The 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:
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.