For a product claiming to protect consumers from unforeseen misfortunes, banks' credit card payment protection plans have made plenty of enemies. A federal probe could give those opponents the upper hand for the first time.
Attorneys general and plaintiffs' lawyers have long alleged that payment protection plans, which promise to delay or cancel debts in the event of unemployment, illness, or death, are a poor value and sold to people who don't want them or can't use them. Banks return only 21 cents of every dollar in payment protection premiums to consumers in the form of suspended or cancelled debt, a gross payout ratio that would be flatly illegal if the products were categorized as insurance.
But thanks to a series of regulatory and judicial decisions favorable to the banking industry, defeating or settling the legal complaints has historically been cheap. Compared to annual profits of $1.3 billion on payment protection products, the industry's tens of millions of dollars in legal costs are a rounding error.
"There is no incentive for getting out of this business unless or until the regulators get in," says Scott Hakala, managing director for consultancy CBIZ Valuation Group LLC and an expert witness for plaintiffs' attorneys seeking to calculate alleged injuries to payment protection customers.
The possibility that the government may do just that was raised Jan. 26 when a federal probe of Discover Financial Services was disclosed in a company regulatory filing. The Federal Deposit Insurance Corporation and the Consumer Financial Protection Bureau are looking at Discover's business practices, and a broader review may be in the offing, industry attorneys say.
The potential stakes include not only the immense profitability of payment protection plans, but the regulatory framework that has allowed the products to thrive.
The Consumer Financial Protection Bureau "is trying to move consumer financial services regulation from a disclosure-based regime to more of a fairness-based regime," says Joseph Barloon, a partner at Skadden, Arps, Slate, Meagher & Flom. "There is every indication that this is an area where we may see that philosophy put into action."
Payment protection products are advertised as a safety net for consumers worried that an unexpected misfortune could send them over the brink.
"Life happens," says Discover Financial Services on its website, offering payment protection for "when times get tough." Consumers who purchase the service can put their payments on hold for up to two years in the event of disability, hospitalization, or other qualifying events.
"Our optional protection products have benefits that offer cardmembers tools to monitor and understand their credit, which helps to provide peace of mind," says Discover spokeswoman Leslie Sutton.
The company is responding to the federal probe by "working through the process with regulators and [we] remain focused on providing our customers with the products they value and service they expect from Discover," she said in a separate emailed statement.
For consumers, the plans function like insurance policies. Issuers who sell the product either waive or defer credit card payments for customers who suffer one of a number of covered events, from the birth of a new baby to job loss or death.
For the privilege, Discover charges 89 cents for each $100 outstanding on a consumer's credit card every month he is enrolled. Other major card issuers charge as much as $1.35 per $100 per month. Currently, 24 million accounts, or roughly 7% of credit cards issued by the nine largest issuers, are enrolled in some form of payment protection, the Government Accountability Office estimated in a March 2011 report.
Discover claims that it has over one million enrolled customers, and the company has earned the revenue to prove it. Since Discover's 2007 IPO, revenue on debt cancellation and deferment plans has skyrocketed. The credit card company posted $241 million in revenue on the products in the fiscal year ended Nov. 30, 2011, which was more than triple the $74 million reported in 2007. (Discover says that some of the growth in the latter two years is due to the addition of reported income from securitized loans under new accounting rules.)
The top nine card issuers posted $1.3 billion in pretax profits on the plans in 2009, or more than half of the $2.4 billion collected in fees paid by enrolled borrowers, according to the GAO. Almost a quarter of the fees collected go towards the cost of marketing and administering the plans. The remaining 21% of fees, or about $518 million annually, are spent providing the plans' actual benefits to consumers.
The revenue inflow from debt protection plans has likely taken on increased importance for issuers following the 2009 passage of the Credit Card Accountability, Responsibility, and Disclosure Act, which restricted credit card lenders' ability to charge fees and hike interest rates.
"Given the CARD Act and the way the revenue model [for credit cards] has generally changed, these products are likely to be getting more focus," says Sarah Phelps, a principal at First Annapolis Consulting.
"A lot of these credit insurance products do drive some revenue for the issuers. As any good business owner would do, if one line item were to come under pressure, issuers look to other line items to replace some of that revenue," she says.