March 19, 2015 in Insurance

Auto insurers long ago discovered that consumers are more inclined to buy a policy if they can pay their car insurance monthly or quarterly rather than paying the full premium upfront.

The fractional payment option typically comes with fees to cover:

  • The insurer’s “carrying cost” of delaying collection.
  • Administrative expenses of generating and processing multiple payments.
  • The risk that fractional payers may stop paying midterm.

Some companies reduce their fees for policyholders who pay online or via direct deposit.

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While auto insurance installment payments are popular with households on a budget, the fees aren’t the only downside. Be late with a payment, and you may trigger a penalty charge. A missed payment could result in policy cancellation, potentially higher auto insurance rates for having been canceled and the suspension of your driver’s license for driving without coverage.

Calculating the cost of convenience

While fractional payments can be a win-win for policyholders and insurers, concerns remain over whether consumers are unknowingly miscalculating the true cost of the installments and whether insurers are overcharging for the convenience.

Joseph Belth, a professor emeritus of insurance at Indiana University and longtime editor of the newsletter “The Insurance Forum,” has been battling for more accurate disclosure of fractional premium charges since Congress enacted the Truth in Lending Act, or TILA, in 1968.

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That law — which required lenders to post credit terms and costs for consumers — ushered in the now-familiar annual percentage rate, or APR, as a simplified disclosure standard.

But since TILA did not require insurers to disclose the cost of their fractional premium charges, Belth says policyholders have been left to their own devices to figure the interest that they’re paying.

APR may be much higher than you think

Auto insurance is typically sold in six-month policies. But, for simplicity’s sake, let’s say you have a one-year policy that costs $1,000 if you pay in full, or $520 twice a year. So, the semiannual payments would cost an extra $40 per year. Dividing that into your $1,000 annual premium would seem to indicate you’re being charged 4 percent interest, right?

“Wrong, W-R-O-N-G,” says Belth. By his way of figuring, the APR is more than four times higher: 16.7 percent.

Here’s the way he and others see it: That $40 gives you the use of $480 for half the year. (The $480 is the $1,000 annual cost of the policy minus your first semiannual payment of $520.) Dividing $40 into $480 equals a semiannual interest rate of 8.333 percent. Double that, and you get an annual percentage rate that can be rounded to 16.7 percent.

Belth says the common miscalculation that arrives at 4 percent significantly distorts the true cost of fractional premium payments.

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“The correct interest figure is going to be roughly twice that high for monthly premiums, three times that high in the case of quarterly premiums and four times that high in the case of semiannual premiums,” he says.

TheInsuranceForum.com offers an online APR calculator for fractional payments, so you can see for yourself.

Paying upfront seen as loan to the insurer

Amy Bach, executive director of United Policyholders, a San Francisco-based insurance consumer group, says consumers who pay in installments should not be viewed as borrowers. She argues that when they pay their premiums in advance, they’re actually lenders.

“They’re asking me to front a whole year’s worth for their commitment,” she says, referring to a scenario similar to the example above. “I’m paying in January for April, and July for November.”

Bach doesn’t begrudge insurers the right to charge a reasonable fee to cover their costs. But she maintains that consumers deserve to know the correct cost of paying on time, especially when it comes to auto insurance, which is required by law if you want to operate a vehicle in most states.

“I’m not OK with the fact that, because auto insurers have a captive audience, almost all of them charge installment fees because they can: You must buy it,” she says. “People who really bear the brunt of this are those who are low-income and can’t afford to pay in a lump sum.”

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Fractional fees are largely unregulated

Glenn Daily, a fee-only insurance adviser in New York, says the real problem lies with the lack of state regulation on fractional premium charges.

He agrees with Belth and Bach that consumers aren’t getting the information they need to weigh the cost of paying on time.

“APR is not really appropriate when you’re trying to make a financial decision, because what you’re trying to figure out is: Can I earn enough money outside to justify paying the insurance company whatever their charge is for their fractional premium?” Daily says.

Still, he’s not convinced that full disclosure alone would prompt radically different consumer behavior.

“Consumers ignore the APR, especially on credit cards,” he says. “But at least a person should be told the interest rates on all of the fractional premium modes and be allowed to choose.”

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