Picking up from where we left off last time on whole life dividends, direct recognition is the opposite strategy to non-direct recognition.
It’s the newer approach to handling the payment of dividends when a policy loan is outstanding, and it’s frequently championed as the feature that allows life insurers to pay higher dividends on non-collaterally assigned policy values (hereinafter, “non-loaned policy values” because its slightly shorter and how we generally refer to it).
High Inflation: a Big Problem
Starting in the 1970s and continuing through the 1980s, interest rates were high – extremely high compared to the decades that preceded and followed. And, this increase in interest rates began quickly, which is a condition insurance companies hate.
When one takes a policy loan from a whole life contract, the loan comes from the insurance company, and the cash stays put (as we’ve discussed). However, since the remaining cash acts as collateral for a loan, its principal preservation becomes dramatically more important.
Today, this doesn’t seem like a huge deal. Since all of the non-direct recognition companies use variable loan rates, if interest rates began to rise dramatically, the variable rate could increase to match the interest rate environment (only to certain maximums), and insurance companies could match asset/liability cash flows. But, back in the day, non-direct recognition came with a fixed loan interest rate.
This means insurance companies issued the equivalent of deep in-the-money calls that policy owners could (and did) exercise to place the money into certificates of deposit and still earn dividends within the whole life policy.
But, when they exercised this option, the insurance company had to pay dividends (that were supposed to compete with prevailing bond rates) on values that couldn’t be invested in bond and rather had to earn loan interest that was much lower than the market rates of the times – not a sustainable strategy.
Instead, insurance companies chose to simply keep their dividend rates low across the board, which brought the industry sharp criticism.
Guardian To The Rescue
It was the Guardian Life Insurance Company that claims credit for the epiphanous question, “What if we simply paid a different rate on the loaned and non-loaned values?” With this idea, direct recognition was born in 1982.
The Guardian and other insurance companies began issuing new contracts as direct recognition and offering old non-direct recognition contracts a chance to convert to this newly devised method (Fun fact: to this day, the Guardian still makes annual offers to switch non-direct recognition contracts issued prior to 1982 that never took them up on the offer for conversion to direct recognition).
What it Accomplished
Direct recognition allowed insurance companies to pay a dividend rate that was more competitive with the market rates of the times so long as the money wasn’t pledged as collateral as a policy loan. During the time of high interest rates, the direct recognition companies definitely boasted higher dividend interest rates than the non-direct recognition companies. We’ve also seen direct recognition companies achieve the highest actual internal rate of return on cash value over the past 20 years under the Blease analysis performed on a $250,000 whole life policy.
The companies that issue direct recognition contracts (again in no significant order) are:
- The Guardian
- Northwestern Mutual
- Penn Mutual
- Savings Bank Life of Massachusetts
- Minnesota Life
- Mutual Trust Life
- Security Mutual
*Note: Massmutual will issue both direct recognition and non direct recognition, however the vast majority of their contracts are issued as non direct recognition.
An Important Note
Direct recognition merely means that the dividend is adjusted. Some incorrectly assume it means the dividend is reduced. While this is generally the case, it is not always the case.
Later this week we'll dive into the debate between the two. We'll weigh in on whether or not we believe one is truly superior to the other. So stay tuned for non direct recognition vs. direct recognition.