The pitfalls of borrowing against an insurance policy

Many insurance policyholders use the investment portion of their policies as security for loans. When policyholders run into short-term financial difficulty (or need an extra wad of cash for the ‘out-of-reach’ luxury) they simply approach their insurance company to ‘help’ out. But they’re often in the dark as to how much this decision will cost them in the long run. If they’d read the July 2008 issue of Ombuzz (the monthly newsletter from the FAIS Ombud) they’d probably have found an alternative solution.

The Ombudsman notes that his office has been receiving a steady stream of complaints about such loans in recent months. And today’s high interest rate environment makes it even more important to carefully consider your options before committing to debt. Let’s use one of the Ombudsman’s recent cases as an example.

A policyholder applied for a life policy for himself and a co-dependent on 15 January 1985. It was issued on 1 April of that year with a term of 25 years and monthly premium of R41.07. The cover on the policy included life cover (and supplementary benefits for accidental death) of R10 000 for the insured; and similar conditions limited to R7 000 for the co-insured. A portion of the premium went to an investment fund.

A decade of premium deductions amount to nothing

The policyholder in this example made premium payments of R7 288 over a period of 14 years and 8 months. We’re not sure what portion of the R41.07 monthly premium was paid into the investment account; but even R10 per month over 168 months (earning 5% per annum compound interest) would amount to R2 446. If we take a snapshot of the transaction on 5 February 2000, the day the insurer decided to lapse the policy, the insured had paid R7 288 against a R415 loan taken out on 25 July 1988. We’re sure there are many similar cases.

What possible ‘value’ can we place on the financial advice given by the insurer in this case? We question whether a finance product provider would get away with a similar transaction in 2008 given the tighter regulatory environment. We’d love to know answers to the following:

- Why was the policyholder never encouraged to make repayments on the loan?

- How ‘steep’ were the interest charges on the loan if they couldn’t be effectively serviced by the policyholder’s investment premium?

- Is the insurer responsible in any way for furthering a transaction that didn’t make economic sense?

- And, why was the loan granted at all?

The FAIS Ombud sums the situation: “This was a case where the policyholder really had no value from the policy apart from a R415 loan, despite the fact that he paid premiums amounting to some R7 288 over 14 years and 8 months prior to the lapse, and some thereafter.”

Another of those ex-gratia settlements

This case oozes with poor administration, policyholder communication and lack of transparency. We don’t have all the detail; but it doesn’t appear the policyholder was encouraged to repay the loan. And we doubt the policyholder knew what interest rate was being charged on the loan either... To get to an outstanding balance of R5 819.79 the insurer must have charged average annual interest of more than 24%!

But the most shocking transgression was that the insurer continued deducting the monthly premium after the policy had lapsed. Were they trying to recover the difference between the loan value and the investment fund balance at the time? The FAIS Ombud reminded the insurer of some of these ‘events’ before suggesting that “it may be more equitable to treat the loan as part surrender rather than a loan.” The insurer agreed to make an ex-gratia payment to the claimant.