“Synthetic Non-Direct Recognition” & the Ineradicable Variability in Policy Loan Interest

A new client recently mentioned a term I had not heard before: a “synthetic non-direct recognition policy.” I had never heard such a term from Nelson Nash neither publicly nor privately, nor had I seen it in any of his writings. I suspected it had something to do with justifying the use of a direct-recognition policy (why else use the ‘synthetic’ terminology?), but I decided to look into it further just in case.

Vocab

For context, direct recognition refers to a mutual life insurance company’s practice of reserving the right to reduce or eliminate a dividend otherwise payable to an owner of dividend-paying whole life insurance or to that owner’s policy in the event that the policy owner has a policy loan balance outstanding at the end of a given policy year.

This does not apply to policies receiving non-direct recognition. Policy owners (or their policies) will receive the same dividend regardless of whether or not they have a policy loan balance at the end of a policy year.

Sometimes you’ll hear about direct or non-direct recognition companies. This refers to a company that applies either recognition method to all of the policies that it offers for purchase. Instead, I tend to say that a policy receives direct or non-direct recognition treatment, because there are life insurance companies that offer the policy owner the choice of whether they want direct or non-direct recognition. You’ll also hear some say that policy loans are either directly recognized or not directly recognized. This is also fine; however, the direct consequence of whether we’re talking about direct or non-direct recognition is almost always whether the policy receives PUA premium from the dividend, so I will typically talk in terms of whether policies receive one method or the other.

Thanks for enduring that vocabulary lesson — we all love how clear the industry is with its terminology.

What is the price of a loan?

I’ll just tell you at the outset that I like non-direct recognition and I do not like direct recognition. I’ve explained why before but here’s a reminder.

In economic terminology, the price of credit is interest.

A loan is a temporal transaction. To exercise authority over a certain quantity of funds, an individual has two options: save money over time, or borrow it now. By borrowing it, the individual “skips the line,” as it were. He advances authority over funds through time to the immediate present. That is, he doesn’t have to save over time in order to accumulate the money to use now.

When we have use of money matters. Something called pure time preference theory in Austrian Economics informs us that, all else equal, we prefer the satisfaction of our desires sooner rather than later. In a world with money, where we use money to exchange for things we will consume to satisfy our preferences (rather than produce in subsistence fashion what we will consume), we can extend this one step further: we prefer authority over money sooner rather than later.

This value-differential between money now versus money later is what’s called the time value of money. Because people value the use of certain quantities of money at certain times differently than others, we have an opportunity for exchange. Two things traded in a given exchange are communicated in a ratio called a price (yes, prices are ratios, not numbers with a currency sign in front of them).

In the loan market, we might say $10,000 made available to a borrower now is available in exchange for $11,000 repaid in a year from now. If we divide the $11,000 by the $10,000, we would arrive at 1.1, or a gross gain of 110% and a net gain of 10%. This quotient, expressed in convenient percentage terms, represents the time value of money for a specific amount of money paid later in return for a specific amount of money borrowed now. This is interest.

And you thought you would escape this article without an economics lesson! I promise there’s a reason for this.

I go through all of that to say that interest is the price of a loan. Because, some might say that other things like closing costs, origination costs, or, say, a reduction in your share of the financial surplus generated by the a mutually-owned lender, are also costs of a loan.

In the context of direct recognition, some might say, the interest rate on a policy loan is one price of a policy loan and the potential reduction in the dividend payment to a policy-owner (or his policy) is just another price of a policy loan.

This would put things entirely backwards. Again, loans are temporal transactions. The price of them is likewise temporal (in particular, it has to do with the amount repaid later versus the amount borrowed now). Loans are not spot transactions, where a good now is exchanged for another good now.

To tell a borrower that there are “administrative” or “clerical” costs to borrowing is just another element of price dis-aggregation that is so common in an economically confused world. I bought jeans recently and all these websites tell you the price of the jeans and the price of shipping. But would you believe that when it actually came time to pay money that only one transaction occurred?! I don’t want to buy “jeans in Indonesia!” Obviously I want to buy “jeans in my condo.” The shipping cost is just another cost of production of jeans I can actually wear here in Texas — and while I recognize the bizarre urge to partial cost of production transparency, I don’t much care (I think this is often because sellers feel guilty for calling for a worthy price; they feel they need to shift blame somewhere else). I care about the final price to get the thing I want when and where I want it.

In the context of credit, obviously I would like for that loan to be administered (whatever the hell that means). What am I doing, borrowing money in order for it not to be administered to my use?! What are we going to do, open a loan negotiation and never “close” it?! I almost can’t keep a straight face with this stuff.

No, the price of a loan is interest. And here’s the punchline for this section: Any ‘additional’ cost to borrowing money is interest dis-aggregated.

A legitimate calculation of the true amount of interest paid in the case of a mortgage includes origination, administration, closing, and all other artificial line items. The mortgage lenders virtually admit this when they offer to lump the ‘additional’ costs into the principal of the loan! They’re telling you, “the amount you’re borrowing is actually greater than what you thought, and you can bet your life that the interest you pay will reflect that higher principal.”

The same goes with policy loans from direct recognition companies. The amount of the potential future reduction in the dividend is just dis-aggregated policy loan interest.

Again with the interest “rates”

Here’s the rub folks: direct recognition companies typically offer fixed rate policy loans while non-direct recognition companies typically offer variable rate policy loans.

Here’s a subversive thought to chew on: direct-recognition smuggles in natural variability in the price of credit.

Let that sink in for a moment.

A little bit ago I gave a very simple, deductive explanation of where interest comes from. But look at mortgage interest. Look at the Truth in Lending Act and so-called Annual Percentage Rates (APR). Look at the reams of paper with never-ending restrictions about how interest must be advertised or marketed. My God man, it’s like the commercial powers that be will do anything but to reveal the essential, basic price of debt, i.e. the quotient of what’s paid later by what’s paid now. We can speculate all day as to why that might be the case, but it sure does seem to be the case.

And look, the time value of money is not everywhere and always fixed! We are inundated with the idea that a “low fixed rate” is everywhere and always a good thing. Well, tell me this, how the hell can it be the case that all rates all the time can be “low and fixed?” There is actually an answer to this question! Interest is low and fixed in a world called the static Evenly-Rotating Economy (ERE). That is, a world of recurring, unchanging economic activity. To be clear, this is a mental construct that does not exist. It’s a tool used by economists to flesh out the effects of marginal changes in an economy. It isn’t real.

When (ha, maybe “if”) a lender offers a true “low fixed rate,” what they’re actually doing is making an entrepreneurial judgement. They’ve assessed that probable future changes in credit markets are such that a given loan, at a given time, to a given borrower, can be repaid at a certain contractually fixed interest rate. Understand that this is not sustainable in all scenarios. You can imagine a situation where a lender offers loans at a low, contractually fixed rate and then the market rate of interest rises, violating the initial entrepreneurial judgement about future interest rates. Now what do you think will happen if a certain subset of borrowers have contractual access to credit at low fixed rates while the market rate of interest shoots up?

It’s a thing called arbitrage. In fact, historically speaking, it’s a thing called the 1980's.

Some interest-ing history

What happens is those individuals with access to credit at low fixed rates exercise their contractual rights and borrow at their cherished low, fixed rate. They then turn around and lend the money they just borrowed at the market rate! After repaying the original lender, the arbitrageur keeps the difference between the interest gained from lending at the market rate and the interest paid at the low, contractually fixed rate.

In the 1980's, this contributed to what’s called the demutualization wave in the life insurance industry. Have you ever wondered why it was the case that all these mutual companies in the 80's and early 90's started to demutualize? Interest rates shot to high heaven. Nelson even mentioned this in the context of his own personal story in Becoming Your Own Banker. Here’s what happened to the rate on the 10-year Treasury (which many financial institutions use as the basis to determine retail interest rates):

Source: St. Louis Federal Reserve FRED Economic Data (retrieved 10/19/2021)

Mutual companies can only get funds from two sources: investment revenue and product sales, and you can bet your left foot that they’re already doing their best to generate as much as possible in both domains. So what happens when a mutual company that practices direct recognition and offers low fixed interest rates on policy loans hits a ten-year interest speed bump called the 1980's?

Answer: a disproportionate, unexpected demand for contractually promised policy loans.

Ironically, this phenomenon contributed to the development of the IBC itself! Nelson writes:

There was no logical reason not to expand — and so I did. The interest rate (they called it “the prime rate” in those days — now called “base rate.” This is the rate charged to the bank’s most secure customers) at that time was 8%, but your must pay 1.5% over “prime” because you are not in that category. They are not lending you money because you have real estate — they are lending you money because they think you can make payments. Why else would they require personal endorsement on the loan? And you must renew the notes every 90 days (or pay off the loan) at the current interest rate.

I got accustomed to paying 9.5% and that was “normal.” And then, along came 1981 and 1982. The prime rate rose and peaked at 21.5%! Add 1.5% on top of that and you see my situation — 23% interest — and I owed them $500,000.00! That amounts to $67,500 of interest per year that I was not expecting to pay.

— From Becoming Your Own Banker by Nelson Nash, excerpted using BankNotes from the Nelson Nash Institute. (Bold added)

And then:

And now for the bad financial news — it was that summer that Interest rates went to 23% — and there I stood owing $500,000 under those circumstances. When a number of bad things like this occur in fairly rapid succession it will increase the quality and quantity of your prayer life dramatically. The basic idea revealed in the Infinite Banking Concept was born over a period of many, many months at 3:00 to 4:00 a.m. in the kneeling position praying, “Lord please, show me a way out of this financial prison that I have created for myself.” The answer came back about like a baseball bat across the eyes. “You are standing in the midst of everything it takes to get out — but you don’t see it because you look at things like everyone else. You can get to money during these awful times at 5% to 8% interest from three different life insurance companies through policies that you own. The only thing that limits how much you can get to is the same thing they tell you at the bank when you ask them how big of a check you can write — how much have you put in?”

If I had not been accustomed to paying very large premiums, by worldly standards, it is doubtful that I would have seen the message. Hardship often helps us to see things to which we are normally blind. It was evident to me that I needed to increase my life insurance premiums dramatically to create a pool of cash values from which to borrow to pay off the bankers that I owed. But I owed $500,000! How could I do both?

— — Excerpted again from NNI.

The consequences of the error in offering low contractually fixed interest rates on policy loans made itself manifest, and many mutual companies (and many of them — direct recognition mutual companies) had to demutualize in order to raise sufficient outside capital and remain solvent. Of course, the unexpected surge in demand for policy loans may not have been the only reason companies decided to demutualize, but I don’t think it’s a stretch to assert that it must have been a significant factor.

Variability in the time value of money is ineradicable

You cannot eradicate uncertainty in future market interest rates. You can’t, I can’t, and neither can a company offering policies treated with direct recognition.

In my opinion, the honest approach is acknowledge this fact and to offer policy loans at variable interest rates.

As it turns out, policy owners of mutual life insurance companies are also part company-owners. So you tell me, would you rather own a company that’s literally in the business of managing inter-temporal cash flows that’s either more robust to future fluctuations in interest rates or less robust?

As of this writing, I own three life insurance policies built for the IBC. They are all non-direct recognition contracts.

[Let me insert the obligatory caveat here for the agents who complain to their clients and colleagues every time they’re made aware of an article I write with an opinion they don’t like: write your own damn article. Tell me where I’m wrong! I’ve been accused of “arriving” on Facebook Banking with Life hate groups. OK, show me the flaw in this reasoning. Ironically, the haters typically result to ad hominem and innuendo rather than address the merits of my claims, which, to me, says all I need to hear.]

And look, if all we had in the world were direct recognition mutual life insurance companies, I’d be first in line to buy and store my capital in them.

Fortunately, however, that is not the case.

Do you know that life insurance companies write the contracts and determine the policy loan rate regime long before you apply for and eventually take delivery of a whole life policy? If a mutual life insurance company wanted to charge more to clients when lending to them, they should raise the interest rate that they determine in the first place!

In a sense, all policy loan interest is variable. Either you borrow against cash value in a contract receiving non-direct recognition under an explicitly variable interest rate regime, or you borrow against cash value in a contract receiving direct recognition under an explicitly fixed interest rate regime and endure a variable reduction in your dividend.

The variability is ineradicable.

“Synthetic Non-Direct Recognition”

Yet, some persist in marketing direct-recognition policies as “the best” (I’ll exclude the specific reference…) “banking” policies available. In fact, so they say, you can transform a direct-recognition policy into a synthetic non-direct recognition policy. Sounds pretty neat doesn’t it? How’s this happen?

Well, dividend paying whole life insurance is a private asset! A policy owner can grant a collateral assignment to and borrow against the cash value from whomever he chooses! That includes a conventional bank.

It’s called a Cash Value Line of Credit (CVLoC). Seriously, you can Google it.

Here are some of the reported reasons why you might do this:

  • No origination fees
  • Multi-year renewing terms
  • No pre-payment penalties
  • Interest-only payments
  • Collateralize cash value in more than one policy
  • Lower interest rates (e.g. Prime)

Boy don’t those sound like amazing terms!

Of course with policy loans from a mutual life insurance company, there are no origination fees, terms of any duration and therefore no such thing as “pre-payment” of anything in the first place, the possibility to only pay interest (or not!), and to take loans against multiple policies.

It all comes down to “lower” interest rates, doesn’t it?

What banks offering these lines of credit leave out and what every single “IBC” website I’ve seen also conveniently forget is the following.

First, if you want one of these lines of credit, you must grant a collateral assignment to the entire policy to the bank. And by the way, that’s a real collateral assignment, not a “synthetic” one (thank you James Neathery for that insight).

In contrast, when borrowing from a mutual life insurance company directly, we have exactly proportionate collateralization. The amount of death benefit (and therefore the amount of cash value) collateralizing a policy loan balance is exactly equal to the loan balance.

With CVLoC, your entire policy is potentially available to the bank in the event that you fail to repay what you’ve borrowed. Let’s exit reality and assume that all bankers are endowed with angelic intentions and that they would never (!!!) call a loan due unexpectedly. We still live in an era of financial consolidation, reasons for which are a story for another time, but what are the odds that in the event your lending bank gets bought out that the new bank shares the same angelic intentions as the old bank?

I don’t know. You don’t know. And the “synthetic non-direct recognition” advocate doesn’t know either.

In any case, last I checked, the book is called Becoming Your Own Banker not Becoming a Different Kind of Borrower.

Secondly, interest on policy loans from a mutual life insurance company compound annually. That means that during the policy year, your repayments go 100% to the principal of the loan. Interest accrues (gets tabulated) daily, but is not added to the principal until the end of the policy year (if some principal is still outstanding and you choose not to pay the interest at that time) or when you extinguish the balance of the loan.

With “low interest” CVLoC, interest compounds monthly. So to say that the interest rate on a CVLoC is “lower” than the interest rate on a policy loan is a half-truth. Sure, the interest rate is lower, but what about the interest volume (interesting, isn’t it, that some of those who publicly align with Nelson Nash would advocate that credit decisions be made in terms of interest rates instead of interest by volume. Hm.)?!

Now, could it be the case that a borrower via CVLoC always pays interest monthly and that the bank never calls a loan due?

Sure. After all, like James says, there’s never a problem until there’s a problem.

And take one little guess as to whether banks offering CVLoC charge fixed or variable interest. Virtually all of them charge according to a formulaic variable regime, i.e. one where the rate is based on that published by a particular index. In other words, CVLoC banks charge interest in virtually the exact same fashion as a mutual life insurance company that lends against cash value in a policy receiving non-direct recognition, with the major exception that interest compounds monthly instead of annually and the entire contract serves as collateral.

Therefore, we might offer the following definition of a “synthetic non-direct recognition policy:”

A dividend-paying whole life insurance policy receiving direct recognition whereby the policy owner is encouraged to deploy a CVLoC with a commercial bank in order to access capital under a similar interest rate regime as afforded to loans against cash value in policies receiving non-direct recognition albeit with sub-optimal interest calculation and by relinquishing ultimate control of the policy in the form of a total collateral assignment to the commercial bank.

Think long range

Let’s indulge Nelson’s admonishment to think long range for a moment by casting our minds to the Golden Years, i.e. passive cash-flow time.

A well-funded dividend-paying whole life insurance policy will feature substantial annual cash value appreciation in the later years. For instance, at least in my office, it wouldn’t be usual to see cash value increases on an annual basis be 5–10 times, or more, of the premium payable in that year after the 30th policy year. It’s after many years that compounding begins to seriously manifest. Total cash value will far and away exceed the cost basis (what you’ve paid in premium since day one), and annual cash value growth will far and away exceed annual premiums.

The most efficient method of triggering a cash-flow to a policy owner in the context of dividend-paying whole life insurance is the policy loan. A policy loan is a loan — not income. Therefore, policy loans from in-force, non-MEC policies are non-taxable cash flows (this isn’t tax advice, but I can read!).

A policy owner in his advanced years may look back fondly on all of the banking activity his contracts afforded him during his hustling years and decide that it’s now time for some of that banking activity to partially or even fully finance his lifestyle. His agent told him that one way to take cash flow would be to take annually-recurring policy loans that may or may not be repaid during his lifetime to use for what he wants, when he wants. The policy owner quite likes the idea of being able to decide how much he’ll take, when he’ll take it, and that these distributions with his particular policy are non-taxable. He also appreciates very much that his cash value grows with compounding, which means that even though he might take substantial policy loans each year, the cash value collateralizing the total loan balance will continue to grow. In fact, with some quick back-of-the-envelope math (subtracting one number on a screen from another), he pretty much knows by how much the cash value is going to grow each year. This, in turn, establishes a baseline for how much he could take in policy loans every year for the rest of his life, if he wanted.

An important point to this story is that the policy at distribution time is not a MEC. To keep it that way and after consultation with his agent, the individual decides to turn down or potentially shut off entirely his own out-of-pocket PUA premium payments that he’d been making each year. In other words, to retain the non-MEC status, he may decide to only pay his contractual minimums.

It’s at this point that he may realize that he’s no longer able to directly contribute to his own on-going cash value growth in the way he used to. That’s fine, after all, there are these substantial dividends that are going back to the policy in the form of their own PUA premium. The PUA premium from these dividends contribute in a big way to on-going annual cash value growth, constituting anywhere from, say, 20 to 40% of annual cash value appreciation late in the policy life cycle.

Suppose this policy owner’s contract receives non-direct recognition. Great! Those big ol’ dividends will continue to route back into the policy in the form of PUA premium where it will continue to contribute to his on-going cash value growth even though he intends to maintain a policy loan balance at the end of each policy year in order finance his Golden Years.

Had his policy received direct recognition, the calculation would have been different, and imbued with more uncertainty. How much in policy loan could the policy owner take each year? To proxy that answer, we’d need to know by how much the annual dividend will be reduced each year, because a lower dividend will mean less PUA, and less PUA will mean less cash value growth. How much will that be?

The policy owner doesn’t know. His agent doesn’t know. The company may not even know until the end of each policy year.

But hey, maybe he can go run a regular CVLoC balance with his friendly local banker, instead.

Conclusion

I’ve got no beef with any agent or website in particular that talks about “synthetic non-direct recognition.” If that’s what you want to sell and if that’s what you want to buy, God bless you. Where I draw the line is telling clients who don’t know any better that a made-up type of policy is everywhere and always better than an alternative. The same goes for the folks out there who are struck with the conviction that one policy structure is everywhere and always best for every client. But by all means, keep it up, because I quite enjoy the opportunity to render my own view on the subject.

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CEO, Griggs Capital Strategies. “Banks lend money that does not exist, and that is evil.” — R. Nelson Nash

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Ryan Griggs

Ryan Griggs

CEO, Griggs Capital Strategies. “Banks lend money that does not exist, and that is evil.” — R. Nelson Nash

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