It is important to take a holistic approach when thinking about your risk mitigation options.
Editor’s Note: This was originally published by State National on its blog as part of a three-part series.
Every financial institution has unique insurance needs. It is important to take a holistic approach when exploring risk mitigation options. The key questions to ask yourself when deciding on how to manage risk in your loan portfolio are:
- How much risk can you tolerate versus how much do you want to transfer?
- What are your goals and objectives?
- What do you expect in return?
Can a lender skip the trouble of finding a collateral protection insurance provider and simply self-insure its auto loans? Yes, but similar to not wearing a seatbelt while driving, doing so increases the risk of unfavorable financial outcomes.
Retaining the responsibility of covering financial losses due to uninsured and/or damaged collateral undermines the fundamental purpose of any insurance program, which is risk transference. The risk is even more adverse because you cannot control the status of a borrower’s insurance coverage or economic shifts any more than you can personally control how another driver may drive on the road around you.
A self-insured lender assumes all risks and absorbs any losses that occur. The greatest disadvantage of self-insurance is the volatility of earnings and that the risk is not transferred. To minimize uninsured losses, some self-insured lenders add such follow-up procedures as:
- requiring evidence of physical damage insurance at the time of loan closing,
- writing or calling the borrower when evidence of insurance is not received, or
- writing or calling borrowers who receive cancellation notices from insurance carriers.
These procedures are time-consuming, difficult to execute without advanced technology and highly trained staff, and rarely effective without a mechanism for forced placement.
With a blanket insurance policy, lenders pay a premium based on the total number of loans, typically a fixed dollar amount per vehicle or a percentage of the outstanding balance. Through a blanket policy, those who conduct business with your financial institution (either borrowers only or everyone who transacts with you, depending on how costs are distributed) must bear the cost of an uninsured borrower.
Some states do not allow the cost of blanket insurance to be charged to borrowers. In these states, the costs must be borne solely by the lender, which can weaken a lender’s competitive edge in the market, especially as the best borrowers can choose a lender that can offer lower rates and fees because they are not building the cost of a blanket policy premium into the loan cost.
Additionally, a blanket policy is, in essence, a “cost plus” policy, with the lender trading dollars with the insurance company that must cover both the cost of claims and the insurer’s expenses. Therefore, the direct cost of the blanket policy to the lender will continue to increase as loan business grows. The cost of a blanket policy on a growing book of business can increase regardless of whether or not a policy’s loss ratio—the ratio of claim payments lenders receive to premiums they pay—worsens.
Collateral Protection Insurance
CPI enables lenders to manage and mitigate risk by transferring the risk of uninsured collateral to an insurance provider. The program is administered by the provider only on borrowers who don’t purchase or maintain insurance.
CPI doesn’t require individual underwriting. A borrower who does not comply with the requirement to procure private insurance is “written” regardless of age, driving record or location of residence. Coverage for insurance placed in a CPI program offers your institution the same protection you would have received had the borrower maintained his or her own private insurance.
In administering the program, the CPI provider receives a file of all new loans and updates on existing loans in the lender’s portfolio and then tracks the insurance status of each loan. The provider confirms which borrowers have not supplied adequate proof of insurance and sends appropriate notices alerting them to do so.
If the borrower doesn’t submit proof of insurance in response to these notices, the lender may then choose to place a CPI policy on the non-compliant borrower’s loan to protect the financial institution’s interest from damage or loss. The lender then passes on the cost to the borrower by adding the premium to the loan balance. The charge is removed as soon as private coverage is reinstated. It costs financial institutions little or nothing to obtain this protection.
Considerations When Determining Which Program Is Right for You
- Determine the level of risk your institution is willing to assume.
- Consider market drivers, costs and broader economic conditions.
- Consider how an insurance product leverages new technology to improve administration and reduce borrower noise.
- Recognize the overall impact on your credit union and its members.
- Analyze your losses, their sources and how they impact your bottom line.
For an in-depth look at these concepts, read our white paper, “Blanket & Self-Insurance vs. CPI: A No-Nonsense Guide to Choosing the Right Program for Your Financial Institution’s Portfolio.”
Advantages of CPI
In addition to protecting loan collateral, there are several advantages to CPI:
- Only uninsured borrowers pay premiums; as a result, CPI is more equitable to the lender and to borrowers who do comply with agreed-upon insurance requirements.
- Since CPI transfers the risk of loss to an insurance company, loan portfolio expenses are predictable, charge-off ratios are more stable, and loan business can be more competitive.
- In challenging economic conditions, when auto repossessions (which often have damage) are increasing, blanket policy premiums can skyrocket, so the relative value of a CPI program over blanket coverage increases in direct proportion to the number of charge-offs in a loan portfolio.
- Because borrowers who have let their insurance lapse often have other financial problems, the detailed insurance tracking in a good CPI program can give a lender warning that a borrower’s credit rating may be slipping.
- Notification of lapsed coverage presents lenders the opportunity to work with a borrower to keep the loan current and prevent losses that come with problem loans.
VP/Insurance Solutions Loren Shelton manages the underwriting, claims and new business implementations for a portfolio of more than six million loans at CUESolutions Bronze provider State National Companies, Bedford, Texas, a division of Markel Corporation. With more than 15 years of experience, Shelton has extensive knowledge of SNC’s collateral protection products.