Shelley Embley of Leicester paid pounds 398 for insurance on the loan.
The lender was a finance house, Associates Capital Corporation, and the policy underwritten by Cumberland Insurance, a related business at the same Windsor address.
Ms Embley had believed the policy's redundancy terms gave her protection when she lost her job as a shop assistant in January.
But the insurer informed her that she was disqualified because she worked two evenings a week in a pub. The bar work paid her just pounds 14. Cumberland Insurance has since agreed to meet her loan repayments, and she now hopes to receive back- dated benefits of pounds 170.
Consumer and trade organisations have received many complaints about credit protection insurance. Next month the Finance and Leasing Association, which represents more than 100 finance houses, will include clauses in its code of practice to ensure that people are given information about the nature of cover and the likely cost before they purchase the policies.
Ms Embley said: 'In November last year I took a loan out to cover my poll tax, hire purchase and store card debts, so that I was just paying one thing instead of several, and I took out insurance as well. 'When I came back from my holiday in January I was told that I had lost my job. When I went to the insurers they told me they wouldn't cover it because I was earning pounds 14 a week for the pub work.'
Neither the insurance nor the loan was cheap. The total cost of a pounds 1,470 loan was almost pounds 3,064 to be repaid over a three-year period at pounds 85.10 a month. It comprised a three- part package of cash loan, refinancing of existing credit agreements, a loan to pay the insurance premium to cover payments in the event of unemployment, and separate life insurance. The insurance required a lump-sum premium, which was added to the loan.
The refinancing of existing debts of just over pounds 1,101 was charged at 41.9 per cent APR. An additional cash loan of pounds 368.77 was charged at 48.3 per cent APR.
The loan for the insurance policies cost pounds 397.87, the bulk of which was for the redundancy policy, and the APR worked out at 42 per cent.
Ms Embley realised the loan costs were high. 'I think the APR is pretty disgusting. I feel I was taken advantage of - I was in dire straits,' she said.
She said she had notified Associates Capital Corporation of her part-time bar work when applying for the loan.
On return from holiday to find she had no job, Ms Embley informed Associates accordingly. The company informed her verbally that her part-time work invalidated the cover - though over a month later she had not been notified of this decision in writing.
Last month she consulted the Consumer Advice Centre in Leicester. The CAC confirmed that the insurer's decision was technically correct. The policy stated that benefits arising from redundancy became payable only if the insured was 'totally unemployed', which meant 'being entirely without gainful employment'.
A CAC adviser, Joan Mitchell, felt the decision was harsh and 'outside the spirit of the policy', and wrote to the insurer to that effect.
In Cumberland's reply the claims manager said: 'You will note that under the redundancy insurance benefit clause, benefits only become payable if the insured debtor is totally unemployed. As this is not the case with Ms Embley, I am afraid no benefits can be paid.'
Cumberland has now agreed to make a more lenient interpretation.
Associates' company secretary, Mike Hall, said that in his view the interest rates charged by the company were reasonable.
'We charge between 23 and 42 per cent according to the type of loan and level of risk. APR is an artificial calculation as it includes administration charges.'
Ms Mitchell said: 'It is probably not extortionate, but it is unreasonable, especially when interest rates have been coming down.'
Ms Embley has received more good news. On the same day that her insurance claim was approved she was offered another job.
Others in the same situation might find their insurer less willing to bend. A spokesman for the Association of British Insurers said: 'It depends on the policy wording, but this wording is fairly common and would have to be observed.'
People buying policies needed to be 'very clear' about the wording.