Should the joint provision of credit insurance with unsecured lending be prohibited? An examination of the UK payment protection insurance market

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1 Shod the joint povision of cedit insuance with unsecued lending be pohibited? An examination of the UK payment potection insuance maket by John K. Ashton Nowich Business School and the ESRC Cente fo Competition Policy, Univesity of East Anglia and Robet S. Hudson Newcastle Univesity Business School, Newcastle Univesity Abstact: This pape examines the joint picing of cedit insuance and unsecued lending. This case has wide egatoy implications following concens that the sale of cedit insuance as an add-on poduct has been detimental to customes. A theoetical model is developed in which banks set pices fo customes who have vaying decision making ability. The model pedictions ae tested empiically. It is concluded that banks coss-subsidise unsecued lending by setting high cedit insuance pemiums. The fom of sales and pofit maximisation by banks ae cental to causing the coss subsidy with the effect being fa less ponounced fo mutually owed banks. Keywods: Inteest ate setting, Univesal Banking, Insuance pemium setting, cedit insuance, add-on goods, joint picing. Acknowledgements: We wod like to thank Moneyfacts PLC fo kindly poviding the data fo this study. Futhe we ae gatef fo helpf comments povided by Tony Coasdale, Andos Gegoiou, Michael Imeman, Buce Lyons, Mathias Siems, Bill Stein and paticipants of seminas at the Univesity of Ulste (2008) and Univesity of East Anglia (2009), the Wolpetinge Confeence at Opoto Univesity (2008), the 31 st UK Insuance Economists confeence at Nottingham Univesity (2009), the 16 th Global Finance Confeence (2009) oganised with the Univesity of Hawaii, the Bitish Accounting Association Confeence at the Univesity of Dundee (2009), the Financial Management Association Confeence, Reno (2009) and the 7 th Infiniti Intenational Finance Confeence, Tinity College, Dublin (2009). The suppot of the Economic and Social Reseach Council is also gatefly acknowledged. All eos emain the esponsibility of the authos. Contact details: John K. Ashton, ESRC Cente fo Competition Policy, Univesity of East Anglia, Nowich, NR4 7TJ, UK. j.ashton@uea.ac.uk Robet S. Hudson, Newcastle Univesity Business School, Univesity of Newcastle, Newcastle upon Tyne, UK obet.hudson@ncl.ac.uk Januay

2 Shod the joint povision of cedit insuance with unsecued lending be pohibited? An examination of the UK payment potection insuance maket 2

3 1. Intoduction In Januay 2009 the UK competition law judgement body, the Competition Commission (CC), pohibited the joint sale of cedit o payment potection insuance with unsecued lending afte 2010 (CC 2009). This ecommendation was successfly appealed by Baclays bank in Octobe 2009 on the gounds that pohibiting the sale of cedit insuance educed custome convenience. The poposed pohibition of joint sales of cedit insuance with unsecued lending was a clea step back fom the de-egation movement allowing the joint povision of banking and insuance sevices thoughout the EU and US. This study examines whethe this egatoy decision to intoduce a blanket ban on the joint povision of consume lending and cedit insuance was justified o altenatively whethe the appeal of this pohibition was appopiate. The potential pohibition poses a ange of eseach questions. Fist is cedit insuance used to cosssubsidise cedit as alleged in the UK? Second, have all banks acted to the detement of customes o have the actions of a few banks lead to a pohibition acoss this entie secto? Thid, if coss-subsidies exist may these be eliminated though geate financial education? Lastly if the joint sale of cedit insuance and lending is viewed to be so poblematic in the UK, shod othe nations also pohibit this pactice? This study advances answes to these questions, though modelling the joint povision of cedit insuance and unsecued lending and poviding an empiical assessment of the joint picing of these financial sevices. A coss subsidy fom cedit insuance to unsecued lending is both pedicted and empiically identified fo pofit maximising o popietay banks. It is pedicted that customes with diffeent levels of financial compehension ae affected diffeently by this coss subsidy. While these cicumstances indicate geate financial education will assist individual customes, financial liteacy alone will not eliminate the use of coss subsidies. Mutual and popietay banks ae also pedicted and obseved to set pices fo these jointly issued 3

4 financial sevices distinctly. Only popietay banks consistently act to the detiment of customes in the joint povision of cedit insuance and unsecued lending. Lastly, deciding whethe pohibition of joint cedit insuance and unsecued lending sales shod be extended intenationally is dependent on how the inteests of banks, less infomed and infomed customes ae elatively weighed. This investigation is impotant as the maket fo cedit insuance is substantial. In 2006 it is estimated that 20 million cedit insuance policies wee in opeation in the UK (OFT 2006). The most common fom of payment potection insuance is fo unsecued pesonal loans, accounting fo 45% of the oveall UK cedit insuance maket, and valued at 2,013m in 2006 (CC 2007). The unsecued pesonal loans examined in this study ae the most common fom of boowing in the UK (Depatment of Business, Entepise and Regatoy Refom; heeafte BERR, 2007). The key contibution of this wok is to examine the stated eseach questions suounding the pohibition of the joint povision of banking and insuance poducts. The pape is stuctued in five pats. Afte this intoduction a eview of the key academic and egatoy liteatues is povided. In section 3 a model is elaboated and applied to the cicumstances emeging in the UK pesonal unsecued lending and cedit insuance makets. Section 4 povides a discussion of the empiical assessment and section 5 povides a summay of the eseach and conclusions. 2. Liteatue Review Past eseach of the joint povision of banking and insuance sevices has been consideed within two boad liteatues. Fist, a substantial liteatue has emeged examining the deegation and divesification of financial sevices. Second, the value fo money offeed by cedit insuance and the methods by which it is distibuted have been epeatedly consideed by egatos. 4

5 2.1 The deegation and divesification of financial sevices Insuance and banking poducts have been povided jointly by financial sevices povides since the Second Banking Coodination Diective (1989) and Financial Sevices Modenization Act (1999) in the EU and US espectively (Fields et al 2007). This legislation allowed banks to mege with insues and othe financial fims and offe banking and insuance poducts individually and jointly. Schmid and Walte (2009) estimate 24.6% of woldwide financial secto meges between 1985 and 2004 involved such coss maket aspects. This divesification was justified in tems of potential coss selling advantages, manageial ove estimates of benefits, (Schmid and Walte 2009), potential infomation pocessing gains (Kanatas and Qui 2003) and efficiency impovements (Yeage et al 2007, Stioh and Rumble 2006). Ove time the maket valuation of such financial fim divesification stategies has shifted. In the ealy 2000s announcing a bank and insue mege was consideed to have positive wealth effects fo bank pofitability and shae pices (Al Manum et al 2004, Baele et al 2007). Moe ecently financial fim divesification is linked to lowe maket valuations than expeienced by specialised financial fims (Laeven and Levine 2007, Schimd and Walte 2009). Recent eseach also indicates the divesification movement has tansfomed banking business esting in geate eliance on non-inteest and fee based income, evenue divesification, highe isk adjusted pofits (Stioh and Rumble 2006) and potentially geate isk divesification (Fields et al 2007). The inceasing impotance of fee based income fo financial fims is also linked to a highe volatility in income, inceasing coss subsides between fee based sevices and inteest magins (Lepetit et al 2008) and, moe ecently, limited pofitability and poductivity gains (Yeage et al 2007). Past academic eseach specifically consideing cedit insuance has been limited with most contibutions focusing on motgage cedit insuance. This liteatue has 5

6 examined the deteminants of cedit insuance take-up, peceptions of and satisfaction with these poducts, and the competitiveness of cedit insuance makets. Fo the UK Pyce and Keoghan (2001) indicated that while pemium size has a limited influence on cedit insuance puchase decisions the decision to take out motgage cedit insuance is ational. Futhe UK suvey evidence indicates motgage cedit insuance is vey expensive, limited in coveage and has egessive elements (Buchadt and Hill 1998). Moe ecently (De Meza et al 2007) indicates the appoach adopted by cedit insuance sales pesons can influence puchase decisions. US assessments have focused on the sales of cedit insuance, with coecive and involuntay tying aangements a pimay concen. This emphasis aises fom the widespead use and high pofitability of cedit insuance in the US. Ealy suvey evidence indicated most customes do not peceive sales to be coecive yet felt obliged to puchase cedit insuance (Polden 1983). Subsequently Dukin (2002) indicated coss selling lends itself to coecive sales and cedit insuance sales have focused on olde and lowe socioeconomic goups; goups paticaly pone to coecion (Baon and Staten 1995). Othe US contibutions have emphasised the limited competitiveness of motgage cedit insuance makets, ovepiced policies (Allen and Chan 1998) and equiements to eexamine the legal teatment of cedit insuance policies (Spah and Escolas 1986). Othe contibutions have also consideed the implications of joint povision of banking and insuance poducts fo bank costs and evenues. Fo South Afica, Okeashalem (2008) indicates bank poduct bundling inceases fee levels. In Euopean banking highe fee level incomes ae associated with lowe inteest ate magins (Lepetit et al 2008) and evenue fom non-taditional business may compensate fo lowe inteest ate magins (Valvede and Fenández 2007). Similaly the owneship and subsequent objective function of banks may also influence the fom of joint selling. Mutual banks ae effectively owned by thei customes, 6

7 while popietay banks ae owned by shaeholdes. These diffeent owneship ights can lead to diffeent bank behavios (Rasmusen, 1988, Llewellyn, 1991). While evidence of diffeential picing between popietay and mutual banks is limited, Ashton and Letza (2003) and Heffenan (2003) indicate popietay banks have offeed lowe etuns on deposits and highe inteest ates fo loans in the UK. 2.2 Regatoy liteatues Cedit insuance has been the focus of epeated US, UK and EU egatoy investigations. In the US egatoy attention has focused on the packing of cedit insuance within cedit sevices such as home and consume loans. Key concens include mis-selling of cedit insuance, misleading advetising, including insuance within a cedit ageement without explanation and not fly evealing insuance costs within total loan costs (Fedeal Tade Commission; heeafte FTC, 2001). Low payout atios fo cedit insuance also occu with most lendes and insues etaining moe than 40% of pemiums (FTC 2001). Recent cases have ested in lage fines fo banks and finance companies which have offeed cedit insuance with consume loans in a manne against consume inteests. In total 8% of all consume complaints eceived by the Fedeal Reseve concen additional fees and chages, including cedit insuance, making this one of the most pesistent souces of consume complaints fo US financial egatos (Fedeal Reseve 2007). In the UK, cedit insuance poblems ae aised within the UK Consume Cedit Act (2006) and by thee egatoy agencies. The povision of cedit insuance with lending between 2000 and 2005 was examined by the UK competition law enfocement and consume potection agency, the Office of Fai Tading (OFT 2006). This agency epoted consumes eceive poo value fom cedit insuance due to a low claims atio of 18%; elative to othe foms of insuance (e.g. ca insuance was 84% ove the same 7

8 peiod, CC 2008) and high commissions paid to cedit insuance distibutos (59% of pemiums, OFT 2006). Subsequently cedit o payment potection insuance povision was efeed to the Competition Commission which ed joint sales of cedit insuance with loans shod be pohibited, pemiums shod be paid though instalments athe than as a single pemium, impoved custome infomation is equied and cedit insuance shod be unbundled fom othe financial sevices (CC 2009). The pohibition on joint sales was successfly appealed by Baclays bank in Octobe 2009 on the gounds that this action ested in a loss of convenience fo consumes. The UK financial egato, the Financial Sevices Authoity (FSA) has also examined cedit insuance epeatedly since 2005 (FSA 2007c). Aeas investigated include fims selling pactices, the povision of poduct and pice infomation, the taining and competence of sales staff and the fims intenal systems and contols. These issues wee assessed using supevisoy investigations and mystey shopping studies (FSA 2005, 2006, 2007a, 2007b). The fims investigated wee selected fom all cedit insuance distibutos including etailes, ca dealeships, bokes, banks and building societies. The FSA identified poblems with fims which do not sell financial sevices as thei main line of business, and especially ca dealeships which sell cedit insuance alongside ca finance. Othe pesistent concens include limited infomation given to consumes, a lack of awaeness of poduct exclusions and a failue to indicate the voluntay natue of cedit insuance. Whilst evidence of pessued selling has been ae, fims often pesent the acceptance of both the loan and cedit insuance as the nom equiing an explicit ejection of cedit insuance by customes (FSA 2007b). In esponse to these concens 16 fims have been publically censued o fined between 14,000 and 7m by the FSA between 2006 to The fines wee imposed following evidence of assumptive sales techniques whee customes needs whee not given sufficient weight, poo infomation povision and poo ecod keeping. 8

9 Lastly the cost of cedit insuance has also been aised by the Euopean Commission (2005, 2008) as pat of the on-going hamonisation of consume potection laws. Euopean cedit maket concens include the emoval of baies to infomation povision fo cedit decision making, the fom of inteest ate setting and distinct debt collection pactices (DTI 2003). Subsequently a Euopean wide appoach fo calcating the total cost of cedit including add-on costs such as cedit insuance (Euopean Commission 2005, 2008) shod be included in the national law of membe states by Futhe discussion of cedit insuance within Euopean inteest ate egation is povided by Soto (2009). 3. Optimal Unsecued Lending Inteest Rates and Insuance Pemiums In this section a model of the joint sale and puchase of unsecued pesonal lending with cedit insuance is developed. Within this famewok unsecued lending is viewed to be a base good and cedit insuance is viewed to be an add-on good. To investigate whethe all customes ae teated similaly it is assumed makets ae popated eithe by homogenous customes o altenatively customes which possess diffeent decision making abilities (see Salop and Stiglitz 1977, Vaian 1980) and ae temed sophisticated and naïve. This step is undetaken as financial sevices makets ae chaacteised by limited consume compehension both in the UK and US (Agawal et al 2008, Campbell 2006, FSA 2006, Hilget and Hogath 2003). A gowing theoetical liteatue examines cicumstances whee customes suboptimal choices when jointly puchasing additional o add-on poducts leads to cosssubsidies. This liteatue (Della Vigna and Malmendie 2004, Ellison 2005, Gabaix and Laibson 2006) consides cicumstances whee a custome once deciding to puchase a good, incus futhe costs by puchasing an add-on o additional good. A consistent 9

10 finding has been the potential fo coss subsidy between poducts and the development of loss leade foms of picing (Ellison 2005, Lal and Matutues 1994). These situations occu when naive, myopic o less sophisticated customes with weake decision making abilities geneate coss-subsidies fo moe sophisticated o infomed customes with moe efined decision making abilities. Given the existence of naive customes, banks can use shouding techniques, including small pint and selectively infomative advetising, to conceal the tue attibutes of add-on goods fom consumes (Gabaix and Laibson 2006). These contibutions indicate two foms of exploitation, i) the exploitation by fims of naive customes, and ii) the exploitation of fims by sophisticated customes. As all goups othe than naïve customes benefit fom this system and naïve customes have limited compehension of the detiment they face, this coss subsidy is pesistent. Convesely if makets ae chaacteised by only sophisticated customes, atificially high picing of add-on poducts and coss subsidy of base poducts shod not pesist ove time. Cuently empiical assessments of fim esponses to non-standad custome pefeences is a neglected aea (Della Vigna and Malmendie 2004). To examine whethe all banks 1 supplying these makets adopt simila picing appoaches it is assumed banks eithe maximise pofits o consume benefits to eflect popietay and mutual owneship espectively. It is assumed thee is no inteaction between banks and the sale of unsecued lending and cedit insuance is undetaken within a monopoly famewok. This appoach is assumed in pevious examinations of etail financial sevices picing with heteogeneous customes (Kahn et al 1999, Ashton and Hudson, 2008) and eflects the limited competition obseved in this maket (OFT 2006, CC 2009). The model is developed ove thee cases: 1 A ange of financial fims povide these sevices jointly; heeafte we efe to these institutions collectively as banks. 10

11 Case A: when unsecued lending and cedit insuance ae sold independently by pofit maximising banks. Case B: when unsecued lending and cedit insuance ae sold jointly by pofit maximising banks. Case C: when unsecued lending and cedit insuance ae sold independently and jointly by mutually owned banks which do not maximise pofits. Thoughout D indicates demand, indicates unsecued lending, i indicates cedit insuance, v and p indicate value and pemium, and u and s indicates naïve and sophisticated customes espectively Case A: Unsecued lending and cedit insuance ae sold independently by pofit maximising banks Homogenous customes ae assumed to all have the same level of decision making ability and have a demand fo unsecued loans epesented by: D D x (1), whee is the bank s unsecued loan ate, x is a vecto of othe vaiables which influence the demand fo unsecued loans. Similaly the demand fo cedit insuance is witten as: D D i, i i p x (2) i whee i p is the bank s insuance pemium and x i is a vecto of othe vaiables influencing the demand fo cedit insuance. Pofits fo unsecued loans povided by pofit maximising popietay banks ae: 2 Naïve customes ae assumed to have less compehension of the egatoy system and to be moe easily influenced by shouding poduct tems. In patica, they ae moe easily pesuaded to buy cedit insuance fom the company that advanced them an unsecued loan, have less compehension of the tue value of insuance benefits and hence ae less sensitive to thei pice. 11

12 c D, x (3) fo homogenous customes whee is the maket ate of inteest, c is the bank s net expenses pe unit of unsecued loan. Similaly the bank s pofits fom cedit insuance fo homogeneous customes ae: i i c D i, p v i i p x (4) i whee i p is the insuance pemium, c i is the net expenses pe unit of insuance sold, and i v is the discounted expected value of the benefits fom the policy. The optimal loan ate to maximize pofits, will satisfy the fist ode condition 3 : D D(, x) x c 0, (5) Thus D, x (6) c D(, x ) An analogous equation can be deived fo the optimal insuance pemium to maximise pofits but this has not been shown to conseve space. When k s is the popotion of sophisticated customes the bank s pofits fom unsecued loans ae: s s s s u u c k D, x 1 k D, x (7) These sophisticated customes have a demand fo unsecued loans epesented by D s = D s (, x s ). Distinctly naive customes have a demand fo unsecued loans epesented 3 Note D(, x ) 0 12

13 by D u = D u (, x u ). The optimal loan ate will, theefoe, satisfy the fist ode condition 4 : s s u u, x k D x 1, s s s u u c,, s s k D s k D c x 1 k D x (8) In this case can be lage o smalle than the optimum inteest ate when customes ae homogeneous (equation 6). Theefoe if unsecued loans ae sold independently it is not inevitable that sophisticated customes ae subsidized by naive customes. When cedit insuance is sold independently and k s is the popotion of sophisticated customes the bank s pofits fom cedit insuance ae: s s s s u u, 1 i i c k D i x k D i, p v i i p i i p x (9) i whee c i is the bank s net expenses pe unit of cedit insuance; sophisticated customes s s s have a demand fo unsecued loans: u u u unsecued loans: D D i, x i p i D D i, i p xi and naïve customes have a demand fo. Equation (9) is closely analogous to equation (7) and the optimal insuance pemium to maximise pofits i p is the fist ode condition analogous to equation (9). Similaly, if cedit insuance is sold independently sophisticated customes ae not necessaily coss-subsidized by naïve customes. 3.2 Case B: Unsecued lending and cedit insuance ae sold jointly by pofit maximising banks Most cedit insuance is sold at the point of sale (CC 2009) and customes will only buy cedit insuance if they have taken out a loan. Altenatively customes may decide not to take out insuance at all o efuse the insuance available at the point of sale and seach 4 s s u u Note,, D x D 0 ; x 0. 13

14 the maket fo the best available policy. These situations ae consideed fo both homogenous and sophisticated and naive customes. If a bank sells both unsecued loans and cedit insuance to homogenous customes its pofit is the sum of (3) and (4):, c D x i i c D i, p v i i p x (10) i When unsecued loans and cedit insuance ae maketed independently the demand function fo the cedit insuance loans D x D i, i p xi will be independent of that fo unsecued,. This implies and i p ae found independently by setting the patial deivative of (10), with espect to and i p, equal to zeo espectively. In this case, no coss subsidies between the two poducts will emege. In pactice cedit insuance is often jointly maketed to customes who have aleady taken out an unsecued loan. This implies that the demand function fo cedit insuance is not independent of the demand function fo unsecued loans. If we assume individuals will only buy cedit insuance when they have peviously accepted an unsecued loan fom the same bank the conditional demand function is: D i x pi D x (11), i p i p., whee p is a function of i p and 0 p(i p ) 1fo all i p. p(i p ) can be viewed as analogous to the conditional pobability distibution function of puchasing cedit insuance afte taking out a loan. Substituting (11) into (10) gives a pofit of, p c D x i p iv ci i p D, (12) x If the bank wishes to find this must satisfy the fist ode condition: D, (13) x p i i i c p v i c D, x p 14

15 We can see that is lowe when goods ae sold jointly in (13) athe than independently in (4) when (i p i v c i ) > 0 (the insuance is not sold at a loss). Theefoe the optimal inteest ate set fo unsecued loans is less when unsecued loans ae sold jointly with cedit insuance athe than independently. Thus homogenous customes puchasing cedit insuance jointly with unsecued loans subsidize customes which only accept unsecued loans. When customes vay in decision making ability the joint pofit fom unsecued loans and cedit insuance will be the sum of (7) and (9): s s s s u u s s s s u u,,, c k D, x 1k D x i p iv ci k Di i p x 1 i k Di i p x (14) i Again the vaious demand functions in equation (14) ae not necessaily mutually independent influencing how banks set optimal unsecued loan ates and cedit insuance pemiums. When cedit insuance and unsecued lending ae sold togethe to naive and sophisticated customes the bank will maximise pofits by setting and i v to maximize (14) and the demand functions fo cedit insuance s s u u D i x ; D i, x i p i i p i D s s u u ;, and unsecued loans, x D x will not be independent. We examine these dependence elationships, below. Initially naive customes can find the best deal on an unsecued loan ate as effectively as sophisticated customes but as they ae unawae of the cedit insuance s costs and value they ae moe likely to buy cedit insuance. In this case: D, s u u, x D x D x (15) s, Futhe, as the demand function fo cedit insuance fom naive customes is geate u u s s than that fom sophisticated customes. i.e. s D s u s u s u,, i xi p i D, i p p u x D i D i, x D i, i p i i p x ; fo all i i p we establish: xi p i D, i p p Whee 0 p ( i ) ( ) ( ) p p ip p ip 1 fo all i p leads to s s s u c D x i i c k p i. D, x k p i D, x p v i p p, 1 (16) x 15

16 If the bank wishes to find to optimize its pofits 5 D D x x s s s u i i ci k i 1k i D,, p v p p p p, As s s s u k p i 1 k p i p p x c (17) (18) subject to 0 p s u i p i p i p p p 1 ; 0 k s 1 ; inceases with the popotion of naive customes, the popotion of naive customes is negatively elated to the unsecued inteest ate. The expected pofit contibuted by each sophisticated and naive custome s pe unit of unsecued loan is c p i i i c p p v i and u c p i i i c p p v i espectively. That is the pofit fom the loan element plus the expected pofit on the cedit insuance that may be sold as an add on. As the expected pofits fom naive customes ae geate than fom sophisticated customes thee is a subsidy fom naive to sophisticated customes. 3.3 Case C: when unsecued lending and cedit insuance ae sold independently and jointly by mutually owned banks which maximise custome welfae. Fo mutual banks which do not maximise pofit and choose to maximise custome welfae, unsecued lending and cedit insuance may easonably be sold at maginal cost i.e. c 0 fo loans and i i c p v i 0 fo cedit insuance. In this case, expected pofits fom mutual banks ae: fo homogenous customes: c p i pi pi p i v c i 0 (19) s fo sophisticated customes: c p i i i c p p v i 0 (20) 5 Note, s u. D x s s 0 p k 1k p Thus

17 u and fo naive customes: c p i i i c p p v i 0 (21) The mutual banks may not wish to gain fom using a coss subsidy between cedit insuance and unsecued lending fo homogenous customes and customes with diffeing levels of sophistication. While thee ae no clea incentives fo mutual banks to coss subsidise unsecued lending fom cedit insuance, it is possible that mutual banks may still chose to levy coss-subsidies. 3.4 Model pedictions Thee pedictions ae fowaded fom this model. Initially coss subsidies only develop when unsecued lending and cedit insuance ae maketed jointly by popietay banks and customes puchase cedit insuance afte accepting an unsecued loan. These coss subsidies occu in both makets popated by homogenous customes and by customes with diffeing decision making abilities. Theefoe when confonting coss subsidy concens the joint maketing of financial sevices by pofit maximising fims must be amended egadless of whethe customes ae homogenous o ae chaacteised by diffeing decision making abilities. Second, the aggegate level of customes decision making ability will influence the elative costs of unsecued lending and cedit insuance. As the popotion of naïve customes ises, the costs of unsecued lending will decline and the jointly maketed cedit insuance pemiums will ise fo pofit maximising banks. Subsequently it is impotant fo naïve customes to tansfom themselves into moe sophisticated customes though geate financial education. Lastly, popietay and mutual banks ae expected to behave distinctly in makets with joint selling of cedit insuance and unsecued lending. Mutual banks ae less likely to engage in behavios leading to the coss subsidy of unsecued lending by cedit insuance. 17

18 4. Data and Empiics In this section the pedictions fom Section 3 ae examined using a desciptive assessment and thee statistical investigations. The data is povided by Moneyfacts PLC, and epesents the cost of a 5000 unsecued loan epaid ove a 36 month peiod with and without cedit insuance. A ange of fims povide these sevices, including etail banks and building societies (heeafte temed banks); all these institutions ae subject to common egatoy demands when opeating in these UK makets. The cost of the unsecued loan is calcated fom the banks posted ates of inteest. The cost of the cedit insuance is detemined fom a single pemium levied befoe the stat of the loan and the cost added to the pincipal of the unsecued loan. The loan inteest ate and insuance pemium do not conside adjustments to accommodate individual custome isks. Subsequently a minoity of customes with poo cedit atings will pay substantially moe fo loans and as cedit insuance coves epayment of the loan, insuance pemiums. The data is ecoded monthly fo 10 yeas, fom 1 Januay 1998 to 31 Decembe 2007 fo 84 banks offeing 211 joint cedit and insuance poducts. This data epesents the vast majoity of UK joint cedit insuance and unsecued pesonal lending poducts ove the sample peiod and includes offeings to diffeent maket segments such as ca puchase o existing customes. Of these 84 banks, 31 offe lending sevices on behalf of a financing bank and only 53 banks offe poducts independently. The institutional unit of analysis is assumed to be the financing bank, as all poducts financed by a patica supplie ae influenced by this bank. This assumption eflects established industy pactice whee the financing fim fequently sets the cost of thid paty lending. 4.1 Desciptive Data This section outlines the key featues of the data set. Table 1 consides all banks which offe cedit insuance and unsecued loans jointly. Panel A of Table 1 indicates the 18

19 duation that banks have offeed these financial sevices. On aveage poducts have had a maket life of just unde fou yeas with a numbe of poducts featuing fo the entie ten yea sample peiod and othe poducts existing fo as little as two months. On aveage banks have opeated in this maket fo aound five yeas with some paticipants opeating thoughout the entie peiod and one paticipant opeating fo only six months. Panel B of Table 1 shows the aveage numbe of poducts on sale by yea. The numbe of poducts slightly inceases duing the middle of the sample peiod. Panel C of Table 1 indicates the aveage numbe of poducts offeed by banks. The aveage numbe of poducts offeed by individual banks is only 2.19 although one bank offes an aveage of ove 10 poducts. This indicates a skewed distibution with many banks only offeing one poduct and othes offeing mtiple poducts. INSERT TABLE 1 Panel D of Table 1 shows the vaiability of costs ove the poduct ange of individual banks that simtaneously offe moe than one poduct. Fo loans the aveage diffeence between the maximum and minimum cost is (about 3% of the elevant 36 month cost) with the lagest diffeence being (57.75% of 36 month costs) and the smallest being zeo. Fo insuance the vaiations in cost ae popotionately geate acoss poduct anges. The aveage diffeence is o 21.84% of the total insuance (36 month) costs and the lagest diffeence is which is no less than 296% of total insuance costs. Table 2 shows how monthly loan and insuance costs vay ove time. Total monthly lending and insuance costs fall fom an aveage of 199 in 1998 to in Aveage monthly loan costs without insuance also decline fom in 1998 to in By contast, little decline is evident in the aveage monthly cost of insuance which was in 1998 and in When the coss-sectional 19

20 vaiation in monthly costs is examined insuance costs ae obseved to be moe vaiable than loan costs. INSERT TABLE The Testing Famewok The possible coss subsidy between cedit insuance and unsecued lending and the diffeential in the picing of unsecued lending and cedit insuance by popietay and mutual banks ae examined using thee foms of analysis. Fist, a egession based test of coss subsidy is employed. Second a non-paametic anking assessment of the elative costs of loans and insuance is consideed. Lastly picing diffeences between mutual and popietay povides ae assessed using a non-paametic test Banks set loan and cedit insuance costs in a manne consistent with coss subsidy fom cedit insuance to loans. In section 3 we pedict that coss subsidies flow fom cedit insuance to unsecued loans. Futhe these coss subsidies shod be moe ponounced fo popietay athe than mutual banks. The egession test fo coss subsides is based on the expected elationship between the loan cost and the cedit insuance pemium. This pemium shod eflect the expected claim amount payable fom the cedit insuance policy. This value will be popotionate to the emaining monthly loan payments and is theefoe diectly popotionate to the unsecued loan costs excluding insuance. If thee is no coss subsidy between cedit insuance and unsecued loans we wod theefoe expect that insuance cost wod be popotionate to loan cost. Convesely if a coss subsidy does occu, this elationship will be positive (see Appendix A fo a fomal explanation of this expected elationship) Subsequently we examine this elationship using the following egession equation: C it = αp it + i + v it (22) 20

21 whee C it is loan cost, P it is the insuance cost as a pecentage of total loan and insuance costs, i epesents the individual time invaiant andom o fixed effects and v it denotes the emaining eo fo i fims and t time peiods. When the coefficient α is positive a geate popotion of total vaiation in loan costs can be explained by vaiation in the cost of cedit insuance; a cicumstance consistent with coss subsidy of unsecued loans by cedit insuance. When the coefficient α is not significantly diffeent fom zeo, no coss subsidy is indicated. The choice of egession model to be estimated is detemined by efeence to Hausman tests which indicate if time invaiant effects ae uncoelated with the independent vaiables. Following Baltagi (1995) if this hypothesis is ejected then it appopiate to employ a fixed effects within estimato; in othe cases, a andom effects estimato is employed. F and Wald tests ae epoted as diagnostic statistics fo fixed and andom effects estimatos espectively. To accommodate concens with the obustness of these findings and potential omitted vaiable poblems 95% confidence intevals ae also obtained fo the coefficient (α) estimates using a bootstapping appoach with 2000 epetitions. INSERT TABLES 3 and 4 The ests of the egession test ae shown in Table 3 both ove time and fo all banks, mutually owned banks and popietay banks. Fo all obsevations a significant positive coefficient α (α=27.71) is epoted. This povides evidence of elatively ovepiced cedit insuance, unde piced unsecued lending costs and that a coss subsidy flows fom cedit insuance into unsecued loans. When we conside this elationship ove time, the coefficients (α) ae not stable, inceasing initially, but timately declining. This indicates levels of coss subsidy ae educing with time. Mutual and popietay banks also povide distinct ests thoughout the sample peiod. The coefficients α ae lowe and not always statistically significant fo 21

22 mutual banks. This evidence is consistent with mutual and popietay banks setting inteest ates and pemiums using diffeent appoaches and mutual banks being less inclined to coss subsidise unsecued loans using high piced cedit insuance. Anothe fomal test of the coss subsidy hypothesis is made by compaing the ankings of the elative costs of cedit insuance and unsecued lending by bank. Table 4 shows the aveage pecentage of total costs contibuted by cedit insuance. If thee is no coss subsidy the bank with the highest insuance costs shod also have the highest loan costs. In othe wods the ankings of banks when soted by total insuance cost and by total loan cost shod not be significantly diffeent if the existence of coss subsidy is to be ejected. The non-paametic ank sum test ejects the hypothesis that banks with the highest insuance costs also have above aveage loan costs at the 1% level (test statistic = 2.71). Thus stong evidence of coss subsidy between cedit insuance and unsecued loans is pesented, as banks with high insuance costs have elatively low loan costs. A second non-paametic test, epoted in Table 4, tests fo diffeences between mutual and popietay banks. The non-paametic ank sum test ejects the hypothesis that insuance costs have the same pecentage of total costs in both mutual and popietay banks at the 5% level (test statistic = 2.1). This povides evidence that bank owneship significantly affects the picing of cedit insuance and unsecued lending. 4.3 Implications of the ests Initially the ests indicate the need to offe unsecued loans and cedit insuance independently. We find that coss subsidies fom cedit insuance to unsecued loans do occu and theefoe the pohibition of joint selling loans and cedit insuance advocated by the Competition Commission (CC 2009) is justified. This long ecognised solution 22

23 (Shogen 1990) is favoued as it emoves the incentive of banks to coss-subsidise loans fom insuance. Secondly, the incidence and extent of coss-subsidies fom cedit insuance altes ove time. This may indicate customes ae becoming awae of concens with cedit insuance and adapting thei behavios coespondingly 6. It is expected that ensuing pemiums ae payable in instalments athe than as a single pemium at the inception of the loan as advocated by the Competition Commission (2009) will assist such leaning by poviding epeated oppotunities to assess the suitability of cedit insuance policies. Lastly it is impotant to detemine whethe the policy of pohibiting the joint sale of cedit insuance with loans is a measued esponse which cod be applied intenationally. Within this assessment it is impotant to conside the inteests of all customes and not just those customes less able to make infomed decisions (Thale and Sunstein 2003). Following Camee et al (2003) the policy effect of pohibiting joint sales of cedit insuance with unsecued lending is: Policy Effect = k B (1-k) C I + δ (23) whee k is the popotion of naive consumes, B denotes the benefit of the policy change to naive consumes, C is the cost to ational consumes, I is the implementation costs and δ is the change in the pofit of fims due to the policy. The policy change wod be beneficial if the expession has a positive value. Pohibiting the joint sales of loans and cedit insuance wod have a numbe of consequences. We epot that naïve customes lose out fom cuent aangements and pohibiting joint sales shod impove this situation. Altenatively, customes with moe 6 In ecent yeas the scale of the US cedit insuance maket has declined (Dukin 2002); a fall closely linked with media citicism of coecive sales techniques. Media exposue of the cedit insuance poblems has also been identified in the UK. Using a commonly used UK newspape database (Poquest) which ecods aticles published in ten majo national daily and weekly newspapes, the numbe of aticles published on the topic of payment potection insuance has tipled in ecent yeas, fom an aveage of 120 aticles annually between 2000 and 2004, to 314 aticles annually in the 2005 to 2007 peiod. The teno of these aticles has become inceasingly citical and focused on egatoy concens and fim fines. 23

24 efined decision making skills who ae not easily pesuaded to puchase cedit insuance jointly with a loan wod lose out by paying moe fo unsecued loans. Individuals may also suffe though not having puchased cedit insuance if they encounte cicumstances that wod have allowed a claim. Futhe thee may also be a loss of convenience fo customes wishing to puchase cedit insuance with thei unsecued loan. Pohibiting the joint sale of cedit insuance and unsecued cedit wod also educe bank pofits. Requiing that cedit insuance policies be sold independently may lead to advese selection if cedit insuance is sold pimaily to customes making an infomed decision to puchase this insuance. Lastly implementing such egation will involve non-tivial compliance costs. This fom of policy calcus leads us to accept cicumstances whee lage benefits fo individuals who ae boundedly ational ae possible while imposing little ham on those who ae fly ational (Camee et al 2003). Judging whethe such a change is timately justified in this case ests on both how we weigh the inteests of customes less able to undetake puchase decisions, the advese effects of this decision on the majoity of customes and the impotance of copoate concens. 5. Conclusions In this concluding section we biefly summaise the study findings and povide ecommendations fo futhe wok. Within this study we develop a model to show how banks pice unsecued loans and cedit insuance both independently and jointly. The model indicates pofit maximising banks set loan and cedit insuance costs consistent with coss subsidies following fom cedit insuance to unsecued loans when these financial sevices ae sold jointly. Secondly, these coss subsidies shod be moe ponounced fo pofit maximising athe than mutual banks. Thid in the pesence of 24

25 naïve and sophisticated customes with diffeing levels of decision making ability, it is pedicted that sophisticated customes will gain fom the poo decision making of naïve customes. These coss subsidies do not necessaily appea when banks do not pofit maximise. The key implication of the model findings is the impotance of challenging the joint sale of cedit insuance with unsecued lending by popietay banks. This pactice athe than the pesence of customes with diffeing decision making abilities leads to the coss subsidy of unsecued loans by cedit insuance. While impoved financial liteacy will decease the popotion of customes losing out fom this coss subsidy, financial education in isolation will not emove the pesence of coss subsidy in the joint sale of financial sevices. The pedicted coss subsidy is examined using both egession and nonpaametic techniques. The egession analysis indicates the degee of coss subsidy between cedit insuance and unsecued lending is pesistent, albeit deceasing ove time. This finding is also confimed by non-paametic tests. Both appoaches indicate popietay and mutual banks set unsecued loan and cedit insuance costs distinctly and that mutual banks ae less pone to set popotionately high cedit insuance pemiums. To conclude, financial sevices deegation and subsequent joint povision of cedit insuance and lending have advese outcomes fo consumes. Clealy futhe eseach is needed. Extensions to the model cod exploe the ole of competition and bank eputation; the empiical assessment cod be complimented by futue assessments of loan level data. Lastly othe etail financial sevices whee the scale of add-on costs ae substantial such as cuent o checking accounts and motgages equie simila investigation. 25

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