A Debt Cancellation Perspective

Bob Hyder, Focus Insurance
December 13, 2004

“For liability protection, credit unions should have a contractual liability policy and a supplemental litigation rider with a limit of $1 million.”

–Bob Hyder"

Since credit unions first began making loans to their members many years ago, we have addressed the subject of the “debt dies with the debtor.” Initially, credit unions protected their borrowers via loan protection insurance. The credit union would pay a monthly fee to an insurance company, and in return, in the event of the death of the borrower, the loan would be paid off, and the estate would not have to deal with the issue of an unresolved loan.

In the mid 70s, faced with rising expenses and the desire to generate additional avenues of income to help offset the costs of “share draft accounts,” then plastic cards and ATM services, credit unions turned to “member pay credit insurance.” Credit life and credit disability replaced loan protection, and have been the programs of choice ever since.

As insurance regulations and licensing requirements changed through the years, and members’ interest in having protection for more than death or disability increased, it became apparent that it was time to examine other options. Hence, the next-generation of “member pay insurance” is now upon the credit union industry. It is called “debt cancellation,” and there are some significant differences between credit insurance and debt cancellation that should be addressed.

Significantly, there is no license required for debt cancellation, and there is very little regulation at this time. Debt cancellation is a “credit union-owned fee-based product.” The contract is between the borrower and the credit union. The borrower agrees to pay the credit union a fee. For that fee, the credit union agrees to cancel, defer, or suspend the borrower’s debt up to the contract maximums. An insurance company reimburses the credit union for the forgiveness of debt.

There are three primary cancellation or suspension methods:

Full cancellation. The entire debt is waived up to the contract maximum on a monthly or total outstanding balance.

Interest cancellation. The full loan payment is not required during the suspension period. Interest payments are forgiven during period of the member’s life event, and the insurer reimburses the credit union for the interest forgiveness.

Debt suspension. A loan payment or payments are waived. The typical types of protected events that debt cancellation can encompass include death, disability, involuntary unemployment, hospitalization, family leave, terminal condition, and divorce. What people are interested in is protecting their credit rating. Unemployment coverage is very popular. However, the bundled packaging and blended fees are gaining popularity.

Some of the benefits of debt cancellation are increased member participation, improved loan officer commitment, increased loan program efficiency, phasing implementation, reduced delinquency and charge-offs, and an increase in non-interest income.

In order to have a successful program, there are several key elements that must be present. They include management commitment, a strong sales culture, and the use of debt cancellation to increase member participation. It is important to not overanalyze program options. In another words, keep it simple. Do not overcharge the member for the protection and educate your staff early and often on the details of your program. The Consumer Federation of America recommends that lenders keep the debt cancellation mark-up under 40% and preferably in the 25% to 30% range.

Since debt cancellation is a contract between the credit union and the borrower, there is more liability for the credit union than with credit life and credit disability insurance. Therefore, for liability protection, it is recommended that the credit union have a contractual liability policy and a supplemental litigation rider with a limit of $1 million. Most of the debt cancellation providers, including CUNA Mutual Group, will provide this type of coverage. Additionally, some of the providers will also supply a warranty that provides defense for certain events including:

-The credit union is challenged by its regulator on its authority to write debt cancellation contracts -The credit union is issued a cease-and-desist order from the insurance regulator in its state for selling insurance without a license -The credit union is a state-chartered credit union and writes business nationwide—what if it is challenged by another state? -The credit union is challenged for using single-fee approach to calculate the debt cancellation fee -A member sues the credit union for denying a claim under the debt cancellation agreement -A member who has a claim denied accuses a credit union loan officer of misrepresenting the contract

There is also a potential tax ramification with debt cancellation. The IRS says any debt in excess of $600, if forgiven, requires reporting on Form 1099. However, there is an IRS Private Letter Ruling (PLR) that other financial institution’s attorneys have sided with. Some insurance companies, such as CUNA Mutual, will provide the PLR for the credit union to submit to its attorney for review and advice.

Bob Hyder is executive vice president of Focus Insurance, a 100% credit union-owned subsidiary of XCU Corporation, Inc. in Carlsbad, California. For questions or further information, contact Hyder at 800-289-3769, ext. 5326 or at rhyder@xcucapital.com.