In this article I’m going to explain how enhanced whole life insurance works, and why you should not purchase this type of policy.

 Enhanced whole life insurance is a type of permanent life insurance intended to provide lifetime coverage (as opposed to term life insurance,which would typically provide coverage only during your working and family years).

 Despite the name, this type of whole life isn’t enhanced. Instead this type of policy has modifications intended to reduce the premium. These modifications cause deficiencies so severe that we here at The Term Guy do not ever recommend this specific variation of whole life.

 Before I get into the mechanics, there’s a few background things we need to understand.

• 1 year term life insurance – this is a type of life insurance with no cash values; it’s just pure life insurance. Premiums are based entirely on your age, so the premiums increase every year in an exponential fashion – the older you get, the more expensive it gets, faster.
• Whole life insurance dividends – these are unrelated to stock dividends. Dividends are related to a type of whole life called participating whole life or just par whole life. With this type of coverage, the actuaries price your premiums using very conservative estimates for mortality, interest and expenses. Once a year (not guaranteed) the life insurance company reviews their experience for these three expenses and not surprisingly, determines that experience was better than the original very conservative assumptions. At that point, they return back to you a small sliver of your premiums for the year – that return of premium is called a dividend. Again, and importantly, this is determined by the company annually, and is not guaranteed.
• Paid up additions – We’ve seen that par whole life produces dividends – an automatic but not guaranteed return of some of your premium dollars each year. We can receive those dividends as a cash refund, but there’s a few things you can do with the money instead. One of these is called paid up additions.

 Paid up additions are just mini par whole life policies purchased with dividends. Lets say your policy kicks out $100 in dividend in one year. The company then automatically spends that on a small par whole life policy of say $300 of coverage. Importantly, this sliver of whole life is single premium – just the onetime $100 dividend is used to pay the premiums over your lifetime. That’s why these are called ‘Paid up’ additions. And this small policy comes with it’s own mini-cash values and dividends. This small sliver of whole life, purchased with your annual dividend, is called a paid up addition.

Whole life insurance basics

 The basic structure of a guaranteed whole life policy is simple. Premiums are level for life, coverage is level for life, and there is a refund if you cancel called a cash value.

Par Whole life basics

 Par whole life has the basic structure of guaranteed whole life, but adds in the dividends we saw above. Those dividends are then used to purchase paid up additions which increase the coverage and the cash value of the policy in a non-guaranteed fashion (the basic policy will still have guaranteed coverage and cash values, but the increase in coverage and cash values provided by the paid up additions are not guaranteed).

How Enhanced Whole Life Insurance works.

 Enhanced whole life is actually a combination of two types of coverage – a par whole life policy, and a one year term. Notably, the one year term portion of the coverage is initially much less expensive than the whole life, but the costs increase every year so in the long term it’s actually much more expensive.

First Year:  Commonly the initial ratios of coverage would be somewhere in the range of 25% par whole life and 75% 1 year term. That right there would be an enhanced whole life. Does it sound enhanced? We’ve replaced most of the whole life with a term policy – this is done because initially the one year term insurance portion of the coverage has lower premiums, resulting in a policy that costs less than a typical whole life.

 Example setup, first year for $100,000 of enhanced whole life, your whole life coverage consists of:

•  25,000 Par Whole Life
•  $75,000 One year term

 Second year: Next year the $25,000 of whole life coverage produces a dividend. That dividend automatically purchases a Paid Up Addition. The amount of coverage produced by the Paid Up Addition replaces a sliver of the one year term coverage.
There’s a premium tradeoff here. The one year term portion premiums are increasing. The paid up addition coverage has no further premiums. Hopefully we can get all of the one year term replaced before the one year term costs become excessive.

 We now have three layers of coverage, the base whole life, a sliver of paid up additions whole life, and slighltly less one year term insurance.

•  25,000 Par Whole Life
•  $500 Paid Up Addition
• $74,500 One Year Term

Year after year, the base par whole life coverage stays the same, the paid up additions keep increasing and the one year term component keeps reducing.

20 years from now or so ....two choices:
Eventually the Paid Up Additions have entirely replaced the one year term insurance coverage. Your policy now consists of your base Par Whole Life, and a bunch of paid up additions, total coverage equal to what you had initially purchased. There’s no more 1 year term life insurance left in the policy.

 The policy is continuing to produce dividends. We have two choices for those dividends at this crossover point . First, you can continue to use the dividends to purchase Paid Up Additions. This will result in increasing coverage and increasing cash surrender values going forward. Secondly, you can switch the dividends from purchasing paid up additions, to paying your premiums. Generally the policies are targeted so at this point the dividends equal the premiums, resulting in a policy that is ‘paid up’ – no more premiums paid by you.

What can go wrong?

 There’s only one thing that can go wrong with these types of policies – and that’s that the life company doesn’t pay as high of a dividend in the future as they’d projected when your policy was purchased. But, that one small lack of guarantee can lead to multiple serious ramifications for you.

 In the example above, we said in year two that we could purchase $500 of paid up additions. But what if dividends are reduced by the life insurance company, and only $300 of paid up additions are purchased. Now your policy looks like this:

•  25,000 Par Whole Life
•  $300 Paid Up Addition
• $74,700 One Year Term

 Recall that the one year term costs increase every year. The policy had been projected to only have $74,500 of one year term in year two, but we’ve actually got $74,700 that we’re paying for. This is a problem that continues to get worse – the one year term is not being replaced fast enough, while the cost of the one year term continues to increase. Here’s were we could end up:

What we thought we would have:

•  25,000 Par Whole Life
•  $75,000 Paid Up Additions

 But what we actually have 20 years in the future:

•  25,000 Par Whole Life
•  $50,000 Paid Up Additions
• $25,000 One year term

 And that $25,000 of One Year Term is now REALLY expensive. So instead of your premiums going to zero in 20 years, or your coverage increasing, now you’re actually faced with a policy that will eventually collapse, or your premiums increase substantially going forward. Both of those mean you could likely end up with no life insurance 20 years from now.

 And that’s why we don’t recommend this type of life insurance. The lack of guarantees in the dividends lead to the one year term not being replaced fast enough, and then you’re looking at 20 years from now having unsustainable one year term premiums.   

 This isn’t a hypothetical situation. It happens, it is happening. In fact, back in the 1990’s there was a series of successful lawsuits against life insurance companies in Canada called ‘vanishing premium lawsuits’ that involved many of the life companies – and the lawsuits were either successful, or settled.   

 So there you have it, you understand how enhanced whole life works, and the risks associated with the coverage type. If you have any questions about your life insurance coverages, please contact The Term Guy at (416) 642-6820.