Credit Insurance Is Your Peace of Mind

Tuesday, October 13, 2015
Thomas W. Miller, Jr.

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?

Credit Is a Powerful Tool for American Families

Friday, April 17, 2015
Todd Zywicki

Americans have an ambivalent relationship with non-mortgage consumer credit: We all use it, yet we feel as if there is something slightly wrong about it. Should we?

Consumer credit is often thought to be just a way to live beyond one’s means and to shift consumption – to spend today instead of saving for tomorrow. But the assumption that families use credit profligately is misleading. To understand how consumers use credit – and why it is a boon to American families and the economy – it is useful to understand how businesses use credit.

Businesses use it for two basic reasons: to invest in capital goods and to smooth income and expenses. Capital goods generate a stream of benefits over time – for example, a construction company could employ workers with shovels to dig foundations for buildings or buy a backhoe to do the same work and finance it out of the crew’s increased productivity.

Similarly, businesses can use credit to deal with short-term fluctuations in revenue and expenses – a retailer might finance its operations on credit during lean times and then pay it back when profits return and more inventory is needed.

But what is often not appreciated is that households overwhelmingly use credit for the same purposes. Much of our use of consumer credit is for investment purposes, such as to buy a home or to use student loans to increase our human capital and earn a higher-paying job.

But most of our big-ticket expenditures have this same characteristic: cars, refrigerators, televisions and other household durables. Consider, for example, the humble washing machine. Its value is the time and money it saves from not having to schlep to the laundromat every weekend with a pocket full of quarters. Refrigerators save us time-consuming trips to the grocery store or eating out; cars expand our job options. In short, the bulk of non-mortgage consumer credit is used to buy consumer durables that generate a stream of benefits over time.

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Why Everything Elizabeth Warren Told You About Consumer Credit Is Wrong

Friday, October 10, 2014
Todd Zywicki

Why do people borrow? To hear law professor turned Senator Elizabeth Warren, it is because they are seduced by rapacious lenders and a consumerist culture into living beyond their means, buying big-screen televisions, new cars, and expensive vacations. And before you know it, you are under the thumb of the big banks—or, even worse, of the street corner payday lender.

But as we show in our new book, Consumer Credit and the American Economy, economists have long understood why consumers borrow. Although there are exceptions to any rule, for most it bears little resemblance to Senator Warren’s picture of hapless victims goaded into debt by rapacious credit card issuers. Instead, consumers borrow for essentially the same reasons that businesses borrow: for capital investments and to smooth disruptions in income and expenses. And paternalistic regulations that make credit more expensive and less available typically makes people poorer.

Consider something as mundane as a washing machine. A washing machine is no frivolous bauble; its value is in not having to schlep to the laundry mat every Saturday with a pocket full of quarters. While a washing machine costs much more on the front end to acquire, it generates a stream of benefits over years. In that sense, it is no different from a construction company that borrows money to purchase a backhoe to dig a ditch instead of hiring ten guys with shovels. Whether it is the financing of a car or a financing of a college education (increasing human capital), the bulk of consumer lending goes to acquisition of investment goods. In addition, like retailers that rely on bank loans to ride out quarterly fluctuations in sales and expenses, households use consumer credit to deal with unexpected expenses like a sick child, emergency car repair, or other financial disruption.

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