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.

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.

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.

His experience in the actuary, accounting, risk management, and risk transfer solutions related to vehicle protection products, precedes him and he has been asked to speak at the upcoming Vehicle Service Contract Administrators Conference held at the Las Vegas Hilton from September 26-28.

The editorial staff here at P&A Magazine thought who better to open the review to than our own Provider and Administrator subscribers because you are the experts in the industry. So, we are inviting you to click on the following link to review and comment on the material to be presented.

GAP Protection Offered by the F&I Office in Conjunction with a Retail Installment Sales Contract

The basic questions we are asking of this material are:

1. Does this document contain all the information an F&I practitioner needs regarding the GAP product?
2. Are there any technical errors, omissions, or commentary?

We appreciate the time that any of our readers can contribute to reviewing the document provided in the link above and welcome any comments, corrections, etc. that you can provide.

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.

• 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.

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.

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.

From an actuarial standpoint, the main problem is risk management: When does the LLPW insurer know that the policy has earned out? When does exposure to potential claims expire?

From a dealer’s perspective, the problem is cost! Because federal law (The Magnuson-Moss Act) places constraints on warranties, purchasers cannot be responsible for the costs of a warranty product, as opposed to a vehicle service product or GAP product. Additionally, federal law requires that the dealer provide the warranty to all customers purchasing the vehicle.

Perhaps an even better question is, “Are dealerships reluctant to offer the product?”

In 2007, when Chrysler came out with its manufacturer’s Lifetime Powertrain Warranty (LPW) as a way to show confidence in the quality and reliability of their products, they added a stipulation that minimized the existing risk management problem that other powertrain warranty providers caught on to.

Most powertrain warranties come with conditions and exclusions. For example, they are not transferrable and exclude any repair that qualifies under another existing policy such as the original manufacturer’s warranty or a VSC purchased with the vehicle.

Chrysler, like many OEM’s and warranty providers, also required that the original owner completely adhere to the manufacturer’s maintenance plan and keep receipts and statements as proof of adherence to the plan.

What Chrysler added was the “five year, return to the dealer” condition that required the owner to return to a Chrysler dealership within 60 days of the vehicle’s five-year purchase date for an inspection. It was this additional condition that solved, or at least reduced, the risk management problem of determining when a policy would be considered void, and hence, opened the door for other insurer’s to offer similar products.

Because the dealer is required to absorb the costs of the warranties, applicable to every vehicle it sells, the potential cost can be overwhelming – even if providers offer the LLPW product at a reasonable cost. But, offering this product, either by way of the manufacturer or a third-party insurer, can be a great selling point for the dealer, not to mention additional income for the service department. Finally, the “five year, return to the dealer” condition could result in new vehicle purchases.

Despite some dealers’ reluctance to offer LLPWs on their vehicles, those who do are seeing the benefits of increased vehicle sales and customer returns to the service department. Dealers say the product has proved its effectiveness in customer retention and satisfaction. They claim their service retention numbers have been on the rise because the product provides a great opportunity to get customers back into the dealership for their vehicle’s routine maintenance.

Dan Pozzuto, service manager/director at Extreme Nissan-Hyundai-Kia, has seen positive changes in his business since implementing the LLPW program.

“The program that they offer through National Automotive Experts has had a huge impact in service,” he says. “This dealership’s seven-year service retention is No. 5 in the nation. Our one-year service retention is No. 1 in our region with respect to Nissan. With my Hyundai and Kia numbers, I am in the top 10 percent in the region in both of those.”

In addition to increasing service retention, Pozzuto says he believes offering the program makes it easier to upgrade customers to additional coverage. “It seems to me you’re getting a customer in the mindset of taking care of their car for a long period of time, and the additional coverage becomes important.”

Travis Freeman, service director at VanDevere Pontiac-Buick-Chevrolet-Kia, has also seen the benefits of such a program. “It’s a great sales tool for us,” he says. “Our units have increased, and it’s a great retention tool for the service department.”

There are, however, some points of confusion for customers. Freeman says that some customers express concern that if they don’t maintain their vehicle according to the LLPW warranty, it would also void the factory warranty. But as he further explains, “It’s just a matter of educating the customers.”

Pozzuto also works to educate customers about the benefits of their LLPW coverage combined with additional warranty coverage. If a customer’s vehicle needs repair and it covered by the extended warranty and the LLPW, the latter will pick up the deductible and the customer will not pay anything out of pocket.

Although LLPWs require that routine maintenance be completed, most dealers say this is not a problem. Customers seem to be following through with the routine maintenance requirements, as evidenced by the increased service retention at the dealerships interviewed for this article.

Pozzuto says, “This program really allows us to build long-term relationships with customers because you are truly able to help the customer, and I think that’s the biggest benefit of the program.”

The important take-away messages from this article follow:

1. The LLPW product is appealing to dealerships as a useful selling feature and as a way to increase service retention and customer visits to the dealership.
2. From an actuarial perspective, there is now a better understanding of how the LLPW product will earn out.

For example, an auto insurance policy for one year will recognize 1/12th of the premium each month for the entire year the policy is in effect. This assumes that one is equally likely to have a claim in one month as in any other.

Of course, for some lines it is more likely that you would have a claim during one season than the other. For example, homeowner’s insurance in Florida would of course see more claims in hurricane season between May and November than the period between December and April. Because the amounts are relatively small, this adjustment is typically ignored.

There is an exception to this rule for policies that cannot be cancelled and last longer than one year. While these products are not considered very common in the overall insurance world, they do make up most of the portfolio of F&I products at a dealership. GAP, VSCs, tire and etch and other products are typically written for a period greater than one year.

Most carriers will earn GAP using a “Rule-of-78s” method. This method was originally used to calculate finance charges before the widespread availability of computer software to more easily calculate interest payments.

The rule will basically be close to interest charges on a loan – in other words, the amount of earned premium for each month is analogous to the percentage of the total interest for a loan payment for that month. The Rule-of-78s does a good job of allocating the total amount of interest to a particular month.

The Rule-of-78s will earn premium as a function of the sum of the digits of the remaining term with the sum of digits of all term values. For example, consider a 60-month contract. The sum of all the months’ earnings is 1,830 (1 + 2 + 3 +4 + ……+ 59 +60). For the 12th month, the earnings would be the remaining months (49) divided by the total (1,830) or 2.7 percent of the total contract.

If the contract were earned evenly (pro-rata), the earnings for one month would be 1/60 or 1.7 percent. You can see that the Rule-of-78s earns more premium at the beginning of the contract.

But is that a good approximation for the exposure on a GAP policy? Remember that GAP will cover the difference between the actual value of the vehicle and the loan balance. At some point, the vehicle value will likely be greater than the loan balance, but the Rule-of-78s will continue to earn premium in these months where there is no exposure – though much less than the earlier months of the contract.

Evidence from claims studies would suggest that, in general, the Rule-of-78s earns premium too slowly. That is, the claims from GAP contracts tend to come earlier in the contract than the earnings pattern would suggest.

Here is a little background on how GAP and other long-term products (such as GAP and VSC) are earned. These rules are promulgated by the NAIC and required for all U.S. insurance carriers.

In general, the unearned premium must be the largest of:

1. The amount needed to refund the policy.
2. The proportional amount of the policy that is unearned.
3. The future losses from all policies.

Our discussion focuses on No. 2 – the proportional amount needed to earn the policy. No. 1 focuses on refunds, which in many cases use the current rules. For accounting purposes, a company may still need to recognize the earned premium using a Rule-of-78s.

No. 3 will usually only be applicable when the loss ratio is high. In this case you need to reserve the expected amount of future losses. For simplicity, there are additional rules that also apply but we will ignore these for our discussion.

Other jurisdictions outside of the United States may require similar rules, as well as GAP accounting.

An alternative pattern that works reasonably well is to shorten the term by 25 percent and earn the premium over the shorter term. The Consumer Credit Industry Association released a GAP study in 2009 that examined a large of number of claims from multiple writers and found this type of approach to be a better fit with claims than the current reserving practice.

In this case we shorten the 60-month term by 25 percent to 45 months. The sum of all the months’ earnings is 1,035 (1 + 2 + 3 +4 + ……+ 44 +45).

For the 12th month, the earnings would be the remaining months (34) divided by the total (1,035) or 3.3 percent of the total contract. As noted above, using the traditional Rule-of-78s will result in 2.7 percent of the premium being earned.

The following chart shows the two earnings patterns side-by-side:

Note that reducing the term by 25 percent is just a technique that fits some books well. Some books will earn faster and others slower.

An earnings pattern should match the emerging claims. For a GAP product, earnings should decrease each month regardless of the earnings method used.

Increasingly, GAP products are offering features beyond simply paying off the balance of the loan. These benefits might include down payment assistance for the purchase of a new car, etc. These types of additional claim payments may also impact the earnings curve. They will lengthen the earnings period if the benefit is flat and not tied to the existence of a GAP (i.e., pays on any total loss whether or not the vehicle value is less than the outstanding loan balance).

There are several implications from a faster earnings curve. First, when customers request a refund, they may be refunded more money than they are theoretically due because more exposure has passed.

For example, savvy customers who realize there is no longer a GAP exposure on their vehicle would be due a refund, despite the fact that all contracts will eventually not have material exposure.

Some lienholders (in particular, the manufacturer captives) and some states require a pro-rata (even refund), which is much more advantageous to the consumer.

However, there are more important implications than refunds. If you are earning the premium too slowly, this distorts your financial results. If the book is growing, the stated loss ratio will be too high. Likewise, for a declining or run-off book, the stated loss ratio for the current period will be too low (though the distortion will be smaller than when the book is growing).

In either case, the inception-to-date loss ratio will be overstated.
For a growing book of business, this distortion may be significant.

Look at the following table and assume that your “true” loss ratio is 80 percent. Also, you have begun a GAP program and are receiving 100 contracts a month for a 60-month term. Each month, the number of contracts received increases by 0.5 percent.

The following table shows the difference in loss ratios:

As you can see, the impact is significant. At one year, your loss ratio would be 24 percent overstated. After 5 years, the impact is still 10 percent.

Of course, one should be careful because GAP is subject to volatile results due to fluctuations in the financing and used-car market. GAP loss ratios will increase when financing standards become more lax as well as when used-car prices fall.

The presence of a few large claims may also distort your loss ratio. But, in general, the actual loss ratio on a stable or growing book of business will be overstated using the Rule-of-78s.

What is the impact? For taxable income, there may be no impact, since you may be required to continue to earn the premium in the usual way. However, for analyzing a book of business the impact may be significant:

• You may take action in a case where merely the earnings pattern does not reflect the true exposure. You may cut back on your writings since you erroneously believe that the loss ratio is poor or take unwarranted rate increases.
• In addition, you may have to establish additional reserves to fund losses if future losses are projected using an incorrect correct pattern. For example, in the case above, a projection of 104 percent loss ratio at 12 months may cause the establishment of additional reserve to cover projected losses. If the correct earnings pattern is used, then no additional reserve is needed.

So in the end, you may be forced to keep two sets of books for GAP business. A traditional earnings curve for statutory accounting and refund processing, and a more accurate curve to analyze the business and project future losses.