Dividend recognition dictates the policy of a life insurance company regarding what it does if a policyholder takes out a loan against his / her entire life insurance. If the company applies non-direct recognition, it does not adjust the dividend if there is a loan against the policy. The company pays exactly the same dividend interest on all insurances regardless of outstanding loans. If the company applies direct recognition, the company makes an adjustment of the policy due to the outstanding loan.
For several years, some marketers argued that non-direct recognition was the superior policy because it ensured some arbitrage that greatly benefited policyholders. A kind of magic so special that it served as the basis for such fantastic ideas as Bank on yourself® and other self-financing-through-life insurance systems.
From experience I can say that it is much easier to explain – as long as you do not have someone who wants to dive into how a company can afford to continue paying dividends on money that it technically no longer has. But we have long held the view that dividend recognition is at best a tertiary consideration when choosing the right lifetime policy for one’s specific needs.
And for good reason, even though companies with direct recognition policies surpass non-direct recognition companies by a good margin, there are still many who apply the much older policy of non-direct recognition, and not everyone produces great policies. If you bought MetLife or Ohio National Life Insurance in the last 10 years because they were non-direct recognition, you condemn that decision, right?
So while some marketers have argued that non-direct recognition is the goldmine of economic success, we expressed our doubts and provided many explanations as to where it failed to create the superior wealth creation that many claimed it would do.
And now I suspect that things are getting interesting.
Interest rates go up!
Oh happy day for the life insurance industry, interest rates are on the rise. This means that their primary investment tool – corporate debt – is about to yield much higher returns. This of course means that we can expect higher dividends in the near future. But there is a small functional problem that may develop soon and that is not good news for your non-direct recognition contract.
Rob Peter to pay Paul
Non-direct recognition insurance companies do not have magical powers. In order for everyone to be able to pay the same dividend regardless of loan status, they must take the money from somewhere to perform this feat. Somewhere there are the other policyholders who do not take out loans against their insurance policies.
The last time we saw inflation so high and then experienced interest rate levels necessary to combat it, non-direct recognition caused a major problem for the life insurance industry.
At that time, the only life insurance companies with dividend insurance were used. And that posed a serious threat to their financial stability. The insurance companies had a problem to deal with. How do we balance the loan interest rate we collect from policy loans with the pressure to pay higher dividends in general? This created a spread that was far too far apart for the insurance companies to handle, and therefore they kept low dividend levels – to the annoyance of policyholders. They also faced a problem with policyholders borrowing at a – much lower interest rate – and using the loans to buy things like CDs at significantly higher interest rates. The disintermediation that followed was quite worrying.
And of necessity, innovation will …
Direct recognition, the answer to the problem
Direct recognition first came on the scene as a mechanism to combat the above-mentioned problem. The linked loan and dividend interest rates for a certain part of the policy – the part that was provided as security for a loan. This led to two things happening.
First, it allowed insurance companies to raise dividend interest rates because they were no longer worried about dealing with the difference between dividend interest rates and loan interest rates.
Secondly, it created a strong deterrent for policyholders to take out loans because their cash value performed better throughout life insurance.
Today, further innovation has come to minimize the negative consequences of the second point mentioned. And the adoption of direct recognition has put many insurance companies in a very strong position to return value to policyholders in a fair way.
Although this is the case, some insurance companies still insist on committing non-direct recognition. Many of them choose this because of the perceived marketability of non-direct recognition. On its face, it sounds like a magic bullet, and the marketing angle of this dividend policy is too good to miss.
Rising rates will be a problem for non-direct recognition
The short and half-correct answer is probably. There are a few reasons.
First, life insurance companies will seem slow in adopting the new interest rate environment. This is not because they are lazy, nor because they want to hold back and keep the profit for themselves. Companies that provide dividend-paying life insurance to the public are mutual or mutual holding companies and they operate in the best interests of their policyholder.
Insurance companies are much like aircraft carriers, they are huge and they manage a lot of assets. It will take time for them to circulate assets and begin to achieve increased returns to the extent required to pay higher dividends. I suspect dividend recognition aside, we are probably 18-24 months from announcing increased dividend rates.
People are impatient. So if my whole life policy does not seem to be crushing other fixed income investments or the interest rate environment seems to be suitable for another opportunity, I might as well think of how I can use that money elsewhere. This manifests itself at best as a policy loan and at worst as a complete surrender of the policy – watch out for unscrupulous sellers with competing products that are particularly focused on life in the coming months due to this vulnerability.
This is likely to lead to disintermediation which will hit the non-direct recognition companies particularly hard as they will be forced to pay their current dividends even though money is flowing out of the company. The good news is that for the most part, they will earn returns on the loans that are close to – potentially above – the returns they are achieving right now. The bad news is that they can potentially be limited when it comes to buying new bonds at higher interest rates than the loan rate provides. Worse, this lending activity could cause a revision of the planned lending activity – a big deal for companies that do not provide direct recognition – and potentially lead to further dividend levels. reductions.
Secondly, given the need to carefully manage the spread between loan interest rates and dividend rates, life insurers who do not recognize direct recognition may have their hands tied when it comes to announcing a higher dividend. The lower returns they achieve on assets due to potential and real lending activity will hamper their ability to pay a higher dividend to policyholders. That is exactly what played out last time we had a rapidly rising interest rate environment. Companies that adopted direct recognition were relieved of the need for spread monitoring and announced much larger increases in their dividends during these years. Their dividend levels also fell much more slowly when prices fell again.
Here is a chart comparing the four largest mutual life insurance companies – which are still mutual life insurance companies today – from 1982 to 2000:
Note that the first recipient of direct recognition – the Guardian – shoots up in the mid-80s. Subsequent adopters of Northwestern Mutual are also increasing, while non-direct recognition companies MassMutual and New York Life are experiencing smaller increases and faster declines in their dividend rates throughout the period.
What to do if you own a non-direct life insurance policy
Step one is to stay calm. There is no need to worry yet. Also keep in mind that you most likely bought your insurance as a long-term plan for wealth accumulation and that what will develop is likely to be temporary.
That said, this is a shining example of a major non-direct recognition weakness. And it should cause a pause for people who want to buy a policy for life based solely on its non-direct recognition status.
The good news is that this is likely to force spreads on companies that apply non-direct recognition less. There are times when these companies randomly abuse high spreads to sell more life insurance policies. We warned about this possibility at MassMutual already in 2012 and saw how the spread went from 200+ interest points to 100 interest points, which dramatically changes how forecast values and real results develop. The good news for us is that we never predicted results on MassMutual with a spread over 100 points.
Finally, if you bought your entire life insurance policy solely for its guaranteed death benefit, then the majority of this discussion is disputed in your case. This situation significantly affects people who applied for full life insurance as a tool for building wealth. For those who bought it and look at the cash value as a temporary part of owning full life insurance, it is not so important what happens to the dividend in the coming years. And the only thing I’m sure about is that none of these companies go bankrupt because of this.