What would Milton Friedman say about collateral protection insurance?
As I mentioned at the end of my last article, I’m going to discuss the unique economics of a collateral protection insurance (CPI) program, including who pays and who benefits. It’s really unparalleled in the insurance business. Simply, CPI is one of the oddest insurance products you’ll encounter, because unlike most other insurance arrangements there are three parties involved: your borrowers, you and your CPI vendor.
Years ago, renowned economist Milton Friedman explained the four ways money can be spent. In his own words:
- You can spend your own money on yourself. When you do that, you’re very careful what you spend it on and you try to get the most for your money.
- Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I’m not so careful about the content of the present, but I’m very careful about the cost.
- Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch!
- Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is and I’m not concerned about what I get.
Let’s look at how these four ways of spending apply to your CPI program.
You can spend your money on yourself, and you’ll be attentive, is Friedman’s first example. This would apply if you were purchasing, and writing a check from the credit union for a blanket policy to cover your auto portfolio. But it’s not the credit union’s money being ‘spent’ within a CPI program. It’s your members who are spending their money; it’s the non-compliant ones who are paying for an in-force CPI policy.
Friedman’s second way to spend money is to spend your own money on somebody else. With a CPI program in place you are not really spending the credit union’s money on somebody else. Now you might be writing a check to your CPI vendor for some coverages that can only benefit you, which would mean, according to Friedman, you try to get the most for your money, or at the least, you’re as careful as you can be about the cost. Even so, it’s hard to unscramble the costs of these coverages vs. their benefits because of archaic insurance filings and the various ways CPI vendors package their programs.
Going to have a good lunch!
Let’s keep going. Spending option three is, as Friedman says, spending somebody else’s money on myself. The premiums for the force-placed insurance are paid by your uninsured borrowers. They don’t maintain proper insurance, they get force-placed upon and have to pay. So these non-compliant borrowers of yours are clearly the “somebody else”.
Which means the ‘myself’ in this option is not only you and your credit union, but also your CPI vendor. The earned premium from the CPI program, money that’s paid by somebody else – your members – is money that pretty much should be split 50/50 between you and your vendor. Both of you are spending somebody else’s money on yourselves, both of you are enjoying a good lunch.
Food for thought: Next time your CPI vendor hosts a reception awash with fine wine and fancy hors d’oeuvres, perhaps at the CUNA Governmental Affairs Conference in Washington, DC, look around the room for “a somebody else” – one of your members who is currently paying for a CPI policy. Don’t bother, he won’t be there. Ok, that was kind of a low blow.
You are undoubtedly living with a CPI program that includes a loss ratio cap and all kinds of program caveats and limitations. Your CPI vendor, on the other hand, is a for-profit entity that structures programs to earn enough premium from your somebody else’s to cover all insurance tracking, customer service, keeping-you-happy-costs, and to make their margin. Although both of you benefit, both of you are enjoying a good lunch, it’s not a stretch to say your vendor is holding the only menu and he’s ordering lunch for both of you.
To grow revenue, CPI vendors can go out and sell new programs to new credit unions. As far as you and your program are concerned, though, they can’t ‘sell’ more CPI policies to your members. They only follow your instructions to force-place policies on your uninsured. Their revenue comes from earned premium and they can only earn premium from your non-compliant borrowers. Thus they continue to become more efficient, lowering their cost per loan tracked and looking to earn the most premium permissible, and hopefully for them, as fast as possible.
Spending like the government
Which brings us to Friedman’s final point in his spending money exercise. Well, if you are spending somebody else’s money on somebody else, as he says: ‘I’m not concerned about how much it is, and I’m not concerned about what I get’. This is how the government spends, but it’s also applicable to a CPI program. Somebody else’s money is your members’ money, and if you are not paying close attention to your program, who you are spending it on could mostly be your vendor. You don’t want to spend somebody else’s money like the government spends it.
Your CPI program might be working very well for you. The cost of continuously monitoring every auto portfolio risk on a per-loan basis, unlike any other insurance coverage you buy for your credit union, might be justified. Just keep in mind what Milton Friedman would say about all of this. With a CPI program in place, you must watch how you spend other people’s money, especially because, as I’ve said for the umpteenth time, every one of these other people is a member of your credit union. Be vigilant in your responsibilities toward managing ‘the spending’ in your CPI program. And, that entails who’s ordering what for lunch.