When it comes to buying life insurance, the options and benefits can feel overwhelming and endless. In past decades whole life policies were often referred to as the most straightforward option for life insurance.
With a level premium, growing cash value, and a guaranteed death benefit, premiums were all that seemed to separate policies. Today, life insurance is not only used for protection but also for investment and collateral. This has sparked a new debate and much confusion about dividend performance and the benefits of direct recognition versus non-direct recognition life insurance.
So which is better?
Policy Loan Basics
Before we get into the benefits, let me explain some basic insurance lingo. With any whole life policy, there is a cash value that is available to access as the policy grows over time. There are many options for how this money can be used in the future. One example includes taking a loan from the insurance company and using the cash value as collateral, also known as a policy loan.
With a policy loan, you are charged a set interest rate on the borrowed money, and not actually accessing the actual cash value. So the insurance company still pays dividends on the full cash value even when you have taken out a loan.
Let's say you have $200,000 in cash value and you take a $50,000 policy loan with a direct recognition company. The $50,000 of cash value collateralizing the policy loan would still receive a dividend. This dividend would be either higher or lower than the dividend on $150,000 you didn’t borrow against.
What's the Difference?
Let's use the same example of $200,000 in cash value and a $50,000 loan. With a non-direct recognition loan, your entire $200,000 of cash value would receive the same dividends, loan or no loan. With that being said, you would think that based on this information non-direct recognition would obviously be the best choice. Right?
Unfortunately, as with most things in life, insurance is not always simple. In theory, non-direct recognition (no effect on the dividend) sounds great and seems to make the most sense. For example, you can borrow against as much of your cash value as you want, and still receive the same dividend across the board.
If this sounds too good to be true, then you know somewhere there has to be a catch. Especially when it comes to dealing with insurance companies or businesses that are trying to earn a profit.
The Downside of Non-Direct
You might be asking, "How can non-direct recognition companies afford to pay the same dividend to everyone?"
The answer is mostly based on a few key points that everyone needs to be aware of. For starters, one of the issues is insurance companies book a policy loan on their balance sheet as an asset, making this basically a risk-free bond.
You borrow money, and they charge you interest while being in control of the collateral. This results in guaranteed interest to them with no guaranteed dividend to you. That means you are actually subsidizing your own dividend through the loan interest payments.
Unfortunately, that is not really the biggest potential issue. The real issue arises when there is a disparity between total return and whatever interest they’re charging you for the loan. When this occurs, the insurance company would have to subsidize this loss through the dividend of all the policyholders. In that case, everyone gets a lower dividend, particularly you, the person who is also subsidizing this.
This risk is particularly true with the smaller non-direct recognition insurance companies. With fewer assets and policies there would be a larger impact if there was a difference. Like we said earlier, there is always a catch. If a non-direct recognition insurance company were using a direct recognition model, then perhaps there would be no impact on the overall dividends. In theory, this should equate to a higher dividend for all policyholders of direct recognitions companies.
Is Direct Recognition Life Insurance Always Better?
Most people often think that in our low-interest-rate environment, direct recognition insurance companies would be inferior. This is due to having a lower interest rate on the loan than what is paid in dividends. When the loan interest is lower, it reduces the dividend. But that really is only a small part of the story.
When it comes to the dividends of a direct recognition company, they can actually separate and allocate collateralized funds in a special dividend pool. This allows them to pay a lower dividend on this portion then what they would pay on the non borrowed portion. The direct recognition companies then have an opportunity to pay a stronger overall dividend.
When it comes to the debate on whether the direct or non-direct recognition approach is better, the simple choice is not always clear. When you are considering if or how you will use the future cash values, this is particularly true.