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Wednesday, July 23, 2014

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Compliance Corner: Third Quarter 2004

Debt Cancellation Contracts and Debt Suspension Agreements: Consumer Products Raise Industry Interest Part I

Credit card issuers increasingly rely on supplemental product offerings to provide alternative revenue sources and thereby enhance profitability. Prime examples of such products are debt cancellation contracts (DCCs) and debt suspension agreements (DSAs). The topic of DCCs and DSAs has relevance to the Federal Reserve Bank of Philadelphia in that several leading credit card issuers maintain operations in the Third Federal Reserve District. In addition, the Board of Governors of the Federal Reserve System has indicated that anecdotal evidence gathered suggests that the sale of DCCs and DSAs in lieu of credit insurance has increased.

The following is the first installment of an informational paper that was written to facilitate an understanding of DCCs and DSAs. Part I of the article provides a general overview, new definitions, and common features and requirements, and discusses arguments by proponents and opponents of DCCs, DSAs, and credit insurance programs, as well. Part II of the article, which will appear in the Fourth Quarter 2004 issue of Compliance Corner, will examine consumer protections and will contain an appendix of sample disclosure forms provided by the OCC that a bank may use.

Introduction
DCCs and DSAs are two consumer products that industry analysts and observers believe will be increasingly offered by credit card issuers due in large part to the release of regulation (12 CFR 37) by the Office of the Comptroller of the Currency (OCC). Previous OCC guidance related to debt cancellation contracts has been replaced by this regulation, which provides a framework for DCCs and DSAs offered by national banks.1 The regulation, which became effective June 16, 2003, addresses concerns over consumer protection, insurance licensing, risk management, standardization, and supervisory authority.

In general, banks have responded favorably to the new regulation, indicating a growing interest in offering DCC and DSA products to their customers as an alternative to traditional credit insurance products. According to Beth L. Climo of the American Bankers Insurance Association (ABIA), "The key to the new regulation is that it clearly articulates and resolves the fact that debt cancellation and suspension contracts are banking products. This should be a real positive for the products. It gives banks a standard that can be imposed nationally, as opposed to credit insurance that is regulated on a state-by-state basis."2 The OCC recognized the future potential of banks switching from conventional credit insurance toward more flexible debt protection products. In a September 2002 press release, a spokesperson for the federal regulator stated, "We expect that a growing number of banks will begin offering these products because the OCC has clarified the regulation in a manner that strikes an appropriate balance between consumer protection and product design."3 CardWeb.com, an independent publisher of payment card industry news, noted, "The popularity of these so-called debt cancellation contracts and debt suspension agreements among national bank credit card issuers has been substantial enough to prompt the recent OCC action which also adds some consumer protections."4

As part of a request for public comment on "clear and conspicuous disclosures," issued in December 2003, the Board of Governors of the Federal Reserve System, recognizing an interest in DCCs and DSAs, requested comment on proposed amendments to Regulation Z specific to such products. Since that time, the Board has withdrawn its request for comment and decided not pursue a uniform standard for "clear and conspicuous" disclosures. Nevertheless, any state member bank that currently issues or is considering the issuance of DCCs or DSAs should contact its supervisory Federal Reserve Bank for appropriate guidance.

New Regulatory Definitions
As part of the new regulations, definitions of DCCs and DSAs were provided for banks and their customers. A DCC is defined as a loan term or a contractual arrangement modifying loan terms linked to a bank's extension of credit, under which the bank agrees to cancel all or part of a customer's obligation to repay an extension of credit from that bank upon the occurrence of a specified event. The regulation does not define what is meant by a "specified event," giving national banks leverage to design their own products to include death, disability, and/or involuntary unemployment. A DSA is the counterpart to a DCC, defined by the OCC as a loan term or a contractual arrangement modifying loan terms linked to a bank's extension of credit, under which the bank agrees to suspend all or part of a customer's obligation to repay an extension of credit from that bank upon the occurrence of a specified event. In this case, specified events can include permanent disability, unemployment, or unexpected illness. Both products require that the customer pay an additional fee, either in a lump sum payable at the outset of a loan or on a monthly basis, to the bank in exchange for the bank's promise to cancel or suspend the borrower's obligation to repay the loan. Both contracts may be part of a loan agreement or contained in a separate document.

Credit insurance, such as credit life and disability, customarily involves the issuance of a group insurance policy to the customer's bank. Under a credit insurance contract, the bank enrolls customers, who pay an insurance premium for coverage defined in a certificate of insurance. In the event of the customer's death or disability, the affiliated third-party provider, not the credit card issuing bank, pays the benefits and assumes any risk connected with the policy. The key distinction to note between credit insurance and DSAs is that there is actually a payment made on the account with credit insurance, thereby bringing down the balance while the consumer is sick or unemployed. DSAs suspend the payments due on the account.

Background
DCCs have been sold to customers for nearly forty years. In fact, national banks were first authorized to offer DCCs by the OCC in 1963. At that time, the OCC concluded that offering DCCs was a lawful exercise of the powers of national banks in connection with the business of banking. In 1964, Comptroller James J. Saxon recognized DCCs as legitimate banking products when he stated:

"The ability of national banks to offer DCCs is not a means for national banks to invade the field of insurance. Rather, it is recognition by the OCC of a national bank's right to protect itself by the establishment and maintenance of appropriate reserves against anticipated losses in connection with its lending activities. The necessity to maintain such reserves and to adjust its charges in relation to both reserves and the risk involved in a particular transaction has long been recognized as an essential part of the business of banking."5

In August 1971, the OCC clarified its earlier ruling concerning DCCs by stating that a national bank may offer to cancel the outstanding loan balance upon the death of the borrower. Moreover, an Interpretative Letter (12 CFR 7.7495 (1972)) allowed banks to establish necessary reserves to cover possible losses associated with these products. Between 1972 and 1984, the OCC released two additional Interpretive Letters, which further refined its position concerning debt cancellation products. In 1972, the OCC permitted national banks to offer DCCs to compensate for loss of collateral. Early in 1984, Interpretive Letter No. 283 was released, which stated that national banks could sell credit life and disability insurance as an "incidental power" and that selling such insurance was directly related to a bank's expressed lending authority.

Over twenty years after first being authorized by the OCC, the Eighth Circuit Court of Appeals upheld the federal regulator's view that such products were banking products and not the business of insurance. Not long after this appellate court decision, the OCC responded to mounting requests from senior banking industry executives to facilitate business line diversification by amending regulations covering DCCs to include disability of a borrower. In 1998, the OCC acted again by permitting national banks to offer their customers debt suspension agreements as part of their express authority to make loans. The following year, Congress passed the Gramm-Leach-Bliley Act (GLBA), which allowed companies with varying business lines to offer a greater assortment of products to their customers. The new law removed the remaining restrictions on combining banking, securities, and insurance activities under the auspices of a single financial company. More importantly, the new law promoted greater financial integration and reaffirmed the authority of national banks and their subsidiaries to sell insurance.

Common Features and Requirements
Although many variations of credit protection products currently exist, there are certain uniform features and requirements of these programs. Common features of DCC and DSA programs include the following:

  • Proof of employment history 60 to 90 days prior to the policy activation date and a minimum of 30 hours full-time work per week.
  • An age eligibility requirement. Regulation B (Equal Credit Opportunity Act) prohibits lenders from discriminating against credit applicants provided they have the ability to contract. It is unclear at this time if the age requirements now employed by issuers violate this federal requirement.
  • The customer's right to cancel the policy at any time at no charge.
  • Credit protection limits between $10,000 and $15,000.
  • Program fees that are automatically deducted from the customer's existing bank account or automatically added to their credit card account balance.
  • Premiums that vary between 69 cents and 89 cents per $100 of outstanding balance.
  • No fees when a credit card balance is not carried for a given month.
  • The inability to use a credit card account for cash advances, transactions, balance transfers, or wire transfers after a cancellation or suspension period commences.
  • Finance charges that do not accrue during the deferral period.
  • Coverage periods that generally range from six months to one year for debt suspension agreements.
  • Activation periods that vary, but usually the consumer must be participating in program for a minimum of 30 days.

Arguments Related to DCC, DSA, and Credit Insurance Programs
Consumer advocates have questioned the ultimate usefulness of credit insurance products for consumers. Reservations expressed concerning these products include the following:

  • The programs tend to be expensive—the minimum monthly premium could exceed the minimum monthly payment without insurance.
  • If a cardholder does not carry a monthly balance, the product's economic practicality may be questionable.
  • In case of death, basic term life insurance may be a less expensive alternative and, in some states, balances may be forgiven.
  • Often, issuers will work with accountholders to establish a payment plan in the absence of a credit protection product in the event of unemployment or disability.
  • The benefits to the consumer may be minimal, since these products have an extremely low loss ratio—the proportion of a total premium returned to a consumer who suffers an insured loss—of generally between 30 and 40 percent. The National Association of Insurance Commissioners recommends a minimum loss ratio of 60 percent.

The Consumer Federation of America (CFA), a leading consumer advocacy group, has stated that in spite of the potentially greater flexibility of DCCs and DSAs, they view both products as the same as credit insurance and equally unnecessary. Bob Hunter, the CFA's insurance director, told the American Banker, "Debt cancellation products and credit insurance are technically the same thing—it's like butter and margarine. But most consumers have no need to buy either."6 Some observers have argued that the DSA product in particular is an even less desirable consumer product than credit insurance, since payments on an account are only temporarily suspended and outstanding balances remain at their pre-suspension levels.

Conversely, a number of industry observers and regulators believe DCC and DSA products can provide a consumer with financial security and peace of mind. In general, advocates believe that debt cancellation contracts and debt suspension agreements satisfy a distinct customer need by providing support in times of financial difficulty and protection against damage of credit ratings, among other benefits. A recent study conducted by Thomas A. Durkin of the Federal Reserve Board's Division of Research and Statistics, Consumers and Credit Disclosures: Credit Cards and Credit Insurance, suggests that consumers may realize positive benefits from the purchase of credit protection products. In the study, Durkin notes, "Others see the product as safeguarding not creditors, but rather uninsured individuals and their families who could otherwise face financial uncertainty and distress from an unpaid debt in the event of an uninsured personal disaster."7 The Durkin study also provides data suggesting that consumers have a positive view toward credit insurance products offered to installment credit customers. "In 2001, more than 90 percent of installment credit users with credit insurance indicated a favorable attitude toward the insurance. The product is good, or good with some qualification, and about nineteen in twenty purchasers of credit insurance on installment credit in 2001 said that they would purchase it again."8

Final Thoughts
Many credit card issuers currently offer or have considered offering DCC and DSA products to enhance product diversity and thereby enhance profitability. Comments provided by industry observers and banking regulators portend increased sales of DCCs and DSAs. In this context, standards established by the OCC regarding the purchase and sale of DCCs and DSAs will benefit credit card issuers searching for product diversification. The OCC regulation also clearly defines DCCs and DSAs as national banking products, not insurance products, essentially ending the debate regarding state regulatory authority and supervision.

Part II of the article, which will appear in the Fourth Quarter 2004 issue of Compliance Corner, will discuss consumer protections specific to DCCs and DSAs. In the interim, if you have any questions about this article or DCCs or DSAs in general, please contact Supervising Examiner Robert W. Snarr, Jr. through the Regulations Assistance line at (215) 574-6568 or Staff and Career Development Coordinator Frederick W. Stakelbeck at (215) 574-6422.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.