There is so much not to like about non-file insurance that it is hard to know where to begin. Non-file insurance costs consumers money but delivers little in tangible benefits in return. Even when the consumer purchases it, it can still be the case that a consumer's collateral is at risk of repossession. Finally, it is often sold in tandem with loans that are booked at the Rule of 78ths and which are frequently refinanced.
What is non-file insurance and how does World Acceptance incorporate the product into its business model?
World Acceptance purchases non-file insurance from the Life of the South ("LOTS") insurance company. They pass that cost on to consumers. If and when a consumer defaults on their loan, World files a non-file insurance claim. LOTS pays World Acceptance for the defaulted debt that is still outstanding.
World Acceptance rarely chooses to perfect the interest in those loans when they default. Read what the company wrote in its 2013 Annual Report:
Substantially all new customers are required to submit a listing of personal property that will serve as collateral to secure the loan, but the Company does not rely on the value of such collateral in the loan approval process and generally does not perfect its security interest in that collateral.
Unfortunately, it is often the case that premiums are overpriced. Loss ratios express that opinion. A loss ratio is the sum of claims paid as a percentage of premiums earned. With many types of insurance, loss ratios can exceed 80 percent. At World, loss ratios on the policies sold in its stores fall below thirty percent. Those policies are written by Life of the South. Life of the South pays a commission to World. That commission is often greater than the benefits paid.
Non-file insurance is only one kind of insurance product sold at World stores. World Acceptance sells lots of add-on credit insurance policies to consumers. Most of these are very overpriced. I can say they are overpriced based upon the judgment of many analysts in the insurance industry. They use a metric known as the loss ratio with which to evaluate the consumer experience. When consumers manage to see benefits that are near to the sum of premiums earned, then those analysts conclude that a product is fairly priced. Generally, a loss ratio above 60 percent is seen as fair. Often health insurance policies generate loss ratios of as high as 85 percent.
But loss ratios sold by World almost never reach that level. In a good year, they might be as high as forty percent. In North Carolina in 2014, loss ratios on credit accident and health policies issued by LOTS realized a loss ratio of 17.4 percent.
These rates can be so low because consumers have virtually no way of estimating the value of the policy. Loss ratios are not widely available, to say the least. Moreover, who can reasonably make the following net present value calculation:
(chance of losing a limb or other covered event * outstanding debt at time of event)/(premium paid)
Moreover, how many people will make an effort to guess that value at the moment when they finish signing their loan documents? I am aware of the position held by industry, which is that very few consumers are aware of the loss ratios experienced by any of their insurance products. In my opinion, this is an example of a fact (we don't know loss ratios) that doesn't manage to dispel the opposite view. What matters is how the price reflects the benefits. And indeed, while the benefit does capture non-financial factors like peace of mind, the price for "POM," shouldn't vary so much across different POM providers. In essence, if POM comes with an 80 percent loss ratio in health insurance but with only a 17 percent loss ratio in credit insurance, then there is still a difference in value. Mathematically:
f (x) = POM + x
where X is the particular loss ratio and loss ratios are always positive and where the value of POM is the same in any context for a given period of time.
Even worse, most policies are sold through exclusive contracts between the retail lender and the insurance company.
But the value proposition is very different when an informed buyer is paying for the premiums. When World is buying non-file policies, the loss ratios are very different. Loss ratios on non-file policies are often near 100 percent. Yes - that seems impossible, but bear with me. I will explain how an insurance company can offer that benefit and still make money.
The next chart shows loss ratios (purple line), recoveries (green line), and insurance company profit margin (gray line).
A reader might respond that this is not a problem for consumers, as they aren't the ones receiving the claims benefits. But that is not true. Consumers are still paying for the cost of the policy, albeit indirectly. This is an important point. While there is no particular contract between a non-file insurer and the consumer borrower, it is likely that the customer is paying a fee that compensates the lender for buying the non-file policy. Over the last decade, Life of the South has been able to realize an average gross margin before investment income of almost ten percent with a standard deviation of only 3 per cent. On a risk-adjusted basis, that is an excellent return.
Moreover, there is a second problem associated with providing collateral while also paying for non-file insurance. The presence of collateral may give a lender more leverage in collecting on delinquent loans. If a local store manager can warn a borrower that a visit from the sheriff is pending, then it stands to reason that there is more opportunity to get a borrower to come into the store to work out a deal. "Working out a deal" essentially means deciding to refinance. That could be very enticing, as World lets any borrower skip the next payment at the moment of a refinance. This is why the average life of a World loan is approximately five months, even though the stated term is usually closer to one year. The coercive power of this technique is underscored by the high rate of refinancing activity. Almost three of every four loan originations at World is a refinance.
- Low-value proposition
- Difficult for consumers to estimate the value of the product
- Can help to trigger a refinance