Credit Insurance and Microcredit Interest Rates
Microcredit products often carry additional fees on top of the basic nominal interest rate charged to the client. In this blog post I will discuss credit insurance, also known as credit-life or credit-plus insurance, as it is one of the most common charges associated with microcredit products.
Credit insurance is a risk management product that microfinance institutions offer to cover borrowers financially in the event of a specific causality. The insurance product most often linked with the microcredit product is credit life insurance, which matches the client’s loan balance in case of death or serious disability. This coverage protects both the borrower’s nominee from debt and often provides some funeral benefits for the family while also protecting the microfinance institution against loss of an outstanding loan balance. Some MFIs also offer the credit life insurance against the death of the spouse of the borrower and against the damage/theft or death of the asset (generally livestock) purchased by the borrower using the loan amount.
In our experience at MFTransparency, the insurance premium (generally known as Loan cover fee/Loan protection fee) is most often charged to the client upfront at the time of loan disbursement as a percentage of the loan amount disbursed or a lump sum amount. As we all know from MFTransparency trainings, these types of fees pose a more significant cost to the borrower as she is expected to pay the total amount upfront, causing a greater cash outflow at the start of her loan term. However, some MFIs do recoup the insurance premium over the course of the loan term and collect a part of it with each loan repayment installment.
One of the most important features of the credit insurance is the “sum assured”. In the context of microfinance market in India, The sum assured offered and the charges levied to the clients vary from MFI to MFI and can be classified in the following three categories:
a) Sum assured equal to the loan amount
This is the most commonly offered credit insurance where the borrower gets coverage worth the loan amount. In such cases the client is generally charged a certain percentage of the loan amount as the insurance premium.
b) Different slabs of Sum assured against the loan size
MFIs create different slabs (ranges) of loan size wherein a fixed sum assured is offered against each slab. The borrower is charged a fixed amount against the sum assured, which applies to the slab of loan size the borrowed amount falls into. In such cases the insurance charges remain partly fixed and partly variable.
c) Fixed sum assured (irrespective of the loan size)
In this case,the MFI offers a fixed sum assured irrespective of the size of the loan issued to the client. The sum assured offered is generally kept higher than the maximum loan size offered to the client so that it can be offered to any of the borrowers. Also, every borrower pays the same insurance premium and therefore reflects higher costs since it increases significantly in terms of percentage of the loan amount for borrowers with smaller loan sizes.
The benefit of credit insurance to a borrower depends on many factors and one such factor is whether the insurance was a voluntary or mandatory add-on to clients applying for new loans. Does the client have a choice in the type of insurance and benefits she chooses? Is there flexibility in the types of coverage offered and the repayment options? Or is the client forced to pay for credit insurance as a mandatory condition of receiving a new loan?
In terms of the financial impact of credit insurance on the borrower, any mandatory insurance charge linked to a credit product is considered in the calculation of APR or EIR. If a condition of receiving a new loan is purchasing an insurance policy, this is considered a part of the cost of the loan and should be included in the APR/EIR calculation of the loan to reflect the true cost of the loan. This is reflected in the industry-accepted definitions of APR and EIR calculations. The theory behind this is that it may be that the borrower has other sources to cover financial risks and would not necessarily need the credit insurance from the MFI. However, the mandatory credit insurance compels the borrower to pay for it and results in an incremental cost to the borrower.
MFIs often argue that the credit insurance offered with the loan is a separate product from the loan and gives additional benefits to the clients. Therefore, the MFI argues, insurance fees should not be included in the APR/EIR calculations of the associated loan. However, the MFI must understand that in the case of compulsory credit insurance it no longer remains an independent product and acts as another product feature of the loan product and comes with a cost.
MFIs generally offer credit insurance through an insurance company, and those who do so may argue that the insurance charges should not be included in the APR/EIR calculations as the insurance premium (or the majority of it) is transferred to the insurance company and does not provide the MFI with an additional revenue source. Here we must understand that from the borrower’s perspective it does not matter who benefits financially from her insurance payments. The borrower’s experience is that she pays additional money in order to secure a loan from her MFI and her cash flow is affected as a result. The fact remains the same that they have to incur the cost of the compulsory insurance charges in order to get the loan. I will conclude by saying that the only thing that decides upon the inclusion or exclusion of insurance charges in the APR/EIR calculation is choice available with the client of availing or not availing the credit insurance.