When trying to explain policy loans, and Direct Recognition vs. Non-Direct Recognition life insurance companies, we like to begin with a discussion of ownership. In a mutual insurance company, policyholders are the owners of the company. Whole life insurance is not like car insurance, home insurance, or other types of property insurance where you funnel money in and may never see it again. Yet life insurance frequently gets lumped together with all other insurance by agents and clients alike.
Helping a client to understand that they’re an owner of the company when they have a policy with a mutual life insurance company, can be a game-changer. This knowledge, when framed correctly, can help clients understand that the success of the company is in their best interest. In other words, it's a good thing when life insurance companies invest conservatively and make decisions that are both profitable and balanced. This keeps life insurance coverage intact and keeps mutual companies mutual (which means policyholders continue to receive dividends).
Understanding Policy Loans
Clients and advisors alike often misunderstand policy loans, and this misunderstanding feeds into some of the other fundamental misunderstandings of whole life insurance. When a life insurance company lends a policyholder money, using their cash value as collateral, the company uses dollars from their general portfolio.
Contrary to some misunderstandings, a policy loan is not money policyholders loan to themselves. Nor do policyholders “pay themselves interest” when they're repaying a loan. While it may seem like a harmless misconception, this actually fuels other “myths” of the infinite banking concept and policy loans in general.
The reason it's important to pay policy loans back is not that you get to magically funnel more money into your cash value. It's important because you're being a good steward of “your” company. It's in your best interest to replenish the company's general portfolio and contribute to the company's success. (Not to mention, the company has your cash value ear-marked anyway.)
If you can help a client step into the mindset of “owner,” you can not only help them better understand policy loans—you also help them understand dividends, and how Direct or Non-Direct Recognition companies pay them.
Why Do PolicyHolders Get Dividends?
Dividends, too, are frequently oversimplified as a return of premium. While this is true from an IRS perspective, there’s more to dividends than that. Dividends get paid to policyholders because policyholders own the life insurance company. Therefore, they get to partake in the profits of the company. In order for a mutual company to stay mutual, it must distribute all of its profits.
Knowing that companies loan money from the general portfolio, this begs the question—how are dividends distributed to the many owners, even if some of them have loans and some don't? Don't the loans reduce what the company can invest and earn in the marketplace? Yes.
And is that fair? Well, only if those with loans are paying for it. If someone reduces the investment potential of the company, the most equitable solution is that the person or people who did so pay for that. Otherwise, every policyholder ends up affected by those with loans.
In order for the loan to not hurt the rest of the life insurance policies, the loan rate has to be at least what the portfolio rate is. Otherwise, everyone who has a policy with the company is paying for this person’s loan. This is part of the logic behind Non-Direct Recognition companies, which have variable interest rates.
Why Take a Loan in the First Place?
The reality is, your clients do not have to take a loan against their cash value. They can liquidate their policies if they don’t want to pay interest.
If the loan rate is 5%, and the net IRR on the general portfolio is 4%, from a pure economics standpoint, would it be better to borrow or liquidate? The answer would be to liquidate: because why would you borrow at 5% to earn 4% when you can liquidate and lose out on 4%? From a pure economics standpoint, over the course of a year, it would be better to lose 4% instead of paying 5%.
However, there’s a problem. And that is: you can’t put that money that you liquidate back. So you’re not losing 4% on your liquidation temporarily, you’re losing 4% on that amount forever. That is going to be more impactful to your cash value over time than taking the loan (as long as your client repays that loan).
Say your client liquidates $50,000. They’re not losing just $2,000 or 4% over a year’s time frame. They can’t put that money back, so after five years that $50,000 would have grown to be $60,833. Over ten years, it would have been $74,012. Borrowing against the cash value allows you to pay a percentage now to get uninterrupted compounding growth indefinitely.
Taking a policy loan is taking a temporary interest payment for uninterrupted compounding over your policy's lifetime, which has a huge impact on growth. To some clients, it may seem counter-intuitive to pay interest. Yet when they can adopt a mindset of ownership, it makes sense. Paying interest on the insurance company’s money keeps the general portfolio operating smoothly so that all owners of the company can continue to profit over the years.
The Whole Truth About Direct Recognition Companies
The next piece of this discussion is Direct Recognition companies. Direct Recognition gets a bad rap by people who don't understand how or why they work. They're often framed as a rip-off; the most common myth being that any money that is collateralized will not earn any dividends. However, in all honesty, Direct Recognition companies are more “fair” to policyholders than Non-Direct Recognition.
Whenever you have a fixed loan rate with an insurance company, it will always be a Direct Recognition company. Let’s say you have a fixed loan rate of 6%. What happens, then, if the insurance company’s portfolio rates skyrocketed to 18 to 20% and they have their money loaned out at 6 percent?
If this were Non-Direct Recognition, everybody is paying for those outstanding loans. that could have been earning 18-20%. Why should it be fair that those who have reduced the company's potential receive dividends in the same way? Direct Recognition, however, says that on borrowed funds, policy owners are capped at what dividends they can receive based on their loan rate. This way, the only person the loan affects is the person who has the loan.
Usually, this is only a 1% differential. So if you have a loan at 6%, the dividend on your collateralized funds will be capped around 5%. Any funds that you have not borrowed against can earn beyond that cap. There is also an upside to this that seems to get ignored. If the declared dividend rate is well below your fixed loan rate, you have a chance of receiving a higher percentage on your collateralized cash value. Because if you’re paying 8% and the portfolio is earning 1%, the company must still be fair—and your loan repayment is a guaranteed 8% for the general portfolio.
So Direct Recognition is really about distributing dividends in a way that is proportionate to policyholders.
Non-Direct Recognition Companies
Variable loan rates, on the other hand, can be Direct or Non-Direct, depending on the company. Say a Non-Direct Recognition company is earning 8% on the portfolio, while charging 6%, and the portfolio rate creeps up to 9 or 10%. They can move the interest rate up to match the portfolio rate. However, most companies can only raise the rate around a quarter of a point a year. So if the portfolio rate jumps a few points, and the loan rate does not, all the policyholders are affected by that.
So while Non-Direct Recognition may seem like a better deal because they pay the same proportion of dividend on all cash value, this also means that all policyholders are affected even if they don’t have a loan.
Direct Recognition vs. Non-Direct Recognition Over 30 Years
The long-term difference between Direct and Non-Direct Recognition companies, in reality, is not that big. Over 30 years, dividend-earning policies will have similar growth trajectories regardless of Direct or Non-Direct Recognition.
This all boils down to the simple fact that there are no deals in the life insurance industry. Everything is a trade-off between cost and risk. Both Direct and Non-Direct make trade-offs that balance out the dividend portion so that the company is sustainable.
Variable interest rates balance cost and risk by adjusting the loan rate to match what’s happening in the portfolio. The fixed interest rates companies balance cost and risk by paying dividends according to policy loans. Neither is better than the other in the grand scheme of things—they’re just different.
The Bottom Line
As a policyholder and part-owner of the insurance company, what should matter most to your client is that the company is being managed in a way that is sustainable and fair. The checks and balances are not to limit you or punish you for taking loans, they’re to keep the company afloat and ensure that their track record of paying dividends can continue.
Both Direct and Non-Direct Recognition companies operate in a way that benefits the company—and therefore the policyholders. If your client is concerned about what will give them the most growth, help them see the bigger picture. Getting too caught up in projections and analysis paralysis will only keep your client from starting a policy. The sooner they get started, the sooner they have coverage and cash value in place. If they find that they don’t like something about the loan rate, they can always choose something different for their next policy.
To learn how to position yourself as an expert to your clients, join us for a 3-day Truth Training. Not only will you increase your confidence and competence with the Truth Concepts software, but you’ll also learn the whole truth about the numbers behind the concepts.