Author Archives | Kerper Bowron

Considerations When Designing New Products: An Update

Considerations When Designing New Products: An Update

Working in the F&I industry stays interesting because of the great products that our industry continues to develop to meet the needs of the public. In 2011, we wrote a short article on developing new products. Since that time, the amount and complexity of new products in the F&I space has only increased.

In developing a new product, there are, of course, many issues regarding such concerns as policy language, pricing, marketing, and systems. We want to focus on some general considerations when developing a product from a pricing and accounting standpoint. Let’s tackle the subject in FAQ format.

Do I Have Any Claims Experience?

Obviously, if you have related claims experience, it can be of tremendous help in determining the potential exposure for your product. Industry experience can be helpful. Census data, crime statistics, and data designed for the auto industry can help solidify assumptions.

How Is the Product Marketed?

Similar products can have vastly different claims experiences depending on how they are marketed. Will the product be marketed to new buyers or to current owners? Is the product marketed at the dealership or direct marketed? What is your expected pricing?

The amount of money that a consumer pays can impact claims consciousness as well. A low-price product will have lower awareness.

Embedded products, which are part of the sale of every applicable item and not charged separately, are increasingly popular. These products typically will have a much lower claims rate. This may be due to consumer’s forgetting about the benefit since they didn’t explicitly pay for it.

A great example of this is that many credit cards include protection for items bought within a certain period. Have you ever made a claim for an item bought on a credit card? Do you think you could have?

How Am I Going to Earn the Premium?

This is a critical assumption for evaluating early experience. Claims occur on F&I products at vastly different rates depending on the product. Some products (even profitable ones) have an initial surge of claims as the buyer may seek to repair some preexisting issues that cannot be fully excluded. Never assume that exclusions can prevent all claims.

To evaluate the experience correctly, you must earn the premium in the same ratio as the claims flow. You may need to earn premium differently for accounting and refunding than you do to evaluate the program. While earnings are necessarily subjective, be careful to use your best estimate.

Some programs, such as lease wear-and-tear, will have virtually no claims experience until the contract is at, or near, the end. You may want to make more careful assumptions about these products because once you see the results you may have a large amount of unearned exposure.

How Will I React to the Results?

Everyone who develops a product expects it to succeed. Don’t let your prior assumptions blind you to the results in your book!

Most F&I products are relatively high-frequency/low-severity products that reach credibility in a short amount of time. If you are earning your exposures correctly (see above), your results could be actionable in a few months. Plan on frequent monitoring after the product launch to ensure that the program is performing to your expectations.

Divide the experience into months or quarters by policy inception date and examine the experience of the most mature contracts carefully. For example, if you expected a “claims surge” for the first few months after the sale of a product, are you seeing the claims from your oldest contracts dropping? If not, you may need to reevaluate your assumptions.

If an Insured Makes a Claim, Will They Be in a Better Financial Position?

Most insurance products operate on the premise that the insured will not be better off financially after a claim. For example, auto insurance will pay the actual cash value of your car. In theory, you could go out and buy the same model car with similar mileage. You cannot buy a brand-new car.

Some products, such as GAP insurance, improve the customer’s financial situation. If you have a GAP claim, the negative equity in your vehicle is erased. A similar example occurs in homeowner’s insurance, which typically offers “replacement value” for your house and contents. If a fire destroys your house, you will receive new furniture and clothes — not the old stuff you had.

These insurance products work because the vast majority of people do not wish to have a fire or a car wreck, even if it improves their personal balance sheet slightly. However, you can expect that these types of products will have higher claims because there are always a few people who will use the product to their advantage.

Will the Claims Be Correlated With the Economy?

For most products, this is not true. Unexpected repairs and collisions are examples of random events. While certain people and certain vehicles may be more likely to have a claim, in general, the claims among similar risks are random.

However, this is not true for all products. Some products will show a higher propensity of claims due to the economic environment. This type of risk can occur when insuring the underlying value of an asset, such as with GAP or residual value insurance. If the used car market shows a big drop in prices, the likelihood and severity of claims will increase across the board. If your product is correlated with the economic environment, be prepared for a wide range of results depending on the conditions of our economy.

New products are what make the F&I business one of the most exciting places in insurance for product development. While the considerations listed above may give you pause, we encourage our industry to continue to develop products which meet the needs of all participants, by providing peace of mind to the buyer and an adequate return to the underwriter and business partners.

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What’s Going on With GAP in 2017?

What’s Going on With GAP in 2017?

In August 2016, Chris Stoll of Allstate and I gave a presentation at the P&A Leadership Summit on GAP. At the time, we noted that GAP losses were up significantly and thought that the trend would continue, due to the underlying factors that are driving up GAP results. Attendees of this year’s conference are asked to join me for a session reviewing what has happened since our last meeting.

Before discussing the trends in GAP, it is important to realize that GAP is a very leveraged product! As the example below shows, changes in asset prices will have a much larger impact on GAP losses.

In this example, the value of a total loss settlement is shown at $15,000 with scenarios of +/-10%. The impact on GAP losses is about five times as much. So a used-car price decrease of 3% might have a 15% impact on GAP prices.

In the past, this has led to conditions which made GAP underwriting very profitable as well as very unprofitable. The instability is a feature of the product. We shouldn’t expect GAP pricing levels to be stable. Volatility and price changes are the norm for GAP insurance.

Recently, we have seen trends in asset prices, financing and the underlying used-car market.

Asset prices: Information from Cox Automotive indicates that retention values for the latest three model-years have declined over the past two years, but at a moderate pace. Type of car is critical. Smaller cars have performed much worse than the pickup and SUV market. This is due to consumer preference as fuel prices have declined.

Financing: Delinquency rates have increased for subprime loans but have been fairly stable for good credit scores. This is important because a tighter financing market will mean less negative equity financed and, ultimately, lower GAP losses.

Underlying physical damage trends: These have remained at historic highs. Frequencies have increased likely due to an increase in miles driven in an improving economy as well as distracted driving. Technology and lighter, more expensive materials are driving up parts costs at a dramatic rate. As severities increase, physical damage insurers will declare cars as total losses and simply pay the market value.

Simply put, a lot of the cost of a car is being pushed from the engine to the outer edges as the replacement cost for these sensors, cameras, and lightweight materials are very high.

So what could stop GAP losses from increasing? The underlying trends still point to higher GAP losses in the future. Some events that might slow or reverse GAP losses would include:

  • Tighter financing, which lowers the loan-to-value ratios on vehicles
  • An increase in used car prices, which is somewhat unlikely in the near term with the large supply of late model vehicles in the vehicle supply
  • An economic contraction which decreased physical damage frequency due to fewer miles being driven
  • Better technology on crash avoidance
  • A lowering of parts prices, perhaps due to increased availability of aftermarket parts for late model vehicles.

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Does the IRS Notice 2016-66 Impact You?

Does the IRS Notice 2016-66 Impact You?

The IRS sent a notice, 2016-66, which requires filings by entities which meet specific requirements. These entities may include dealer- or producer-owned reinsurance companies, as well as the dealership itself and the owners of the dealership.

Originally, the filings were due by Jan. 30, 2017 but the IRS extended the deadline to May 1, 2017. Let’s take a moment to answer some frequently asked questions about Notice 2016-66.

1. Why Is the IRS Making Me File This?

For decades, dealers have owned reinsurance companies which have reinsured some or all of the risk on the F&I products they sell, including vehicle service contracts, GAP and other products. Most of these companies use the 831(b) election for their reinsurance company (which changes the taxation).

In 2015, Congress passed legislation which increased the limits of the 831(b) election from $1.2 million to $2.2 million (for 2017 and indexed for future years) in premium each year. In addition to this, there were other provisions related to 831(b) companies, including authorizing the IRS to require this disclosure.

Over the past few years, other companies have started insurance companies using the 831(b) election. Typically, in these cases, the companies are insuring their own exposures such as loss of key contracts, litigation risk and cyber risk (among others).

The IRS is concerned that some of these transactions may be abusive. While there are several cases in litigation, it has not generally been found by the courts at this time that companies insuring their own risk in this way is abusive.

While the IRS does not appear to be focusing on dealer-owned reinsurance companies, these companies are utilizing the same portion of the tax code and may fall under the provisions of the notice.

2. Do All Dealer-Owned Reinsurance Companies Need to File?

Our interpretation is that companies that have the following conditions will need to file the 2016-66:

  • “Dealer Obligor” business (further discussed below), and
  • Common ownership between the reinsurance company and the dealership, and
  • Loss ratios (the ratio of losses to premium) under 70% for the covered period or loans by the reinsurer to related parties.

Dealer obligor business are contracts for which the dealer would be legally required to pay a claim in the absence of a contract. One example is GAP waiver contracts, where the dealer agrees to pay the balance of a loan under certain conditions; namely, the vehicle being declared a total loss by an auto insurance company).

Of course, the dealer is really never under obligation to pay the loan, since these types of contracts are always insured. But, technically, the risk is passed from the consumer to the dealer and then to the insurance company and then back to the dealer in the form of reinsurance.

Another example is limited warranty contracts. These contracts are typically marketed and placed on every vehicle sold by the dealership (or a significant segment like all new vehicles). The customer does not “opt in” to the transaction. The dealer is simply warranting the product to the customer under certain conditions.

Once again, the risk passes from the customer to the dealer and then to the insurance company and finally back to the dealer again through the reinsurance company. In this case, the insurance product may not even be required — if you sell a car, you can warrant it however you wish — but these types of warranties are typically insured.

If your reinsurance company has engaged in these types of transactions, we feel that it would be wise file the 2016-66.

3. What About Dealerships and Dealership Owners?

If the reinsurance company and the dealership have 20% or more common ownership, the dealership and all dealership owners must make a separate disclosure. A participant (including reinsurance companies, dealerships and dealership owners) who fails to make the required disclosure may be subject to a penalty of up to $50,000.

The 2016-66 notice has caused some concern and confusion among the F&I community. We feel that the concern is not warranted as the accounting and tax positions for dealer owned reinsurance companies have been established for a number of years. The confusion is real because interpreting an IRS notice with no precedent is always difficult. We feel that it is better to be safe than sorry and make a protective disclosure if you might meet the conditions of the notice.

Of course, you should engage your own professionals for legal and accounting advice as it relates to this notice. Nothing in this article constitutes legal, accounting or tax advice, or a representation that any position is suitable or appropriate to your situation.

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What’s Going On With GAP?

What’s Going On With GAP?

If you follow GAP, you may have noticed that many companies are seeing dramatically higher losses. What are the reasons this is happening?

First, we need to know how we got here. After the financial crisis, loss ratios were historically low, due to the combination of robust used-car prices and restrictive financing. In other words, consumers couldn’t finance much more than the car was worth and the vehicle wasn’t depreciating as fast as in the past.

This double benefit had industry loss ratios for GAP insurance below 20%. Note that industry results aren’t available for the more common GAP waiver. In 2014 and again in 2015, those loss ratios increased by a large margin, and it is likely that we will see another increase in loss ratios in 2016. Why is GAP suddenly so unprofitable?

The Used-Car Effect

The used-car market is the basis for the settlement of the physical damage and the most important factor in determining the value of GAP claim. A 1% decrease in the used-car index will imply a 6% increase in GAP claims, based on our research.

The good news is that, overall, used-car prices are at a high level and have not seen significant deterioration in the last five years. However, some segments, such as compact cars, have seen dramatic decreases. According to Manheim Consulting, the average price of a compact car has fallen 11% in the last 18 months. This type of decrease will cause a large increase in GAP severities for this type of vehicle.

Predicting the future value of used cars is difficult, but there are signs that a decrease could be coming. The increasing number of vehicle sales will increase the number of late-model used cars. This is especially a factor when leasing rates are high since the majority of these cars will be back on dealer lots in a few years. For example, industry data shows that leasing returns will increase around 40% by year-end 2018. What will this additional supply of vehicles do to pricing?

Financing Trends

Another important factor is the financing market. As lenders allow more negative equity to roll into loans, the potential gap increases. Companies should track the ratio of loan-to-vehicle value in their books. It is likely that business originated in dealerships will have wider credit swings than those generated by financial institutions.

There is some evidence of increasing loan-to-value ratios. In their Spring 2016 Semiannual Risk Perspective, the OCC specifically noted the increased risk to lenders from increased loan-to-value ratios. The impact of increasing LTVs is easy to see, since all of the increase will, at least initially, be covered by the GAP contract.

An important consideration when examining credit information is that this occurs at a time of the vehicle purchase and not at the time of the claim. So there is a delay between the credit market and the impact of GAP claims, while changes in used-car prices will impact GAP claims instantaneously.

Therefore, if the loss ratio increase is mostly on the most current business written, it might be due to financing considerations while broad based increases may point to higher frequencies, repair costs or a downturn in used car prices.

Propensity of Total Losses

All GAP claims begin with a total loss occurrence. A total loss is dependent on both a triggering event (a physical damage claim) and the determination of a total loss by the insurance company. There is evidence that both of these are on the rise. What would cause the amount of total losses to be increasing so much? This will be the subject of a feature article in a later issue.

The increase in GAP losses is due to combination of several factors, including underlying loss frequency and severity, financing and some disruption in the used vehicle market. Some of these changes may be structural, such as higher repair costs resulting in more vehicles being deemed total losses. This will not likely abate in the near term.

Used-car prices, which have remained high, are an additional concern since a lowering of used-car values would only increase pressure on the GAP market. Aggressive financing continues to be a concern as well. Those factors, along with each of the variables described above, will bear scrutiny in the months and years to come.

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VSCs in 2016: New Terms, New Costs

VSCs in 2016: New Terms, New Costs

For the 2016 model year, there are some major changes in the warranty market which will impact service contracts.

First, of course, it will increase the costs for the same service contract. Some claims that were previously covered by the manufacturer’s warranty will now be covered under the service contract. Second, the claims would be projected to occur, on average, earlier in the contract period. Therefore, the revenue should be recognized — or premium earned — more quickly than in the past.

What is the impact?

For an administrator, the reduced claims covered by the manufacturers are unwelcome news. On the positive side, the decrease in warranty terms increases the “value perception” of a service contract. Unfortunately, there are no easy answers in addressing the impact of the additional coverage without a detailed analysis of actual claims. The decrease in powertrain coverage will not increase claims equally by make, since some makes will have proportionally more claims in the powertrain portion than other makes.

The impact on service contract costs is a complicated question and there are a number of factors to consider:

  • Make/model of the car: There will be variation in the powertrain claims by vehicle.
  • Starting mileage: Since the time limit remains unchanged, used vehicles with remaining warranty will be impacted less. For example, a used car with 36,000 miles that is three years old will have minimal cost increase since the warranty would be active for two more years in both cases.
  • Driving patterns: Notice that the time remains the same and the new term offers 12,000 miles per year while the old term averaged 20,000 miles per year

In order to calculate the impact of this change, we made assumptions which are general in nature and may not be appropriate for a specific book of business. The assumptions are that powertrain costs are 50% of total service contract costs.

In addition, we assumed claims would increase by 10% per year as the car ages. Finally, we assumed the contract holder would drive on average 15,000 miles per year, with some driving as few as 8,400 miles per year and others 21,000 miles per year at most.


Note that the increase in costs is only a rough estimate due to the decrease in warranty terms; it would not include any increase due to new technologies or more expensive repairs.

Why the increase in costs? Note that the previous warranty of five years/100,000 miles effectively eliminated the powertrain portion except for the last year. Relatively few drivers “miled out” of the previous warranty. Effectively, the new terms penalize the high-mileage drivers, because a normal driving pattern would not have exceeded 60,000 miles in five years by a great margin.

Earnings are also included under a “Reverse Rule of 78s” method. This method is often used for earning new car vehicles. It uses a sum-of-the-digits method in which the earnings are in proportion to the month. For example, in Month Three of a 12-month contract, the earnings would be (1+2+3)/ (1+2+3+4+5+6+7+8+9+10+11+12) or 6/73 or 8.2%. So in Month Three, a total of 8.3% would be earned.

While this method is easy to implement, it only does a fair job of approximating earnings. It tends to earn too fast early in the contract when there is very little exposure due the manufacturer’s warranty.

More interesting are the hypothetical earned experience curves. While the examples above are hypothetical, it does show that earnings will speed up to some degree under a decreasing manufacturer’s warranties.

Are you still using triangles?

Actuaries typically use triangles when analyzing service contracts. They are typically organized by purchase date, term and type of car. They are easy to produce but past trends can be problematic. In this case, the patterns in the past will show too little development at the end of the contract. If you don’t adjust for this type of exposure, you will not only be facing increased costs but may not realize for a number of years. We prefer “triangle-free” approaches using miles outside the warranty. We will discuss this more in a future article.


Of course, a detailed analysis of the specific factors in your book would be necessary to quantify the impact of a change in the manufacturer’s warranty. Extended eligibility is another concern for a couple of reasons. First, these vehicles will show significantly different earnings patterns since the expiration of the manufacturer’s warranty will occur sooner. Also, the manufacturer may extend the warranty on these vehicles.

It is important for administrators to know both the underlying cost and the correct earnings rate of their book of business. Administrators need to be prepared to understand the impact of these changes on their service contract offerings.

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Earnings Curves: The Past, Present and Future

Earnings Curves: The Past, Present and Future

The Earnings Curve

For vehicle service contracts (VSCs), the earnings curve is a critical tool for financial reporting and experience evaluation. Typically, the earnings curve is a set of factors by month, which show how much of a contract should be earned.

When a company evaluates its financial results at the end of the year, each active contract will be aged from the months since purchase and the premium or reserve for that contract will be multiplied by this factor to calculate the earned reserve. For example, if the reserve on a contract is $400 and it is 12 months since purchase, the system will look up the factor for 12 months. If the factor is 20%, then $80 is earned and $320 is unearned.

It is important to realize that no earnings curve is perfect. It is always an estimate. Only in retrospect, by examining the claim pattern, will the true earnings pattern be known.

In the past, it was common to earn using a formula. Typical formulas were pro-rata (even earnings for each month) for used cars and Reverse-Rule-of-78s for new cars.

In Figure One are examples of various earnings curves. The “Actual Claims” curve is only known at the end of contract.

Figure One

Month Reverse Rule-of-78s Pro-Rata Experience Based Actual Claims
12 3% 17% 1% 0%
24 11% 33% 7% 10%
36 25% 50% 33% 34%
48 45% 67% 55% 60%
60 70% 83% 85% 81%
72 100% 100% 100% 100%

The Past

The “Reverse Rule-of-78s” method uses a sum-of-the-digits method and the earnings are in proportion to the month. For example, for a 12-month contract in month 3, the earnings would be (1+2+3)/ (1+2+3+4+5+6+7+8+9+10+11+12) or 6/78 or 7.7%. So in month 3, a total of 7.7 percent would be earned.

While this method is easy to implement, it only does a fair job of approximating earnings. It tends to earn too fast early in the contract when there is very little exposure due the manufacturer’s warranty.

At the end of the contract, it earns too slow because many vehicles will “mile out” and expire the coverage before the end of the term. For example, if a contract holder with a 6-year/72,000-mile contract reaches 72,000 miles in year 5, the contract is completely earned at this point.

The Present

While many companies still use the Reverse-Rule-of-78s and other formulaic earnings, it is more common to base earnings curves on experience reviews.

In order to use claims experience, one must define curves based on the characteristics of the contract. For example, different terms require different curves. In addition, new, used and program cars will require segmentation. Losses are then examined by month since contract inception. Experience should be smoothed out where little data is observed.

While this type of analysis is preferable to formula curves since it covers actual claiming behavior, there are still some major shortcomings to this approach. First, notice that we needed to segment by new, used and program as well as term If we got more detailed, we would segment by coverage (exclusionary, powertrain and wrap) and manufacturer warranty. Also, we might see different earnings patterns between business produced by banks or credit unions, dealers and direct business.

If we chose to segment by all these variations, we could literally have hundreds of earnings curves to maintain.

Finally, there is no mechanism to model changes that would have a significant impact on earnings. One major problem is a change to the underlying manufacturer’s warranty. For example, an increase in the manufacturer’s warranty would have the welcome impact of decreasing claims. However, the claims we would see on VSCs would occur later in the contract. Our earnings pattern would “overearn” the contract at the midpoint of the contract and our profits would be overstated.

Another issue is mileage. If the driving habits of the contract holders change (for example, the contract holders begin to drive more miles), we would see an understatement of earnings since many of these contract holders will “drive out” or expire their VSCs prior to the expiration date.

In the past, mileage information has had to be estimated from claim or cancel records. However, new sensor technology is allowing odometer readings to be given in real time. We’ll return to this topic when we discuss the future of earnings curves.

The Difference between Financial Reporting and Experience Evaluation

While earnings curves are used for both purposes, it is important to realize that that there are different purposes for using earnings curves for financial reporting and experience evaluation.

Financial reporting, that is preparing financial statements for shareholders, regulators and participating dealers, may be subject to the Statutory Statement of Accounting Principles 65 (SSAP 65). In addition to other requirements, this statement says that unearned premium must be greater than or equal to the greatest of these three amounts:

  1. The amount of premium, which could be refunded if all contracts cancel,
  2. The portion of premium proportionate to future losses and expenses to total expected (past + future) losses and expenses,
  3. The present value of future losses and expenses.

The second goal is what we usually think when we think of earnings curves – that is, the premium will match the loss. However, in cases where the refund provisions are high, the company may earn the contract according to the refund provision

Earnings curves for financial statements should have the following goals (some of which are in conflict):

  • The earnings curves should reflect the actual emerging experience of the book.
  • The earnings curves should be simple and easy to reproduce to explain to stakeholders (auditors, regulators and shareholders).
  • The earnings curves need to follow financial guidelines.

Because of the need for some simplicity and the requirements of SSAP 65, the earnings curve for financial reporting may not be the best for analyzing the experience.

The best curves for analyzing experience may need to be more sophisticated than those used for financial reporting. If there are issues between implementing a better earnings system and maintaining financial reporting standards, the administrator may need to create an earnings curve for financial reporting and another curve to analyze the experience.

What is the exposure base?

One of the implicit arguments in all types of earnings curves is that each month of coverage is an exposure. All insurance coverages usually have a common exposure base, which is used for rating. Common exposure bases are revenue (liability insurance), cars (auto insurance) and payroll (worker’s compensation).

A better exposure base for VSCs is an estimate of “months exposed.” By “months exposed” these are the months that the service contract:

  • Is not covered by a manufacturer’s warranty
  • Has not expired the VSC by driving out of the coverage
  • Is covered under the contract (powertrain only, wrap or exclusionary)

Without knowing the mileage, it is impossible to know definitively the answer to whether the manufacturer’s warranty or service contract is still in effect (unless enough time has passed to expire the manufacturer’s warranty).

However, as explained above, new technology can allow us to know the current mileage on our exposures. Even if we don’t know the mileage, we can estimate this based on different driving patterns observed in our claims and cancel data.

Projecting the Losses

Statistical techniques, such as generalized linear models, can be used to model losses from the exposures developed above. An average “cost per month” can be calculated and the results can be varied using “relativity factors” derived for each of the characteristics of the contract. In our experience, contracts have typically varied on the following bases (this list is not exhaustive):

  • Age of contract
  • Deductible
  • Coverage
  • Mileage of vehicle at contract purchase
  • Make and model of vehicle
  • Source of business (dealer, direct, financial institution)
  • Participation status of business source in underwriting gain
  • Other (dealer, state, marketing group)

By combining the exposure base developed above with cost per exposure estimates from the characteristics of the contract, an estimate of the losses for each month of a specific contract may be formed.

The Future of Earnings Curves

This type of analysis implies a contract level earnings curve. When a contract is underwritten, a predictive model based on the term and the factors above can generate predicted claims by month. These “predicted claims” can be used to form an earnings curve for this contact. As the contract earns, the system can simply look up the earnings pattern for this specific contract.

If actual mileage is available, the curve can be adjusted by the specific driving patterns of the contract holder. The positives for this type of analysis are that it allows the most accurate earnings curve and it responds immediately to any changes in the underlying manufacturer’s warranty. In addition, it does not require the maintenance of hundreds of separate earnings curves.

One disadvantages is that it does require some front-end analysis (though likely less ongoing analysis than traditional earnings curves). In addition, it may be difficult to explain to stakeholders and does not guarantee that the contract is above the refund value (which may make a simpler curve for financial reporting advisable).

Administrators should consider the availability of new data and techniques to improve their earnings curves. By using a parameter-based model, administrators can address the many facets for their business without relying on formulas or earnings curves based on limited assumptions.

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