A trade-in guarantee program, when first viewed, may look like a lease-end, keep-the-vehicle value program for purchased vehicles. The basic promise is simple enough: an obligor promises the vehicle buyer a minimum resale value if the vehicle buyer replaces the vehicle during a specified replacement time window.

Trade-in guarantee programs, however, are marketing programs. In addition, the actual guaranteed trade-in value may be the least important factor in estimating the expected loss cost and in determining the wholesale cost the obligor will charge the provider for making the contractual promise.

If the vehicle buyer’s actual trade-in value at replacement time is more than the guaranteed trade-in value, the vehicle buyer receives the actual trade-in value. Otherwise, the vehicle buyer receives the guaranteed trade-in value, and the obligor pays the difference between the two values. Examples are shown in the following chart.

The complimentary version has no identifiable charge to the vehicle buyer, so it is a clear win-win decision for the vehicle buyer. A provider like an original equipment manufacturer (OEM) or lender can likely obtain an insured program for $300 or less if the provider is adding the benefit on all vehicles or loans, or a specified subclass.

The optional version presents the provider with degrees of cost recovery or even a profit on the sale, but the underlying motivation remains a marketing opportunity. As with most F&I protection products, the obligor “buys the product wholesale and sells it at retail.” The wholesale cost can range from $300 to $500, depending on the terms and conditions, the maximum benefit available, and the volume of anticipated sales. The provider ends up with a no-cost or low-cost product that has real marketing potential.

One optional approach is to treat the program as a typical dealership F&I office protection product, but this means a retail price similar to GAP.

Possible Providers

Possible providers include OEMs, dealerships, direct lenders, and indirect lenders.

The most obvious of possible providers is the OEM.

Hyundai released the newest component to its Hyundai Assurance protection package on May 1, 2011. A complimentary trade-in value guarantee is provided on all new 2011 and 2012 vehicle purchases (not leases or fleet sales). The ad campaign kicked off during the NBA playoffs and was another masterful commercial in the same league as the original Hyundai Assurance “walkaway” component in 2009. The 30-second commercial leaves one word in the viewer’s mind—GUARANTEED. The Hyundai program is administered by Interstate National Dealer Services.

Another OEM program has recently been created for a comparable soon-to-be-released complimentary promotion. This program was designed by Brian Olson, Kenny Olson, and Tony Wanderon of TradeCycle Management/Family First Dealer Services (TCM/FFDS) using its TradeLock trade-in value guarantee product. TradeLock is administered by cynoSure Financial, Inc. and insured by a residual value insurance carrier.

Since 2009, Subaru of America has offered a slimmed-down version of a trade-in guarantee. The Subaru dealership will provide the customer with a guaranteed trade-in amount if the customer trades in a pre-owned Subaru on the purchase of a new Subaru.

A dealership is the next provider candidate. The dealership has the option of a complimentary program or an optional program. “There are challenges entering the F&I office that already has established programs,” said Brian Olson of TCM/FFDS. “But when dealers see the demand from consumers wanting programs that hit home with current media trends, like protecting resale values, these programs quickly become standard practice. In addition, these programs can be made available on cash purchases, opening up new opportunities for the dealers and OEMs.”

A direct lender, such as a credit union, is a clear potential provider because it presents the lender with a direct method to bring the vehicle buyer back to the lender during the repurchase phase.

An indirect lender is also a potential provider of a complimentary product, but the promise probably will require a dual trigger of the buyer returning to the same dealership and the dealership then placing the replacement purchase financing with the same indirect lender.

Large national indirect lenders may be able to make a unilateral lender-only promise requiring only that any replacement dealership place the replacement purchase financing with that indirect lender.

Relating Terms and Conditions to Marketing Goals

As with all obligor promises, the product designer can specify the exact benefit, the terms, and conditions for qualifying for the benefit. Now that a few programs are being marketed, administrative/marketing organizations, obligors, or insurers have current programs to start with and then modify.

Today’s marketplace programs contain conditions that serve specific marketing goals. For a dealership, dealer group, or OEM program, these are some of the conditions and goals they serve:

• For complimentary programs, the vehicle must be bought during the promotion period.
• For the current sale transaction, the trade-in guarantee serves to counter the vehicle buyer’s purchase objection that the OEM’s/make’s historical or prospective resale values are a concern to the vehicle buyer.
• The trade-in value applies to a specific time window for the replacement purchase. This period can be set with the goal of advancing the repurchase time cycle.
• The vehicle buyer must return to the provider to purchase the replacement vehicle.
• The vehicle buyer must have all scheduled maintenance performed, AND the maintenance must be performed at the provider’s dealership(s). The goal is to improve dealership service revenue and to raise dealership, dealer group, or OEM absorption rates (the percentage of dealership overhead covered by gross profit from service and parts).
• The replacement vehicle must be a financed purchase through provider-arranged financing or for an OEM, possibly a captive financing arm.

For a lender, similar conditions and goals apply, but the primary goal is to be the first stop when the vehicle buyer begins the search for the replacement vehicle. Various versions and new options are just now being explored. The lender may be the sole provider, or there may be various combinations of lender plus dealership, dealer group, or OEM. Some of the dealership program requirements, such as performing all scheduled maintenance, may be retained to control loss costs even though the lender does not have a specific marketing goal in mind.

Loss Frequency and Severity

The development of the loss frequency contains some or all of the following components:

• Probability that the vehicle will be in service during the qualified replacement time window and will not be disqualified (e.g. commercial use), multiplied by
• Probability that the vehicle will be traded-in on a qualified replacement vehicle during the qualified replacement time window, multiplied by
• Probability that the vehicle buyer will return to the provider for the replacement vehicle, multiplied by
• Probability that the vehicle buyer will have performed scheduled maintenance at the specified service provider, multiplied by
• Probability that the vehicle buyer will finance the replacement at the qualified financing source, multiplied by
• Probability that the vehicle buyer will remember the protection, and THEN multiplied by
• Probability that the guaranteed trade-in value will exceed the appraised value.

Finally, the average loss severity must be determined. This can be done by high-powered modeling, but by this point, a conservative estimate will likely serve for pricing purposes.

The Age-Old Concern

Many thoughts go through the mind of the potential vehicle buyer. Purchase criteria focus on the vehicle’s benefits and costs during the period of ownership, but the vehicle’s trade-in value often makes an appearance in a buyer’s list of top 10 criteria.

Most buyers have a repurchase horizon of four to seven years, and hope that the vehicle will be the foundation of that next purchase. From the dealer perspective, a repurchase horizon of three to five years is a bit more appealing. So, any protection product that improves the likelihood and appeal of an accelerated trade-in cycle has real value to the dealer.

The Negative Equity Concern

Even if the current buyer arrives at the dealership without existing negative equity, almost every financing buyer faces some period of negative equity. New-vehicle buyers accept the substantial first-year depreciation, but a lurking concern is that the value of the vehicle will depreciate faster than the debt is being repaid.

Nothing squelches a buyer’s trade-in fantasies faster than the specter of negative equity. And then, there are the 30-plus percent of finance buyers who bring a fair chunk of negative equity to the current transaction and have a deeper hole to climb out of.

The importance of this concern is demonstrated every day by the high acceptance rates (30-plus percent) of GAP waiver protection (or GAP insurance). GAP was not on the F&I menu 10 years ago, but is now a staple of the F&I protection suite.

A total loss is just one form of trade-in. With GAP protection, the vehicle buyer has a chance to enter this involuntary trade-in process on an even keel. GAP takes care of the one percent of vehicle buyers who experience a total loss at a time of negative equity during a vehicle’s period of ownership.

A Different Triggering Event

How can we protect the other 99 percent of vehicle owners from negative equity at trade-in and build/make dealer loyalty in the process?

The traditional answer is a lease. It provides residual value protection at a specific point in time, such that the lessor knows that a “trade-in” can occur at a specific “trade-in” price. At the lease termination date, the lessor can close the lease with zero equity or purchase the vehicle at a stated price. Lessors’ dealer loyalty is strong, but the terms of most leases are shorter than most new-vehicle buyers’ next purchase window.

Can we design a protection product that will eliminate any existing negative equity by defining the protection’s triggering event as the point when the owner is willing to purchase a new vehicle? Can we provide the protection over a wide trade-in time window, yet nudge the vehicle owner earlier in the trade-in cycle? Despite there being some terms and conditions on the protection, it is economically feasible with buyer-acceptable underwriting controls.

Two options are now available in the marketplace today:

1. A complimentary protection product where the cost is absorbed by the dealer, lender or manufacturer (OEM).
2. A voluntary product purchased by the vehicle buyer. Either option can be provided on specific vehicle make(s) or model(s).

The 2009 GM Total Confidence Program

For sales during April 2009, GM provided a complimentary protection product that made the following basic promise, subject to various other terms and conditions:

IF you buy a new GM product during the sale period, excluding certain models … AND you finance your purchase under a conventional, fixed-term loan with a term of 72 months or less and a loan-to-value that does not exceed 110 percent AND you make at least 50 percent of your loan payments on time AND at least 50 percent of your loan term has passed AND you buy a new GM vehicle from a qualifying GM dealer,

THEN the administrator-obligor will pay you the amount by which the balance of your trade-in vehicle loan exceeds the NADA clean retail value of your vehicle, up to $5,000.

In other words, GM (via the administrator-obligor) agreed to cover the buyer’s negative equity up to $5,000 if the buyer traded in the protected first-purchase GM vehicle on a new GM vehicle after more than one-half of the vehicle loan term had expired.

Trade-In Protection (TIP)

The concept is currently marketed by TradeCycle Management to OEMs, lenders and dealers on both a complimentary and optional basis. Its administrator-obligor is cynoSure. The administrator-obligor promises are backed by a commercial contractual liability insurance policy issued to cynoSure by Wesco Insurance Co., a member of the AmTrust insurance group.

As with any obligor program, the underlying protection product starts with a blank sheet of paper. The underlying promise, along with the various terms and conditions, can materially affect the cost of the protection.

The GM terms and conditions are certainly a good starting point. The underlying promise meets the buyer’s desire to have a viable trade-in opportunity during the buyer’s traditional trade-in cycle window while offering the dealer the opportunity after one-half the loan term has passed to initiate a next-purchase/trade-in call with an approach such as, “Good news, don’t forget that you are now eligible to trade in your existing vehicle now without worrying about negative equity.”

A complimentary program comparable to the GM program can be provided to the dealer for about $300 per vehicle, assuming the dealer (or OEM) places the protection on a “blanket basis.” An optional program’s dealer cost will be higher due to the lower volume of protected sales, and the retail cost to the consumer will include a dealer markup.

Lenders Can Do This, Too

If the current purchase is financed under a retail installment sales contract, an indirect lender could include a debt cancellation TIP loan addendum comparable to the dealer’s TIP promise; e.g., “if you return to this dealer, trade in this vehicle and that loan is “sold” to this indirect lender….” This is a bit of a stretch, but such a program is possible.

Alternatively, the promise could be an administrator-obligor promise. (A debt cancellation addendum is a lender-obligor promise to cancel part or all of a debt if the contractual conditions are met.)

A more viable approach is available to direct lenders, such as banks and credit unions that are not active in indirect lending. Here the promise becomes more straightforward: “if you return to us (the lender) to directly finance your replacement purchase….” This promise can also be a debt cancellation loan addendum or an administrator-obligor promise.

In either situation, the lender can insure its contractual promises under a commercial contractual liability insurance policy.

In the early 2000s, manufacturer warranties were 36 months or longer and some manufacturers had begun to extend the base warranty further but limited the extended protection to the powertrain parts.

The original Limited Lifetime Powertrain Warranty (LLPW) concept was developed primarily for the Japanese makes. At that time, Toyota and Honda dealers were trying to hold the line on MSRP in the face of significant discounting by the American makes.

Also, they did not want to compete in a local market with other same-make dealers based on price. Having a program like LLPW would allow the Toyota/Honda dealers and others to have a distinguishing edge without compromising on the sticker price.

The idea of providing a complimentary extension beyond the new vehicle manufacturer’s base and extended powertrain warranty began to take shape. Given the manufacturer warranty protection, another extension had to be inexpensive. The marketing team got excited: “Should we go to seven years, 10 years? Wait, how about a lifetime powertrain warranty? What could be better than a lifetime extension?”

The idea went beyond the marketing team, but the wet-blanket actuaries and risk managers threw cold water on the deal. It wasn’t pricing that presented the challenge; in fact, with fairly reasonable contractual provisions, controls and requirements, the underlying loss cost for a new Toyota or Honda was only about $50.

The problem was risk management. The new-vehicle buyer is told that if he meets the manufacturer’s maintenance requirements (and keeps meticulous records of compliance), he has powertrain coverage as long as he owns the vehicle.

The actuaries could project the pattern of when the exposure to loss would likely decrease, but how would the risk taker ever know if a particular vehicle owner no longer had protection? No vehicle owner would send an email saying, “Oops, I have not changed my oil in a year, you can take me off the active list,” or even, “You can quit worrying about me, I sold the vehicle today.” When do you ever get to take the reserves down?

It was Chrysler’s entry into the LLPW market in 2007 that appeared to give the concept a real future. Chrysler needed a sales boost, so it chose to include it on most new Chrysler vehicles.

Recognizing the need to bring closure to the loss exposure and always looking for an excuse to become reacquainted with the customer, Chrysler added the “every five years, return to the dealer” inspection requirement.

Within 60 days of the fifth-year anniversary, and every five years after that, the customer simply had to return to a Chrysler dealer for a complimentary inspection. Without complying with the inspection requirement, all coverage and loss exposure ceased. Chrysler could hardly take any of the reserve down for five years, but at least at the five-year anniversary it had a clear count of the remaining exposure and a chance to spend some quality time with a customer about the time that customer might be considering a replacement vehicle.

With the “five year, return to the dealer” requirement in place, several insurers were willing to insure the promise with a contractual liability insurance policy if the dealer would provide the protection on a complimentary basis. The dealer price for a new vehicle was about $200; a lot of cost to put on every vehicle sold just for the benefit of an unknown number of marginal sales decisions, the opportunity to pick up some additional scheduled maintenance visits and a nice long chat every five years.

GM followed suit for a short period, then thought better of the idea. Chrysler continued its program until early 2009, leaving the concept to be offered occasionally by individual dealers.

Rick Case was featured in an Automotive News story regarding a dealership promise to extend the Hyundai/Mitsubishi 10-year/100,000-mile powertrain warranty to 20 years/200,000 miles.

Given the basic requirements to qualify for a claim under the protection, it is likely that the dealership cost for that contractual liability insurance policy from Protective was inexpensive.

How Does a Warranty Differ from a Vehicle Service Contract?

Warranties are regulated at the federal level by the Magnuson-Moss Act. The principal constraints placed on a warranty are that (1) there cannot be any identifiable charge to the buyer for the warranty promise and (2) the protection must be provided to all buyers.

Most warranties are manufacturer warranties. The original manufacturer can warrant its products from defects and promise to repair or replace any defective part or product. Anyone in the chain of distribution can warrant a product that the wholesaler/retailer/dealer sells.

Finally, Magnuson-Moss permits third-party warranties. A party unrelated to the manufacture or sale of the product can agree to warrant a product. In many cases, the LLPW is a dealer-obligor promise backed by a contractual liability insurance policy or, in some cases, an administrator-obligor promise backed by a contractual liability insurance policy.

Pricing for New-Vehicle LLPW Contracts

The underlying risk is the failure of one of the listed powertrain parts. For ease of understanding and administration, the powertrain coverage is defined and described as being identical to the definitions and coverage in the manufacturer’s warranty or the extended powertrain protection.

Loss frequency and loss severity are actually fairly straightforward to determine. For manufacturers, they know the loss frequency and severity for the manufacturer’s base warranty, the manufacturer’s extended powertrain warranty and likely have experience through at least seven years of ownership drawn from VSC loss experience. Projecting beyond seven years is a straightforward task.

For insurers, the experience associated with the manufacturer’s warranty period is not needed since that period is excluded from the LLPW exposure. The insurers have access to extensive VSC loss experience and could project forward through 20 years of ownership.

The challenge is projecting the loss exposure. Start with 10,000 sales this month. For every month over the next 240 months, how many vehicles still meet the requirements to qualify for a claim if a covered part fails? The conditions for staying eligible for five or more years are reasonably tough to meet:

Coverage is only provided to the original owner.

Coverage excludes any repair covered by the manufacturer’s warranty.

Coverage excludes any repair covered by an optional VSC.

And, most importantly, the owner must fully comply with the manufacturer’s scheduled maintenance plan and must keep records to support that compliance. The easy way to comply is to return to your original dealer who has graciously consented to keep meticulous records for you.

The pricing for LLPW is complex, but the best news is that the probability of a claim in the first five years is limited. Many manufacturer warranties have powertrain coverage up to 5 years/60,000 miles and at least 30 percent of the buyers will have purchased a VSC, thereby taking the no-LLPW-claim window up to 7 years/100,000 miles. Vehicles are sold, stolen, totaled and taken out of service for other reasons. We are still waiting for the tally of customers who satisfy the “every five years, return to the dealer” inspection requirement to see how much exposure remains from the early adopters of the LLPW concept.

A few insurers continue to be willing to insure LLPW for new vehicles and several now have programs available on used vehicles. The challenges a dealership faces today are far different from the heady days of 2006-2007.

The per-vehicle cost of LLPW is daunting, but an occasional dealer is willing to take the plunge, at least for a while, to test the marketing power of the concept.