Direct Recognition vs. Non Direct Recognition

Direct RecognitionThe debate between direct recognition and non direct recognition is a long standing one.  If you missed posts from earlier in the week detailing direct recognition and non direct recognition, be sure to review.  So which is the superior method of treating dividends when there’s an outstanding policy loan?  Are the “purest” correct when they point to non direct recognition as the only way a company should approach whole life policy loans?  Or does direct recognition have an advantage by “not subsidizing the policies with loans with the ones without them” as the companies that issue direct recognition contracts are quick to point out?

The Non Direct Approach

As we’ve covered, non direct recognition does not adjust the dividends paid on a policy when there is an outstanding policy loan. For a long time, this has been regarded as a superior feature. We’ve covered the notion that policy loans do not come out of the policy. And in truth whether the policy is direct recognition or non direct recognition, something still gets paid on the cash values that are pledged as loan collateral. This feature has been the catalyst behind numerous marketing packages mentioned in the non direct recognition post. The addition of non direct recognition augments this benefit; so the claim goes.

But one question non direct recognition adherents must address (and they typically do so poorly) is the fact that there is no magic bullet. The likes of Massmutual, New York Life, Ohio National, and Met Life (some big names in the non direct arena) do not have access to a magic well from which to pull money. So while it’s very nice that they don’t adjust dividends, there has to be something that they give up in order to make that benefit a reality.

The Direct Approach

Direct recognition, as we know from the last post, was introduced as a way to combat rising interest rates that caused whole life insurance policies of the day appear to dramatically lag other fixed income based assets. Direct recognition companies are quick to point out that their non direct counterparts are subsidizing policies with loans with policies that do not take loans (i.e. they are dragging down the dividend they could be paying non loaned policies to prop up the loaned policies).

This seems like a fair criticism, but some non direct recognition companies would counter with the fact that the practice of “subsidizing” the dividend with other business units is a prevalent practice among all companies. For example, a company may derive a significant amount of income from a non participating block of insurance business. Profitability on this block is not shared with policy owners, and instead is part of the company’s surplus that would go towards whole life dividends.

Traditionally, direct recognition has been criticized by its opponents for reducing the dividend rate when a policy loan is outstanding. However, since fixed loan interest rates on some policies are currently higher than insurance companies are earning on their general account investments, direct recognition has turned into a feature that is increasing dividends paid on loaned portions of policies (keep in mind whole life is a product issued mostly by mutual life insurers who take very seriously their claim that participating policy holders are owners, and that the company works to deliver the best benefits to its owners).

It’s important to note that this practice (increasing dividends) does not enhance policy performance by virtue of taking a loan, as there is still a spread between loan interest and the dividends paid. It does, however, offset what in current conditions seem like very high interest rates.

It’s Really Not One vs. the Other

As disappointed as you all might be, the truth is one is not superior to the other. Direct recognition vs. non direct recognition is more a game of smoke and mirrors used to keep your focus away from the really important stuff. In the fight among insurance companies, there is no magic, just magicians.

What I mean here is simply that there are good direct recognition contracts and bad direct recognition contracts. And, this should come as no surprise, there are good non direct recognition contracts and there are bad non direct recognition contracts.

I’ve talked about the Blease projected income report, which is done every year by Blease/Full-Disclosure. This report solves for death benefit based on a specified base premium for several companies and then solves for projected income. If you want to read the article here on the Insurance Pro Blog, it can be found here. Here’s an image taken from the current report that shows us all participating companies and their results:
non direct recognition

Now, if non direct recognition were the ultimate feature, then the non direct recognition companies should have no problem reporting higher incomes, but that’s not the case. Ohio National (a non direct recognition company) does take second place but Penn Mutual (a direct recognition company) wins top prize.

Also note that we have to cut through Security Mutual, the Guardian, and Country Financial (all direct recognition) before we get to another non direct recognition company Lafayette Life. Now, it is noteworthy that both Massmutual and New York Life are missing from this list. We suspect Mass could give Penn a run for its money. New York Life on the other hand, probably isn’t going to win this fight.

Details, Details, Details

I said it at the outset, and I’ll bring it up, again. There’s more to a whole life contract than just its dividend recognition. The total package is important, so if you’re looking at one product simply because it is or isn’t non direct recognition, you might be headed down the wrong road. Direct recognition is more prevalent, but can also have some pitfalls (note that the worse performers are direct recognition contracts).

Life insurance contracts can be robust. If wealth accumulation and retirement income is a strategy you are looking at with a life insurance purchase, be sure to wade through all the details and not just whether it’s a non direct recognition or direct recognition contract.


5 Responses to “Direct Recognition vs. Non Direct Recognition”

  1. Oren says:

    There’s an important extra point to make. If someone has good credit, and a substantial cash value with a Direct Recognition company, they actually have the option of going either way, as follows:

    1. They can borrow directly from the company at a fixed rate, or

    2. They can pledge their policy as collateral and borrow from a bank or other lender at a variable market rate.

    If interest rates turn the other way (up) and loan is still needed, strategy can be reversed.

    On the other hand a policy with a variable rate still bears interest rate risk on the policy loan.

    Furthermore, income illustrations are more reliable with direct recognition, as the loan interest rate is KNOWN as is the related dividend on the loaned amount. With non-direct recognition loan we can see dividend interest rates and loan rates go in opposite direction (as NYL did a while ago on their older series Whole Life – I know because I own several NYL policies with loans. I also own several Guardian policies with loans.)

    • Brandon Roberts says:

      Hi Oren,

      Thanks for bringing this up

      We’ve actually done collateral assignments for both direct and non-direct recognition policies in the past. It’s not a terrible strategy, though at times the fees assessed against loans of this nature from the bank seem a tad excessive.

      I’m not sure I’m in complete agreement about direct recognition being more reliable on income per se. Yes the loan rate is fixed, but there are a number of direct recognition companies that do not fix the dividend rate when a loan is outstanding. Guardian, for example, has a current practice regarding what happens to the dividends when there is a loan that is very nice, but it’s not a guaranteed feature to the products.

      We’re still very much of the opinion that this feature alone should never be the deciding factor. There are more pieces and parts to look at before making a decision.

  2. Jeff says:

    The Blease report can be very deceiving because it focuses on a death benefit only as it’s starting point, but the premiums are much different from carrier to carrier. With that, the higher premium products will have more cash growth, less leverage on death benefit. If you fund a policy with a matching premium among all carriers and same initial death benefit using the highest contract premium in the bunch and funding the lower premium policies with excess going to paid up additions, you will see a much different result. This is a more accurate level playing field.

  3. Jack Clough says:

    Jeff makes a good point. Can you provide a new analysis with his suggestions in mind?

    • Brandon Roberts says:

      No actually Jeff’s point was very off base in terms of its criticism as Blease had numerous reports that compared things like internal rate of return (IRR) and also solved death benefit for premium keeping the outlay even across carriers. We only used that comparison as supporting evidence of our point, and not definitive evidence.

      That being said, we’ve provided numerous other comparisons that also speak to this issue in the competitive analysis section of the Insurance Pro Blog.

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