What if you bought an insurance policy, only to find out that the real beneficiary was your agent?
To explain what I mean, let's review the social contract between insurers and policyholders. Implicitly, insurance protects a policyholder against the downside risk from known and specific types of losses. A buyer understands that payouts are unlikely to be equivalent to paid premiums. But given the imbalance between the weight that people attach to risk and reward, that is fair. Willingness to pay and willingness to receive surveys repeatedly show that consumers want to avoid marginal losses more than they want to see marginal gains. There is a value to certainty.
Insurers take that risk in exchange for the opportunity to profit. In the short run, they may lose money. But over time, they make up for those costs. Think about how the costs of Hurricane Katrina impacted property insurers and their reinsurers. It was a catastrophic event, but it was also an unusual event. After the fact, claims normalized. Indeed, sometimes premiums went up. But insurance has to be a profitable enterprise to have value for anyone. To protect their balance sheet, insurers have to accumulate and maintain resources. Otherwise, there will not be enough cash to cover future claims. Moreover, the margin has to have room for more than just claims. Premiums (and other revenues) have to be in place to cover not just the future claims, but also for ongoing administrative costs. An additional benefit of the system is that since premiums are prepaid, the insurers can take advantage of the time value of money to make returns on lower-risk investments.
The market finds an equilibrium point between the prices of premiums relative to the size of claim payouts. But what is the ideal line in the sand? Policy makers express the share of claims as a portion of premiums with the term "loss ratio." The National Association of Insurance Commissioners has said that a loss ratio should be at least sixty percent. In property insurance, claims as a share of premiums can approach ninety percent. In the Affordable Health Care Act, there is language in place which says that insurers must adhere to minimum loss ratio levels. If they don't, then they have to rebate some share of the premiums paid by policyholders. The minimums are between 80 and 85 percent.
But it turns out that in the market for credit insurance, loss ratios are dramatically lower. Sometimes insurers report loss ratios of less than twenty percent.
Consider the next chart, which relies on data from the Payment Protection Division at Fortegra during the years from 2008 to 2013:
The period ends in 2013 because Tiptree Financial bought Fortegra in 2014. The brown columns represent revenues derived from premiums and transaction fees earned by Fortegra. Premiums accounted for approximately 65 percent of revenues from those two categories. As is common with any insurer, Fortegra makes a bit more from investments and from the dollars it receives when it sells its policies on to third-party reinsurers.
The key columns are the two green ones. Most telling is the fact that the sizes of these commissions are greater than the sizes of claims payouts. Fortegra is paying a lot to the retailers who sell these policies to consumers. Policyholders get the crumbs. The retailers and the insurers win at the expense of consumers.
The red dotted line shows just how profitable this business is for Fortegra. The profit margin (EBITDA margin) from operations was as high as 50.5 percent!
Fortegra sells credit insurance under two names: Life of the South ("LOTS") and a sub of the LOTS sub called Bankers Life of Louisiana. LOTS partners with many retailers, but some of the biggest include familiar names like World Acceptance, Badcock Furniture, Capital One, BB&T, Regions, Farmers Home Furniture, SiriusXM, and Valvoline. If you are not familiar with LOTS or Bankers Life of Louisiana, it could be a reflection of how you finance your purchases. World Acceptance is a consumer installment lender whose loans can bear interest rates of between 65 and 200 percent. The banks mentioned apply these policies to select products. For example, BB&T has a buy-here-pay-here division. Generally speaking, credit insurance is not associated with prime borrowing.
That hints at why it exists, of course. It is purchased by people who may feel that they will have trouble repaying a loan. It is offered by lenders who may feel the same way about their customer's prospects. But credit insurance should not be a substitute for underwriting. We are now in a policy world where the CFPB is holding lenders accountable for doing real underwriting. On a product-by-product approach, the Bureau is establishing standards for how someone is vetted for their "ability-to-repay" a loan. Selling an insurance policy is an end-around to making a real ATR analysis. It should not be a stand-in alternative.