Direct recognition, indirect recognition and the dangers of agent misinformationArticle added by Jeffrey Reeves on May 11, 2011
Ranked: #11 (3,979 pts)
A client recently sent me a copy of an email received from an insurance agent promoting whole life insurance policies from a specific life insurance company. The email from the agent was inaccurate and therefore misleading. The exercise of clarifying the issues raised in the email are meaningful, so I am repeating my reponse here and expanding on it as needed.
A client recently sent me a copy of an email received from an insurance agent promoting whole life insurance policies from a specific life insurance company. The primary goal of the original email seemed to be to demonstrate that one form of dividend calculation on whole life insurance policies is better than another.
The email from the agent was inaccurate and therefore misleading. I have no doubt the agent was convinced that the information in the email was correct or that s/he was operating in good faith. However, my client asked me to confirm or deny the claims in the email and I felt compelled to clarify the inaccuracies as much as possible.
The exercise of clarifying the issues raised in the email are meaningful, so I am repeating my reponse here and expanding on it as needed.The original email content is in standard type. My responses are indented, italicized, and preceded by my initials in brackets thus [JR].
Two types of mutual insurance companies
There are two types of mutual insurance companies. They are called direct recognition and non-direct recognition. I have policies in both these types of companies.
[JR] Actually, there are direct recognition mutual companies and mutual holding companies and non-direct recognition mutual companies and mutual holding companies. Whether a company is structured as a mutual company or a mutual holding company is as significant as whether it pays dividends on a direct recognition or non-direct recognition basis.
Direct recognition vs indirect recognition
Non-direct means the policy owner receives the same dividend rate no matter how many dollars he has borrowed from the insurance company using his death benefit as collateral.
[JR] Well, that’s not exactly correct. Actually, the policy’s cash value is the primary collateral used when a policy loan option is exercised by a policy owner. One cannot borrow more than a whole life policy’s currently unencumbered cash value.
So you may have borrowed $10,000 whereas another policy owner borrowed $100,000, but you both earn the same dividend rate.
Death benefit only comes into play in the event of death.
[JR] The statement is true as far as it goes. However, it ignores the fact that the policy owner that borrowed $100,000 would pay a lot more interest to the insurer than the policy owner that borrowed only $10,000.
Or you may not have borrowed anything but you would still earn the same dividend as someone else who has borrowed and is using that borrowed money to earn even more profit somewhere else.
In both cases, the interest paid by the policy owners — one to a greater extent than the other — would add to the surplus of the insurer; and the company pays dividends from its surplus, which is where dividends come from.
[JR] The unasked question is, “Why is that a bad deal for anyone?” Some indirect recognition companies have followed this pattern for over a century.
(As an aside, what the devil difference does it make what the policy owner is doing with the money s/he borrowed from the policy that s/he owns? Sorta sounding like a Robin Hood argument).
Direct means the company determines the dividend rate according to policy holders fair share ...
[JR] This statement is irresponsible. It assumes the indirect companies dividend paying practices are unfair to their policy owners.
... according to how many dollars he has borrowed from the insurance company’s general fund using his death benefit as collateral.
Should indirect recognition companies like Mass Mutual be ashamed after over 100 uninterrupted years paying top dividends? How unfair.
[JR] There you go again Mr./Ms. Agent. It’s cash value, not death benefit, that is the primary collateral used to back a policy loan.
The higher the amount of dollars on loan to you does mean you will receive a lower dividend rate.
[JR] Ah! A moment of clarity. It’s true. Direct recognition companies apply a different — often lower dividend rate to those policies that have loans outstanding.
Now, why does this matter? Well, it doesn’t really matter a whole lot ...
The obvious conclusion according to this agent is that a policy owner that plans to exercise the right to take policy loans granted by his or her policy — a binding contract — an indirect recognition company may not be the best option.
[JR] Another brief moment of clarity. Often the difference between the performance of non-direct recognition policies and direct recognition policies is not significant enough to make it a deciding factor on a buying decision. But if it doesn’t matter, why the epistle?
... but some insurance agents use the fact that a company is a non-direct company as a selling point when trying to sell someone a policy.
[JR] OK, now I know why. Mr./Ms. Agent in this epistle uses the direct recognition dividend practices to promote the sale of policies for their direct recognition companies.
The banking concept
But it is good to understand that an insurance company makes money using the velocity of cash flow...
[JR] If a policy owner-borrower is being what R. Nelson Nash, formulator of the Infinite Banking Concept™, calls “an honest banker,” the insurer has very good cash flow.
... just like a bank does.
If the policy owner fails to repay the loan and the interest, the insurer uses the policy’s cash value, which was used as collateral, to repay the interest and protect the other policy owners/borrowers. If the policy cash value is all used to pay premiums and/or interest, the policy lapses.
[JR] Insurance companies, like banks, use the money that policy owners pay in premiums and interest to make loans and enter safe and conservative joint ventures. That much is accurate.
If you have your money sitting in a five or 10 year CD at the bank, the bank knows that it has a set amount of money that it can lend over and over and over again during that set period of time. An insurance company does the same thing.
However, insurance companies do not act “just like banks.” Banks work for shareholders, not depositors. Mutual insurance companies and a holding company’s mutual insurance company work exclusively for the benefit of policy owners.
[JR] Banks operate on a completely different set of principles and rules than insurance companies. Insurers do not do “exactly” the same thing.
The velocity of money ... sorta
Banks operate on money that they derive from depositors. In addition, they have access to a form of ”matching funds” from the Federal Reserve Bank. Therefore, the banks can actually lend up to 10 times the amount of money they have received from depositors.
Insurance companies limit themselves to using only the money they have on hand.
You pay your premium and it can lend an amount of money over and over and over again for a lifetime. However, if you borrow money from your life insurance company, now they can no longer velocitize that money.
[JR] An insurance company can only lend up to the limit of its cash available excluding reserves. Insurance companies cannot leverage Fed funds to increase the amount they can lend. That’s not at all the same as a bank.
Instead, you are now in control to velocitize your own money.
In fact, if the insurer lends money to Home Depot, they cannot “velocitize” (not a recognized word in any dictionary) the money either, nor can they leverage through fractional banking like a commercial bank.
[JR] The insurance company is, in fact, “velocitizing” the money by charging the policy owner a competitive interest rate and, again, by contract, the policy owner is always in control of the cash value in a whole life insurance policy.
The attempted deception falls apart
Moreover, because a whole life policy is a contract with borrowing provisions decided by the insurer, the burden is contractually on the insurer to make sure it makes money for all of its policy owners and not one more than others — and that’s true for both direct and indirect recognition companies.
However, one must consider this fact. How long will an insurance company be able to stay in business if a large portion of their policy owners are receiving an unfair share of the profits?
[JR] Hmmm. How is it possible for a policy owner to receive an “unfair share of the profits” by being charged a fair interest rate under contract terms determined by the insurer. Robin Hood again?
Who actually owns the insurance company again? The policy owners. That would be you.
Again, does that put Mass Mutual — 100+ years old and never missing a dividend — at more risk than a direct recognition company like Northwestern Mutual — also over a century old with a great dividend record?
[JR] This is accurate when describing mutual companies. Although mutual holding companies “operate” as mutuals, the holding company — not just policy owners — holds significant interests in the mutual insurance company.
Some of the non-direct recognition companies restrict the number of loans, or the amount one can take as a loan or the number of policies one can own etc.
That is not an indictment of the mutual holding companies. It’s merely an attempt to bring clarity where none exists.
[JR] Tell me who you are talking about so I can avoid them. I’ve not experienced that in 40 years of dealing with a wide variety of insurance companies of both types, except when the insurance company was in receivership— and that happened only twice that I experienced personally either as an agent or policy owner.
Do you want to have a policy that restricts your capital availability?
[JR] This is a cheap shot and poor salesmanship. I know of no direct or non-direct company that issues a contract that says the owner of a whole life policy cannot access to all of their cash value on demand.
Some non-direct recognition companies fire the agents that tell their clients about banking ...
[JR] This, too, is uncalled for. If an insurance company were to take this action, it would be grounds for a significant law suit by both the agents and the insureds. The insurer cannot deny rights granted by the insurer in a recognized contract.
... and also some have been bought by stock companies and are in th process of converting from mutual to stock because too many of their customers were borrowing from their policies.
[JR] I’d like to know the names of those companies so I can confirm the claim, avoid doing business with them, and make sure the agents and advisers I deal with all across the U.S. know about it.
The company I recommend is a direct recognition company.
[JR] Well who woulda guessed? This agent is surely operating in good faith, but is in dire need of information, knowledge, and wisdom.
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