Earned premium, earned fast in a collateral protection insurance program
Collateral Protection Insurance (CPI) vendors look to earn the most premium permissible, and hopefully for them, as fast as possible. I made that statement in my last article ‘What would Milton Friedman say about CPI’ and was asked to elaborate.
Let’s start with ‘hopefully for them, as fast as possible’ –the second part of what I wrote.
Earned premium is comparable to revenue for CPI vendors. It’s what keeps them in business. In a traditional CPI program, your vendor force-places an annual policy on one of your non-compliant borrowers, you pay for the entire annual premium up front, apply it to the loan, and the premium ‘earns’ daily as time goes by.
However, few CPI policies stay in effect for a full year. Approximately 80% cancel before going the full year. And the lion’s share of the policies that cancel will cancel in the first 90 days. The policies issued in newfangled ‘monthly’ programs have similar behaviors.
Note some CPI policies cancel without earning any premium. That’s when your borrower has had good insurance all along but neglects all the notifications from your CPI vendor, eventually gets forced-placed upon, and only then is motivated to provide proof of good insurance. The force-placed policy is cancelled with no earned premium and the CPI vendor claims to lose money on the deal because of administrative costs.
The other scenario, which occurs more often than the above example, is when your negligent borrower does not have insurance, has a policy forced-placed, is only then motivated to purchase good insurance and provide proof to your vendor. The forced-placed policy is then cancelled, with the premium that was in effect for the days your borrower was uninsured earned for the CPI vendor, with the remainder of the annual premium is refunded.
So if most CPI policies cancel, and do so pretty quickly after placement, you can see why CPI vendors want to (or as they would say, ‘need to’) earn premium as fast as possible on the policies that cancel but do earn some premium. I’ll get back to that in a minute.
Which brings me to the first part of what I wrote last time: CPI vendors look to earn the most premium permissible. All of them have a variety of tricks up their sleeve to do just that.
Earned premium and the economics of a CPI program
First and foremost, your CPI vendor must be profitable. Profit comes from earned premium after subtracting the claims paid to you, insurance tracking expenses and all administration costs. Since earned premium and your claims fluctuate month over month, your vendor closely monitors which way your loss ratio is trending. If it’s steadily trending higher, which means it’s trending in your favor, you can bet that sooner rather than later, your vendor will be at your door proposing changes to your program.
These changes can entail a number of actions, or a combination of them. Your CPI vendor might suggest raising the rate of a CPI policy, i.e. raising the percentage applied to the outstanding balance of the loan to determine the cost of a policy.
Other actions include adding a policy fee on all CPI policies placed, establishing a minimum earned premium for every policy placed and implementing accelerated earning strategies to disproportionately earn more CPI premium earlier in the policy term –again, because most CPI policies cancel, and do so pretty quickly after placement.
One example of accelerated earnings is Rule of 78s, a tactic in which more insurance premium is earned by the CPI vendor, and subsequently more is paid by your borrower, in the early stages of the policy. And this earned premium can be substantial. For example: for a CPI policy in effect for only one month, your borrower pays almost twice the amount if the refund is calculated using Rule of 78s vs. if it’s calculated using the straightforward pro rata method. CPI vendors will argue the risk is greatest early in the policy term and that there are those pesky administrative costs in issuing a CPI policy, so that an early cancellation justifies earning additional premium.
You should know if your vendor is applying an accelerated earnings method and if the disproportionate amount of earned premium appears fair to both the vendor and your borrowers. Contact me if you’d like to learn about earnings methods and see some examples of the differences in refund amounts over different time periods.
Another more obscure action to be aware of is how the premium is calculated for the days your borrower was uninsured before a CPI policy is actually forced-placed. Once your vendor uncovers a date of no insurance (say February 1st, for example), the cycle for contacting your borrower, designed to give him ample opportunity to provide proof of good insurance can stretch for well over two months before force-placement (think mid-April!). If your borrower was indeed uninsured for that period, that’s gold for your vendor–two months, maybe three, of premium that has already earned before the actual policy is forced-placed. And keep in mind, your vendor is the one who has established the length of the cycle.
If you have a program that does look back to earn premium for the period before force-placement of the CPI policy (and some don’t), ask how the premium is calculated; sometimes it mirrors the rate of the forced-laced annual policy, but sometimes it doesn’t. If it doesn’t, ask why not.
Mae Culpa et Caveat Emptor
Earlier, I referred to CPI vendors’ actions to earn premium as tricks –as in tricks up their sleeves. I probably should have used a different word. All are pretty standard practice, legal and probably approved by your state’s insurance department. So ‘practices’ is perhaps a better term and I’ll stick with that.
Also keep in mind there are a handful of other practices CPI vendors frequently use to keep your loss ratio where they say it needs to be when earning more premium is not an option. These include: adding an insurance tracking fee that you cut them a check for, eliminating coverages, raising your deductibles on claims, implementing loss ratio caps on certain coverages, and reducing (or even eliminating) your administrative reimbursement. All are common practices, too.
Every CPI vendor professes to offer complete transparency to their interactions with borrowers. Make sure yours offers your credit union a comparable level of transparency by periodically explaining all the practices in place to earn premium, or to otherwise impact your loss ratio. Once you know, you can determine which ones you are most comfortable with, and as mentioned, which ones seem the most fair. Discuss alternatives if some don’t feel right. But first make sure you are aware of them, all of them.