October 2008 

Debt protection products are no longer a new concept. In fact, CSC created its first debt protection program for mortgages in 1991, and several credit card lenders were offering protection well before that. If you ask most lenders today about debt protection, they have most likely heard of it, even if they are not offering it. But many times debt protection is referred to as being, “just like credit insurance.”

Gary Fagg opens his new book (Debt Protection Products: A Practical Guide for Lenders, CreditRe Corp., 2008) with a preface titled, “It’s a Lending Product!” Even if we accept that debt protection is a lending product, not insurance, what does that mean and what are the implications for implementing a debt protection program?

Debt protection terms and conditions must be handled as an addendum to the loan contract. No matter what underpinnings have been put in place to shift risks or transfer administrative responsibilities, the terms and conditions specified for debt protection must be interpreted in conjunction with the payment terms of the protected loan and the legalities imposed on the loan contracts. Lenders offering debt protection products must examine their own servicing operations to ensure all appropriate linkages have been made between systems, staff and processes. Ignoring that connection can impact income and create payment application errors, customer frustration and legal exposure.  
 
The objective of this paper is to present examples of the many variables and considerations pertinent to debt protection and the need for all involved in the rollout of a debt protection program to also understand the lending process.

Debt Protection Requires Loan Servicing Expertise
Credit insurance is very much an “out-of-sight, out-of-mind” product. Once the coverage is sold, only a claim is likely to bring the individual policy back to anyone’s attention. 

When a loan with credit insurance is entered into the lender’s loan system, the premium for the insurance is typically lumped into the amount financed. There may be an indicator in the system that the loan has insurance, but more often than not, the loan servicer will rely on the hardcopy or imaged loan documents to determine if a loan has coverage. Since loan servicers do not have any obligations under a credit insurance policy, they normally don’t pay special attention to covered loans unless delinquency causes them to look for alternate payment options or early payoffs cause them to file for rebates of unearned premiums.

Unfortunately, a number of credit insurers learned the hard way about the insurance not being associated to the loan when refunds were not issued as required. The debt protection product solves the refund issue, but what other considerations arise when considering debt protection?  

1. Debt Protection Can Affect Interest Income
The fact that debt protection is not an insurance product puts lenders in direct control of their expenses and risks. Lenders are likely self-funding their debt protection programs.  Consequently, lenders need to think about the fact that the money paid for benefit activation is the bank’s own money. Potentially, the bank can pay the benefit plus lose interest income in the same transaction.

When an insurance company pays a credit insurance claim, the insurer sends a check to the lienholder. The lienholder applies the payment to the loan as if the insured had sent a regular payment. If the insured has remained current on the loan, most or all of the insurance payment may go to principal.

This scenario could lose the lienholder a notable amount of interest income. Not only is the lienholder now using its own money to make the payment, the additional reduction of loan principal reduces the balance on which future interest is computed.

How much interest income could be lost? For a 60-month loan of $10,000, with an APR of 10 percent, if the benefit payment is applied on the same day as the 12th regular payment and it all goes to principal with no payment or due date changes, the loan will yield $103.12 less interest over the remaining term.

Loan systems are all different in the way they process; loan types vary in how they amortize; and loan policy frequently differs in how payments are posted. If the resulting anomaly is not one of those just described, it can be another just as detrimental to income and service. Many programs go to great lengths to avoid these pitfalls by paying only full monthly benefits (no partial payments), computing benefits due based on current loan balances (not when loss occurred), applying benefits as current payments and not returning fees as part of the benefit. These compromises might make the program easier to administer, but they are not always aligned with the true intent of debt protection.

For a positive financial outcome, due diligence is essential in developing the debt protection product and its interactions with the loan system. An experienced team can help identify issues that could create revenue, legal or customer satisfaction problems.

2. Debt Protection Coverage Changes when Loan Payments Change
Payment amounts can change over time, and the amount of the benefit must change accordingly. Most credit insurance is computed and sold based on the original terms and conditions of the loan. A single premium is charged upfront for coverage that will correspond to the original payment schedule. The payment, term and expected balance are all established prior to Day One of the coverage period. When a credit insurance claim is settled, if the loss period falls between the original loan effective date and the originally scheduled final payment date, the benefit is paid based on the original scheduled payment amount.

A reality of lending, however, is that loans may have payment changes over their lifetime. When credit insurance is sold on a loan with expected payment changes (such as variable rate or line of credit), a MOB (monthly outstanding balance) computation is normally used to allow for the changing payments, balances and terms. However, even loans designed to have level payments and fixed terms may very well change for any number of reasons. Some simple interest installment loans can have payment amounts change from one month to the next, depending on when the customer makes their payment. Likewise, if a customer pays more than the scheduled amount due, the next payment due may be adjusted for the overpayment. Understanding the linkage between how payment schedules can change and how to calculate and apply the benefit is important to ensure loan integrity.     

Additionally, it is not unusual to have multiple payment extensions and even a payment holiday on a loan. What happens when these transactions occur in a monthly-pay debt protection policy? With credit insurance, skipped or extended payments have no effect on the daily benefit calculation. However, with debt protection, whenever a payment is skipped or extended, the fee is not collected, no payment is required from the protected borrower, and no benefit amount would be paid for that skipped or extended payment period. 

3. Payment Allocations Affect Benefit Status/Fee Income
The calculation to determine the debt protection fee is easy when all that is required is multiplying a rate times a monthly benefit or loan balance. The part that causes issues is the payment of a benefit that then cancels the payment and related fee.

Most loan systems compute the debt protection fee each month and save the amount in a fee bucket. That amount appears on the borrower’s statement as a “protection fee” and is added to the scheduled payment for a total due amount. If the borrower makes a payment for something less than the total due, what happens?  Payment allocation orders can vary based on loan type. To prevent a loan from being delinquent for fees, some lenders will apply payments to outstanding fees prior to the reduction of interest and principal. Most lenders apply amounts paid, first to reduce interest due, then principal due, then any outstanding fees and late charges, and then the debt protection fee. In the latter scenario, unpaid debt protection fees will continue to show as due and delinquent on the borrower’s account even though the borrower may be current on his loan.  

Since the loan is not actually considered delinquent by the loan servicing system when debt protection fees go unpaid, the debt protection system of record normally does the work of tracking the “paid to” date for coverage, based on the fees that were paid. The debt protection system, not the loan system, informs the borrower of the consequences of delinquent fees. 

Most loan systems do not allow a negative fee bucket or for a fee to be paid ahead. The impact of that restriction comes into play when a benefit activation payment of more than one scheduled payment is posted to the loan system as a single payment. Per the rules noted above, the payment is applied, in order of priority, to interest, principal in scheduled payment, and fees. Any leftover amounts are applied to reducing the remaining principal.

Since the fee cannot be negative or accrued into the future, the benefit typically is applied to the customer’s loan rather than to the fee income due to the bank. Not only is this a potential lost-interest issue, it is also a misapplication of fee income. Solutions to this issue vary by loan type, loan system and lender policy.

One solution is to divide the approved benefit payment into the applicable payment periods so the payments can be individually applied to the correct period. This determination takes a sophisticated benefit adjudication system that has access to all payment history.

4. Flexible Debt Protection Benefits Require Complex Management
As mentioned previously, debt protection benefits are affected by many variables, including: interest rate changes, changing escrow, advances, fixed loans within lines, payment holidays and negotiated payments. The more complex the loan product, the more necessary lending knowledge and sophisticated administration systems are to the program.   

For example, with a HELOC, a benefit claim might come in three months after the incurred date of the loss. The benefit could also have a 30-day retroactive benefit exclusion, which then requires looking at loan history over the previous four months.

What if the borrower took an advance 15 days prior to the incurred date, “locked” part of the balance into a fixed loan 30 days after the incurred date (but during the covered period) and at the same time the rate changed and the minimum payment went up during the benefit period? We won’t list all the considerations and policy decisions that go into determining the benefits due, but it is not simple and will likely trigger a customer service inquiry no matter how it is processed. Deploying debt protection on a sophisticated system tailored to handle this complexity can help maximize profitability and minimize manual intervention and customer dissatisfaction. 

5.  Knowledge of Both Loans and Debt Protection Ensures Customer Satisfaction
Since debt protection is a loan product, knowledge of loans and debt protection products is essential to providing effective customer service. Customers generally request information on how to file a benefit, how it’s calculated and how the payment will be applied to the loan. 

An effective training program is vital to ensure that customer service agents, branch personnel and servicing staff are well trained in all aspects of the debt protection program. Underestimating the type and amount of training during implementation will create unnecessary customer dissatisfaction, rework and legal exposure.

More than 40 percent of the calls to CSC’s Banking Lending Services on new implementations can be from misdirected calls. These calls can be from the bank’s personnel or customers asking about coverage provisions and how to post a benefit. To answer inquiries correctly, avoid misrouted calls and limit repeat calls from the same customer, the lender’s customer service group must understand the loan and debt protection coverages and how they work together.

Pekin Life Insurance Company: Evolving From Credit Insurance to Debt Protection
For an example of a successful debt protection provider, take a look at Pekin Life Insurance Company. Since 1969, Pekin Life Insurance Company has provided credit insurance products through a network of financial institutions and auto dealerships throughout the Midwest. Pekin has also begun to offer debt protection programs.

“While we believe credit insurance will have a place in the market for some time to come, debt protection is here to stay and will continue to evolve,” said Jay Holloman, director of Financial Products for Pekin. “Our accounts are intrigued by the events they can cover with debt protection programs, other than just life and disability.”

When Pekin decided to offer debt protection, it looked for a provider with high levels of experience in both lending and insurance that could help from a software standpoint and also design a browser-based system that could be integrated with Pekin’s existing Web site. Pekin manages its debt protection programs with CSC’s proven Convenience system and gets support from CSC’s consulting and BPO services.

About the Author
John F. Kilgore is vice president of Banking Lending Services for CSC. He is the architect of industry benchmark systems for consumer lending, financial insurance products, debt protection, service contracts and warranties, and Internet sales tools. His experience makes him a sought-after industry speaker. 

For More Information
CSC offers more than 35 years of experience in creating financial products. CSC’s debt protection software is built from the ground up and has been proven with numerous clients. CSC also offers consulting services to help you work through the challenges of offering debt protection. Contact CSC at 800.345.7672 or send an e-mail to This e-mail address is being protected from spam bots, you need JavaScript enabled to view it Visit us online at www.csc.com/bankingbpo.

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