Wednesday, February 01, 2006

Kelly's Korner - The Rule of 78

Can you explain the Rule of 78 and when is it applicable?

The Rule of 78 is used to determine earned and unearned insurance premium amounts when, for example, a loan is prepaid or a customer no longer desires the coverage and requests policy cancellation.

The premium funds are always refunded in reverse cash flow order. In other words, since the lender paid the dealer for the insurance premium, refunds are returned to the lender and applied to the balance of the customer’s loan.

Let’s use a credit life insurance policy to illustrate the Rule of 78:

• The contract premium was $400.00. (I made up the number.)

• The loan period was 60 months.

• The loan has been active for 28 months, 16 days.

• The customer comes into the dealership to request a cancellation since he is trading in the vehicle.

There are Four steps we need to take to calculate the Rule of 78.

Step 1:

[60 (60+1) / 2 = 1830]

Step 2:

Calculate the sum of the digits for the TIME REMAINING. 28 months, 16 days will be considered as 29 months. [60-29=31]

Sum of the digits for the time remaining: [31(31+1) / 2 = 496]

Step 3:

The sum of the digits for the time remaining, divided by the sum of the digits for the original term, equals the percentage of unearned premium to refund to the lender and apply to the customer loan.

[496/1830 = .2710]

Step 4:

Multiply the original premium ($400) by the refund percentage (.2710) to determine the dollar amount to refund to the lender.

[$400 X .2710 = $108.52]

Depending on the state, service contracts can be cancelled using Rule of 78 time. Service contracts can also use the “pro-rata” or “mileage method” to determine the refund amount.

In Oregon and California, accident and health insurance are cancelled according to the “Rule of Anticipation”. All other states use the Rule of 78 to calculate the refund.

Tire and rim protection (road hazard) and roadside assistance policies are typically cancelled according to “Pro-Rata” time.

In all cases, read your policies to identify which method the company utilizes to calculate refunds.

A cancellation fee may also apply to service contracts and road hazard products. Be sure to locate this information in the policy so that you can inform your customer. Cancellation fees do not apply to credit life policies.

Obtain the customer’s signature to authorize a policy cancellation. Send the refund to the lender unless the customer can verify that the loan is satisfied and the refund should go to the customer.

Refunds represent a loss of revenue to the dealership and to the insurance company. Accuracy and verification will count.

“Kelly’s Korner” Column, OIADA Squeaky Wheel Newsletter, January 2006, p. 33