direct recognition versus non-direct recognition of whole life insurance dividends

The Definitive Discussion on Whole Life Insurance Dividend Recognition

Whole life insurance dividends are a fun subject we discuss quite regularly.  But a more obscure and advanced topic on this subject is the way life insurer adjust dividends (if at all) whenever a policyholder takes a loan out against a whole life insurance policy.

We refer to this concept as dividend recognition–it's a reference to how insurers “recognize” loans and treat dividends accordingly.  There are entire sales systems dedicated to one of the two dividend recognition styles and for years much debate took place trying to establish one as superior to the other.  Today I'll detail everything you need to know and give you the background you need to figure out how–if at all–this matters.

Non-Direct Recognition

Non-direct recognition means that the insurer made no adjustment to the dividend payable whenever a policyholder takes a loan against a whole life insurance policy.  In the interest of helping everyone at all levels of life insurance proficiency, I'm going to use an example to help further solidify understanding of this subject.

Non-Direct Recognition Example

Jim has a whole life policy with $100,000 of cash value.  The current dividend interest rate on the policy is 6%.  Jim Decides to take a $20,000 loan against his whole life policy.  The contract is non-direct recognition.  The life insurer will not make an adjustment to the dividend payable to Jim's whole life policy.  Jim will receive the same 6% dividend on all values of the policy despite the fact that he has a $20,000 outstanding loan.

Notice that, despite the loan, Jim achieves the same appreciation of value on his cash as he would have had he taken no loan against the policy.

Several marketers point out that this allows policyholders like Jim to access cash value without sacrificing the earnings on the cash value.  But, these same marketers have incorrectly suggested that this happens as a result of non-direct recognition.  This is not an incorrect depiction of whole life insurance.  We'll revisit this point in just a little bit.

Direct Recognition

Direct recognition means that the life insurance company can and will adjust the dividend whenever a policyholder takes out a loan against the policy.  The adjustment affects the values held in the policy that act as collateral for the loan.  Let's also use an example to ensure understanding of direct recognition.

Direct Recognition Example

Laura owns a whole life policy with $100,000 of cash value.  The current dividend interest rate is 6%.  The policy uses direct recognition so the dividend rate for loaned values is 4.75%.  Laura decides to take a $20,000 loan against her whole life policy.  The life insurer will pay dividends to Laura's whole life policy in the following way.

$80,000 of the policy will use the 6% dividend interest rate.

$20,000 of the policy will use the 4.74% dividend interest rate.

Notice that the adjustment to the dividend only affects the portion of the policy that backs the loan ($20,000 in the above example).

Also, note that the adjustment is a negative adjustment in this example.  That is not always the case, but it is usually the case.  I just want to make sure you walk away from this blog post understanding that in some cases direct recognition could cause the dividend interest rate paid on loaned values to be higher than the ordinary dividend interest rate paid when no loan is outstanding.  This would generally happen if the loan interest rate on the policy was higher than the ordinary dividend payable to all policyholder (i.e. the rate paid when there is no loan outstanding).

Taking your Whole Life Cash Value out for a Drive

I mentioned in the non-direct recognition explanation that some marketers claim that non-direct recognition allows policyholders to access cash value without sacrificing the earnings on the cash value.  The allusion often made is something to the effect of “taking your money out for a spin around town and then putting it back in the garage when you are done.”  By doing this, you aren't giving up earnings on your cash, it still working for you.

But…I also noted that these same marketers confuse this fact about whole life insurance (it actually works on universal life insurance as well in some cases) by claiming that it's a feature of non-direct recognition.

In truth, this is a feature of whole life insurance dividend recognition completely aside.  Guaranteed cash value accumulation (i.e. the interest paid on the cash value that has nothing to do with dividends) will always happen regardless of loan activity.

And…for all whole life policies I'm aware of (and I'm aware of many) the policyholder still receives some dividend (even if it's less through direct recognition) whenever a loan is outstanding.

So whenever the guy or gal who wrote the book about using whole life insurance to create your own private bank tells you that there's a unique feature to whole life insurance called non-direct recognition that permits you to use whole life insurance as a means to finance major purchases because it allows you to spend your money without losing the earnings on your money, they've made a critical error in their depiction of whole life insurance.  This feature is true of either form of dividend recognition.

The Direct vs. Non-Direct Recognition Debate

Non-direct recognition has an almost obvious reason to like it.  Who doesn't find an appeal to the claim that no matter what you choose to do loan wise, the life insurer must pay you the same dividend?  Life insurance agents and companies are aware that there's a baked-in attractiveness to being able to make this claim…and they use it.

Agents have been arguing the superiority of one form of dividend recognition over the other for decades, and non-direct recognition enjoys the upper-hand.  I'm not here to tell you that a great miss-service ensued as a result of this because it hasn't.

Instead, I'm here to warn you against believing any claim of superiority of non-direct recognition over direct recognition or vice-versa.  Hopefully, you've learned by this stage in your life that finance is far too complex a topic for any singular contractual provision to ultimately rule all other considerations.  If you haven't yet accepted that vine-length recommendations are scary wrong, I'll simply let you know now that the day will come.  That or you're on a collision course with financial ruin.

We Reviewed this Debate for Years

We watched for years as agents, insurance companies, and marketing organizations claimed some degree of superiority of one form of dividend recognition over the other.  We analyzed just about every whole life product on the market specifically concerning dividend recognition trying to find a universal advantage that one had over the other and always came up with little evidence that one always held an advantage.

This along with our deep and profound understanding of life insurance not just theoretically, but in real-world applications led us to suggest that there were far too many other variables that mattered to declare dividend recognition the key feature that separated the good from the bad.

Still, though, people wanted succinct evidence and argued that perhaps if we looked at this more granularly, we'd discover that truly non-direct recognition was ultimately best for cash value accumulation scenarios.

I can't tell you the number of times we hear something to the effect of “yeah I understand, but I plan on taking loans a lot so that probably means I shouldn't even consider a whole life policy that is direct recognition.”  Says the student to the teacher.

So late last year we decided to make what we felt was an apples-to-apples comparison using two of the best whole life products when it comes to cash accumulation and pitting them against each other for projected cash value.  We then used a number of loan scenarios that sought to figure out when non-direct recognition would show a clear advantage.  We then presented the information in a live webinar that you can now access as part of Predictable Profits the book we wrote on how to use whole life insurance for its cash value.

Quantitative Dividend Recognition Analysis Webinar

Accessing the Webinar through Predictable Profits gives you not just our analysis but background on dividend recognition and access to a Q&A session we did on the webinar submitted by webinar attendees.  You also get Predictable Profits which will not only detail the top reasons to own whole life insurance for its cash value but will detail how you go about using this cash value.

You can read more about Predictable Profits by clicking this link

Prejudices can Hurt You

Discounting any financial product because it does or doesn't have a specific attribute it foolish.  In all the years we've run The Insurance Pro Blog we've never asserted that one feature of any financial or insurance product is superior to them all and the defining feature that makes it good or bad.  There is a reason for this.

We understand that openness to things we might not have initially thought work can lead to discoveries that are quite fantastic.  Having a prejudicial approach to finance can cause us to make mistakes or at least shut out some really wonderful options we never took the time to hear out.

About the Author Brandon Roberts

Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.

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