What is insurance?

When you borrow to buy a home, vehicle, equipment or commercial property, the lender takes a security interest in that asset. If the asset is damaged, destroyed or stolen, that security is at risk, so most finance contracts require you to keep adequate insurance for the life of the loan. Letting cover lapse can itself trigger a default.

The cover required depends on the asset and the finance option. A vehicle financed with a chattel mortgage, hire purchase or car loan needs comprehensive motor insurance; for equipment finance the lender wants cover that suits the asset: machinery or plant insurance, or a broader business policy that covers the financed equipment. The lender's interest is noted on the policy as "interested party" or "loss payee", so the insurer notifies the lender if the policy lapses and pays claims to the lender.

Lenders mortgage insurance (LMI) is required by most home loan lenders when the borrower's deposit is small, usually less than 20% of the property value. It protects the lender, not the borrower, against loss if the borrower defaults and the property sells for less than the debt. The borrower pays the premium, either upfront or capitalised into the loan. After paying the lender's loss, the insurer can seek to recover that amount from the borrower, so LMI does not cancel the debt.

Consumer credit insurance (CCI) covers your loan repayments if illness, injury, involuntary unemployment or death stops you paying. It is optional and has drawn regulatory scrutiny: ASIC found some CCI products offered poor value and were sold using pressure tactics. The usual check is whether income protection, life insurance or savings you already have would cover the repayments anyway.

Residual value insurance protects a lessor against a shortfall between a leased asset's expected residual value and its actual market value at the end of the term. It is used in operating leases and fleet leasing and is typically arranged by the lessor, not the lessee.

Trade credit insurance protects a business against customers not paying. It is not tied to a loan, but it strengthens the receivables that back invoice finance or a working capital facility, which reduces the lender's credit risk. Key person insurance may be required for a business loan where the business depends heavily on one or two people; if that person dies or is incapacitated, the proceeds help repay the loan or carry the business through the transition.

Most finance agreements spell out the insurance conditions: keep comprehensive cover for the full term, note the lender as interested party, meet any minimum insured value, and provide a certificate of currency at settlement and on renewal. You usually cannot cancel, reduce or materially change the policy without telling the lender. For vehicles, the lender may recommend or require gap insurance, which covers the difference between the insured value and the finance balance if the car is written off.

Insurance is a real cost of borrowing. LMI can add thousands upfront, asset premiums vary with the asset's type, value, use and claims history, CCI premiums are usually added to repayments, and a higher excess lowers the premium but raises what you pay on a claim. Asking your broker to include insurance in a finance comparison shows the total cost.