As an actuarial consulting firm, we spend a lot of time deriving the specific cost for F&I products, both from an overall perspective and down to the granular level. For example, we develop models which inform you that the cost of a wrap service contract for a Hyundai Elantra with 30,000 miles and 2.5 years of service will be $45 less than a Hyundai Elantra with 45,000 miles and 3.5 years of service. (Note, we just made up these numbers).

So we are very precise with our estimates of what drives service contract claims. However, we don’t seem to be very precise when setting the final price to the consumer. Many administrators charge the same administration fee for all the contracts within the same product That makes little sense when some contracts are two years in length and others may be eight years in length. It will cost the administrator significantly more money to administer a longer contract (which will generate substantially more claims).

This problem is even worse with dealer and agent markups, which are often the same dollar amount regardless of the underlying coverage. The result is that the differential in the actual retail prices of service contracts are much narrower (from a percentage standpoint) than the underlying costs.

Percentages vs. Flat Dollar

A curious thing seems to have happened in the service contract industry: the common use of flat dollar amounts for dealer margin and administrative costs. Traditional insurance (including credit insurance) relies on percentages for acquisition and perhaps a mix of flat dollar and percentages for administration costs.

Percentages have definite advantages but these are not perfect. One problem with using percentages is that small dollar policies are not practical because the acquisition costs are too low to entice production.

One example is renters insurance. Renters insurance (which covers an insured’s belongings but not the structure) is a great product which protects the consumer against theft, fire, natural disaster, and personal liability. It is also fairly inexpensive, with typical premiums of less than $300 per year.

Since the premium is so low, the typical commission arrangement of 15 percent would provide less than $45 of commission. Because of this, agencies will rarely promote or market this product and penetration rates are low. According to the Insurance Research Council, only 43 percent of renters have renters insurance.

Too Much Coverage

Returning to service contracts, we often see higher sales on the most expensive coverage options – such as low deductibles, more coverage, and more expensive vehicles. While it may be true that buyers of these vehicles want these plans, it is also true that for most buyers the difference in the price of these plans (once again, in percentages) may not be so great.

While it is great to sell the most coverage, we might be seeing lost sales on the more discounted plans. It is often a murky world at the dealership, with trade-ins, negotiation, and other factors often driving the F&I product purchase decision. But flat dollar margins and administrative costs are making the most affordable products less affordable.

One option might be to use a combination of the two (percentage and flat dollar amounts) to price service contracts. For example, suppose the average reserve for a contract is $1,156, the administrator fee is $200 and the average dealer markup is $400. The table below shows the pricing options using flat dollar additions versus using 50 percent flat dollar and 50 percent percentage mark ups:

As you can see, the overall average margin is the same, but there is more price differential with allocating margin partially on percentage markups.

This reflects basic cost accounting for both the dealer and the administrator – higher priced coverages should not only reflect higher reserves for claims but also higher administrator fees and higher margins for dealers.

Beyond Cost Accounting

So far, we’ve limited our discussion to a more proper application of cost accounting, but we’ve ignored the other half of the equation: the demand for the product.

As we all know, some items are priced more for the demand than the cost of the supply. Airline tickets and hotel rooms are almost exclusively priced on the demand for the items.

For a hotel, it makes little sense to allow a room to remain unsold for the night when a lower price would entice a traveler to stay there. The same is true for selling an airline ticket – the plane will fly regardless of whether the seat is sold.

For dealers, the margin is controllable and could be optimized. For example, selling a service contract with a $100 margin is preferable to not selling the contract at all – and receiving a margin of $0.

For example, the willingness of a customer to pay for a service contract might depend on a variety of things, including:

• The customer’s demographic profile
• The vehicle that is being purchased
• The time of day the sale is made
• The dealership
• The salesperson
• The F&I manager
• Any other factors
• The price of the contract

The only one of these items that can easily be changed instantly is the price of the contract.

Wouldn’t it make sense to offer higher prices to those customers who see the benefit of the contract (and are more likely to purchase a contract) and lower prices to entice those who are less likely to purchase?

Using the information above, one can build a model which will predict the likelihood of purchase for any price. Of course, this model is dependent on the underlying data – both the amount and its predictive qualities.

Once the predicted sale rate is determined, the margin can be determined to increase the likelihood of selling the service contract. Using such a model would allow the dealership to increase the penetration rate for service contracts and the overall profitability for the book.

In this hypothetical case, the dealer can increase the average profit by 11 percent and offer a lower margin (but sell more contracts). Typical results for optimization projects are a 5 to 10 percent increase in profitability.

To begin a project such as this, you need data. If you are not capturing data which reflects your customers, your F&I product offerings and the results of your sales process (the margin and products offered and customer’s decision to a specific offering) you should begin to collect that data now for future analysis.

The next step is to create a model which predicts the sales penetration for products. This is helpful to see what factors are driving sales, such as product, vehicle, customer demographics or the F&I personnel.

Finally, this information can be used to develop a more robust pricing strategy for the dealership – one that incorporates the customer demand along with considerations such as negotiations, dealer objectives, long term customer relationships, refund exposure and all of the other factors which are part of the F&I process.

Administrators who price their products more effectively should see some increased penetration as lower priced coverage options should be more attractive as well as less costly to administer.

Regardless of your pricing strategy, the “Dark Ages” of simply adding flat dollars to a premium reserve should come to an end.

While publicly available data is not available for GAP writers, it is clear of that 2011 will go down as a profitable year for GAP Insurance.

This is due to two factors: the lower leverage permitted by the credit markets and the high value of used cars.

How does GAP work?

Why do these factors have such an impact on the results for GAP insurance? Remember that GAP covers the difference between the book value and the loan value. Therefore the book or actual cash value of the vehicle acts like a very high deductible in a traditional insurance policy.

When customers are allowed to finance more for their vehicle, this increases the loan value and therefore increases the GAP severity.

Also, when a claim is submitted, the increase in used car prices means that the auto insurance policy will pay more for their vehicle since it is worth more in the marketplace.

Because GAP covers the difference between these amounts, it is very sensitive to changes in these values. For example, a 10 percent increase in used car prices might imply a 40 percent reduction in GAP losses.

Trends in Financing

First and most important the availability for consumers to finance more than the MSRP of the vehicle is still under pressure.

The financial crisis of 2008 caused the banks to restrict the amount of financing for vehicle purchases. While there is some evidence that banks are increasing the amount that they will finance, restrictions that were instituted in 2008 have not been fully removed.

For the F&I industry, this is been a benefit and a detriment. While the lower leverage ratios are a benefit to the GAP underwriters, the lack of additional funds for the consumer may limit some F&I product purchases.

As we move into 2012, we expect to see further loosening of the loan-to-MSRP ratio requirements. However the extent of this will obviously be determined by the market and the general economic recovery as well as the banks appetite for risk.

The Manheim Used Vehicle Value Index

The other factor that has favorably impacted losses is the strong pricing in the used car market.

As you can see from the graph, the index of used vehicle values is at or near an all-time high.

The index is published monthly by Manheim Consulting and is available on their website at www.manheimconsulting.com.

The index is based to January 1995 where January 1995 is equal to a value of 100.

The transactions that make up the index represent a substantial portion of the used vehicle market and are compiled from auction sales of mostly late model used cars.

Recently we spoke with Tom Webb, chief economist of Manheim consulting and the author of this index, about what he sees as the future direction of used vehicle values.

We wanted to know his thoughts on why the market for used cars was so strong. He said that the increase in used car values was not only due to increased demand for used cars but also a reduction in the supply of late model used cars.

This reduction in supply is due to a number of factors. First, the new vehicle sales in 2008 and 2009 were much lower so this has led to a corresponding decrease in the availability of late model used cars from those model years.

Second, the number of vehicles purchased by rental car companies decreased in 2008 and 2009 so there are less late-model used cars from that source as well.

In addition, vehicle manufacturers were less likely to lease their cars in 2008 and 2009 over concern about the amount of residuals for those deals. Since leasing will generate a late model used car sale a few years down the road, the decline in leasing during this period is reflected in fewer vehicles for sale now.

Also, the number of repossessions has declined recently from 2008 and 2009 further restricting the supply.

Finally, there were certain issues with particular makes models that impacted their supply in 2011.

For example, the Japanese earthquake in 2011 severely impacted the supply of certain models for Honda dealers. There was a corresponding increase in the value of the used cars for those models.

What should we expect in 2012?

First we will expect that rental market sales will go up in 2012 as purchases made over the last year begin to find a way into the used vehicle market.

It would also expect that the supply disruptions in 2011 will not continue into 2012. Therefore those models that were impacted by this distraction would probably see declines in the used car prices.

Leasing is again popular due to the strong residuals and corresponding low lease payments. This will generate future supply in the marketplace.

But the biggest question is the sales and supply of new vehicles.

There’s no doubt that the automobile manufacturing business model has changed over the past five years, for example, there was a profitable year in 2011 with 13 million vehicles sold versus severe losses in past years with sales much higher.

Under the new business model, it appears that new car inventories on dealer lots have declined substantially. Due to this lack of supply at the lot, some consumers may be opting for late model used vehicles

Whether automakers continue to limit the supply of new automobiles to ensure profitability per unit or return to a model of a large number of vehicles produced is an unanswered question.

In addition to GAP, other products are being introduced which capitalize on the high value of used cars. These include trade in value protection.

Whether these products remain viable in the future will depend on the relative high value of used cars.

Based on all these factors we would expect that 2012 would remain a profitable year for GAP underwriters. But we also would expect that 2011 was the “low water mark” for losses.

Underwriters should remain diligent in monitoring both the credit market and the used car market for future direction of their results.

Recently I had the pleasure of moderating a session on best practices for carrier and administrator relations at the VSCAC conference in Las Vegas with representatives from both leading carriers and administrators.

Before discussing the best practices of maintaining a fruitful relationship between these parties, let’s briefly review the structure of the industry.

An administrator will generally design and market a service contract program, as well as administer the contracts by providing customer service and claims services.

While there are many administrators, there are a limited number of carriers which regularly service the independent administrators.

A carrier’s primary role is, of course, providing an insurance component to the service contract.

In addition, a carrier can provide valuable assistance with all aspects of the program because carriers will have experience with a large number of programs. For example, carriers can potentially provide analytical, actuarial or legal support in the design of the program.

In evaluating a program or administrator, what do carriers typically desire?

• Profitability

Obviously, programs need to be profitable for both parties.

• Transparency

In discussions with carriers, transparency is always mentioned as a key. Because carriers have limited information about a specific program, it is important that there be complete transparency in all aspects of the service contract – from design, administration, claims, and financial reporting. Carriers may have different metrics than the administrator for evaluating programs – this is due to having a different role in the business as well as standard metrics so they can evaluate a large number of programs.

For example, consider a new program which is meeting volume expectations but the loss ratio is higher than projected. If a carrier has access to all information, they can form an opinion on whether the adverse experience is due to claims settlement, pricing issues, bad luck, or perhaps an early surge of claims due to preexisting conditions.

• Trust

As in any relationship, trust is key. Trust and transparency are critical in solving any problems that arise with the management of a service contract program.

• Compliance

Compliance is critical for carriers. Administrators should be vigilant in being compliant with the many regulations and laws regarding service contracts. Of course, most carriers can assist in being compliant.

For administrators, the key factors are similar but differ in a few ways:

• Marketable program

Administrators need marketable programs. Programs are expensive to develop and market and administrators will need volume to offset the fixed expenses of administration and hopefully make a profit.

• Profitability

Of course, administrators are also concerned with the profitability of a program. While volume may be key initially, it is the overall profitability which will ensure that the program is a success. Administrators often have significant participation in the overall results of the program.

• Flexibility

Administrators need carriers to be flexible in the rapidly changing world of service contracts. New products are rapidly being developed and marketed. A good carrier will be responsive to an administrator’s needs.

• Partnership

Good administrators look for long-term partners and relationships. Administrators want carriers who are committed to the service contract market and the independent administrator business model. Similarly, carriers also seek long term relationships and not administrators who look to move books simply to gain a few commission points.

For administrators, the benefits of maintaining good relationships are clear — a steady reliable carrier for your products.

Carriers need administrators to be profitable, trustworthy, transparent and compliant – kind of like boy scouts!

While the independent administrator market is currently healthy, it is important to realize that this market only exists due to the willingness of the insurance carriers to provide their services.

It is critical that the general state of relationships remain good between the parties since the “independent administrator” model is not viable without carriers.

Vehicle service contracts have traditionally been sold as a single pay product purchased at the time of vehicle purchase. While the typical retail charge for the vehicle service contract (VSC) can be in the thousands of dollars, the availability of the vehicle finance contract provides a ready source of funds to pay the full cost.

However, there are many excellent marketing opportunities for a service contract where a finance contract is not available to pay this cost. These include:

• Follow-up sales after delivery of the vehicle
• Service drive sales
• Direct market sales
• Inability to finance the service contract with the lender

Currently, the typical approach in these situations is to use a finance company that specializes in VSCs to finance the cost over a period that is usually one-half or less of the time term of the VSC.

Month-to-month (monthly pay) VSCs are an alternative product for the above scenarios where special financing is otherwise needed. This product may also appeal to customers who do not want to pre-pay the cost of the VSC.

A month-to-month vehicle service contract provides one month of coverage for each monthly payment. The contract is generally renewable to a predetermined mileage and/or time limit and the monthly rate may be guaranteed for some or all of the term. The contract can be designed to renew at lower coverage levels and/or a higher price level as the covered vehicle ages, thus making longer terms more attractive to the administrator or underwriter.

Month-to-month VSCs are not likely to replace single pay VSCs in situations where funds are available to pay the total cost upfront for one obvious reason— cash flow. With a single pay contract, all parties involved in the transaction (dealer or seller, administrator, insurer, agent, etc.) get the money upfront instead of waiting for their share of the monthly payments. Most, not all, of the parties involved prefer to collect upfront.

Another disadvantage is that in some states an obligor can offset claims against cancellation refunds for a single pay VSC. This money is not available in a month-to-month VSC, so it must be considered in pricing.

There are advantages to the obligor for month-to-month over single pay contracts. In the case of cancellations, the refund due to the consumer will be much smaller since there is very little unearned exposure. This eliminates most of the unearned portion of the fees paid to every other party involved in the sale of the VSC and the possibility that that party won’t be around to pay its share of cancellation refunds.

Another advantage is the ability to non-renew or adjust rates due to the experience of the service contract. For example, a problematic vehicle could be surcharged or non-renewed if there is a persistent issue of claims.

Currently, there are two approaches to determining claim eligibility under a month-to-month VSC— time only and time plus miles. Using time only, a vehicle is eligible so long as the monthly payments are made through the date of claim, subject to the overall mileage limitation. If eligibility is determined by time and miles, then each monthly payment extends the vehicle eligibility by one month and a certain number of miles. In this case, it is important to have some mechanism to make a reasonable estimate of miles driven per month at time of sale and to get updated information from the customer after initiation of the month-to-month VSC. If the customer is and continues to be a regular service customer, this information will be readily available at the time of sale and for adjusting the miles per month purchased in future months. If not, this information can be obtained by having the customer provide regular updates using an online form.

The time only approach is simple to explain and easier to administer at time of claim because a customer won’t be in a position of needing to make extra payments to extend mileage eligibility in the event that he didn’t purchase enough miles per month. However, the time only approach does create a subsidy of high miles per month drivers by low miles per month drivers. A simplistic example illustrates this point.

If the overall term and mileage limit for a month-to-month VSC is 72 months and 72,000 miles from time and mileage at purchase and the monthly charge is $40, a customer that drives 3,000 miles per month will exhaust the coverage in 24 months and pay a total of $960, but a customer that drives 1,000 miles or less per month will exhaust the coverage in 72 months and pay a total of $2,880.

A third approach that is not exactly month-to-month is providing coverage for the customer’s maintenance interval. The service contract can be sold at the time of regular vehicle maintenance and designed to cover the time and miles to the next regular maintenance visit.

This month-to-month product design is very new, so there are issues to overcome for it to be viable in the long term. These issues include: adapting administration systems to capture monthly payments and make appropriate adjustments to determine claim eligibility and obtaining regulatory acceptance. The possibility of anti-selection will probably lead to a slow roll-out of this product within each market to ensure that customers will make enough monthly payments to cover any potential shortfall caused by early claims.

The month-to-month VSC has tremendous potential to favorably increase VSC sales to the many customers who are not able or would not prefer to finance their contract. In time, systems will be updated, regulators will be taught its value to consumers and the month-to-month VSC will become one of the standard products offered by VSC administrators.

Hyundai recently announced an innovative program: a trade-in value program which guarantees the value of the customer’s car. Here is how the program basically works:

• Buy a new Hyundai after May 1, 2011
• Perform all recommended service at a Hyundai dealer
• Between 24 and 48 months, trade-in your vehicle for a new Hyundai
• The value of your trade in will be guaranteed.

When manufacturers develop these kinds of programs, it’s interesting to think about what is going through their minds – what are the benefits to them and what is the potential cost?

On the benefit side, we can assume that Hyundai wants:

• To sell a few more cars – maybe this will be the magic trick for a few consumers.
• Drive more service business back to the dealership.
• Increase loyalty
• Quicken the purchase cycle

What are the risks? In many ways, this program is similar to a lease with a guaranteed purchase amount from Hyundai. However, it is of course limited to those who are trading for a new car.

If the actual trade-in values are equal to the market, then the program would not cost Hyundai anything. If we assume that Hyundai is projecting the trade-in values according to current market forecasts, then the expected cost of the program is probably negligible.

Of course, there is risk. For example, the controversial TARP program is actually now projected to be profitable to the federal government, but that does not mean the program was without significant risk to the taxpayer or that it did not provide significant benefits to the recipients.

For Hyundai, there is the risk that used car prices will fall sharply and Hyundai will have to make up the difference. While we are not privy to the assumptions that Hyundai has made, the risk is probably fairly small.

Even if Hyundai has overestimated the trade-in, they will make up some of the difference on the new car sale. It is not clear whether a consumer participating in this program would be able to negotiate the price of the new vehicle or have to pay the retail price.

In addition, many people will not choose to trade in their cars, purchase another Hyundai or service the vehicle at a Hyundai dealership, further limiting the exposure.

This program replaces the Hyundai Assurance program which allowed customers to return their cars if they lost their jobs. In this case, the customer simply returned the car and stopped making payments. While this program brought Hyundai some goodwill and probably some sales, customers who used this program were still left without a car (but could have erased any negative equity in their vehicles).

The Detroit Free Press estimated that the program cost Hyundai about $8 million (which Hyundai apparently disputes).

So the bottom line is that we will probably continue to see manufacturers being creative with incentives and programs which provide an insurance aspect to the vehicle purchase. The recent surge in used car prices allows manufacturers to be more aggressive in projecting the residual values of the cars they sell – and allows them to develop programs and products such as this.

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 developing a new product, there are, of course, many issues regarding policy language, pricing, marketing, systems, etc. We want to focus on some general considerations when developing a product from a pricing and accounting standpoint.

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. If so, you will need to adjust the claims experience for any changes in the product. For example, if you are adding a new feature to an existing product, you might be able to use the frequency of claims for the current product and adjust the average claim for the new feature.

You should also bring the claims level in your historical database to current levels by applying the expected inflation costs from the time the original products were sold. For example, if you are looking at experience on 2009 sales for a product you plan to introduce in 2012 you will have 3 years of inflation to consider.

Be extra careful if you are considering pricing coverage based on the historical behavior of insureds. A classic example is a “refund program” which refunds a portion or the entire price if the buyer does not make a claim. Historical experience may show a low percentage of non-claimants. However, buyers will not file small claims if there is a financial incentive to avoid doing so.

Therefore, the percentage of contracts without claims on a refund program are much higher. Assume that buyers of your product will adjust their behavior based on their financial self interest.

How is the product marketed?

Similar products can have vastly different claims experience 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. A product that is automatically added as part of the sale will have even lower costs.

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.

How do you react to 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 which reach credibility in a short amount of time. If you are earning your exposures correctly (see above), your results should 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 months 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 actually improve your financial situation. If you have a GAP claim, the negative equity in your vehicle is erased. A similar example occurs in homeowner’s insurance with “replacement value” which pays for the replacement value of 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. Car repairs and vehicle accidents 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 GAP or residual value insurance). If the used car market shows a big drop in prices, then 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.

Conclusion

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 with and an adequate return to the underwriter and business partners.