October 13, 2015

Credit Insurance Is Your Peace of Mind

Thomas W. Miller, Jr.

Senior Affiliated Scholar

Thomas A. Durkin

Summary

Although life insurance agents and lenders provide socially important products, few people get lively when thinking about them. Fewer still get excited about lenders who also sell life insurance on loans. While few people have even heard of an important insurance product known as credit insurance, many borrowers rely on this product for peace of mind. What is credit insurance? Borrowers sometimes worry that they will not be able to pay back their loan due to unforeseen events. The market, of course, provides a way to calm these anxious borrowers by allowing them to add a product to their loan: credit insurance.

Although life insurance agents and lenders provide socially important products, few people get lively when thinking about them. Fewer still get excited about lenders who also sell life insurance on loans. While few people have even heard of an important insurance product known as credit insurance, many borrowers rely on this product for peace of mind.

What is credit insurance? Borrowers sometimes worry that they will not be able to pay back their loan due to unforeseen events. The market, of course, provides a way to calm these anxious borrowers by allowing them to add a product to their loan: credit insurance.

There are three basic types of credit insurance. Credit life insurance pays off the remaining loan balance if the borrower dies before paying off the loan. Credit disability insurance makes the monthly loan payments, up to policy limits, if the borrower becomes infirmed or disabled. Credit involuntary unemployment insurance similarly makes the payments if a borrower loses his job.

Many, though by no means all, borrowers purchase one or more of these kinds of insurance on a loan. As with other kinds of insurance, risk averse individuals purchase credit insurance when they feel that it is a good way to protect themselves against some possible financially catastrophic event. Likely buyers of credit insurance are borrowers without much traditional life insurance or savings, older borrowers, smokers, those who know they are unhealthy, and those who are worried about layoffs. Such a risk pool is clearly not favorable to the sellers of credit insurance.

In 2012, the Federal Reserve Board published research results by one of us and a colleague that showed about one quarter of installment loan borrowers purchased credit insurance. By contrast, 40 years ago, almost two thirds of such borrowers bought credit insurance.

Credit insurance remains an attractive product for some borrowers. If consumerist policy advocates get their way, however, the product will not be available to them.

For example, a recent publication by The National Consumer Law Center (NCLC) uses the term "exorbitantly expensive" when describing the cost of credit insurance.

These allegations are serious, but the NCLC offers no supporting analysis or current data to buttress them. Instead, the NCLC chose to rely on one decades-old court case (FDIC v. Gulf Life Ins. Co), statements made elsewhere by the NCLC, and statements made by those partial to the leanings of the NCLC. These reeds are weak.

As an example, consider credit life insurance. This product is the largest component of credit insurance. All states regulate the price of credit life insurance, and one can easily find data about this product. A recent Consumer Credit Industry Association (CCIA) publication based on figures from state insurance departments shows the average regulated premium nationwide in 2013 was $0.50 per $100 per year. On a $2,000 one-year installment loan, such a premium is $10.00-less than a dollar a month. At this price, credit life insurance might well be an attractive product to some otherwise underinsured lower middle income borrowers.

From this premium, insurers must cover the claims on the policies-46 percent of the premium-according to the CCIA publication. The remaining $5.40 must help cover the share of operating costs of the insurance company and the building of reserves to protect borrowers and to meet state requirements. To attract capital to this insurance enterprise, companies must earn a normal profit.

To be sure, just like the sale of any insurance product, some of the premium goes to the lender who sells the product as a commission. The lender, however, must use a portion of this commission to pay for employee time, operating expenses to book the sale of the product, the filling out of paperwork to satisfy auditors and regulators, and claims processing expenses. There might be a residual that is a "profit" for the lender, but the amount is likely puny.

Some consumer advocates propose to include the insurance premium in the cost of the loan for Truth in Lending (TIL) disclosure purposes. This idea damages consumers because such an inclusion makes credit shopping more difficult: Sometimes the insurance premium is included, and sometimes it is not. Moreover, including credit insurance in the loan cost could send borrowers the implicit message that they are expected to buy credit insurance. This product is voluntary, and it should be kept that way.

These advocates seemingly forget that the costs of the loan and the cost of the insurance are already required TIL disclosures. The TIL disclosures are appropriately separate because these are separate products. This appropriate separation has been TIL policy since 1969, i.e., since implementation. That many borrowers choose not to buy credit insurance underscores the fact that credit insurance is not part and parcel of the loan. Consumers benefit from seeing separate costs.

Credit insurance is not right for every borrower, but it makes life better for some. These borrowers, informed by existing disclosures, should be permitted to choose credit insurance products. As is currently required, the costs of these products should be disclosed separately from the costs of the loan. Why make consumers worse off by haphazardly merging credit insurance costs with loan costs?