces the same amount of term insurance. Lets say the first year you get a $1000 paid up addition. You now have a policy that is $25,000 whole life, $74,000 of one year term, and $1000 of paid up addition whole life.
That process continues until all of the term is fully replaced by paid up additions – leaving you with a $25,000 whole life policy with $75,000 of fully paid up additions and thus a fully whole life policy. This is called the crossover point and you have two choices what to do with future dividends at that time.
The first is to use it to reduce premiums. In practice, the policy might be structured so that the dividends are high enough to actually pay the premiums – leaving you with a policy that has no more premiums. Not that the effect of this is similiar to the quick pay whole life discussed above, but in this case, because it depends on dividends, is not guaranteed.
The second choice is to continue to purchase paid up additions. Your $25,000 of whole life and $75,000 of paid up additions would simply continue to increase while you pay premiums.
The problem with this structure is that dividends are not guaranteed and thus anything that depends on them is also not guaranteed. If you purchased enhanced whole life and expect that at the crossover point your premiums will become 0, that is not guaranteed. Similiarly you may find that the paid up additions do not increase as expected. This lack of guarantees is notable because these situations are not hypothetical. The downsides can and do happen – people with enhanced whole life thought that they’re premiums would become paid up after many years,only to find out that they continue to have to pay premiums. Be wary.