Tag Archive | "Kerper Bowron"

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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Bowron, Stoll to Close the GAP at PALS 2016

LAS VEGAS — Actuarial experts Lee Bowron of Kerper Bowron LLC and Chris Stoll of Allstate Dealer Services will co-host a discussion about GAP losses at the upcoming P&A Leadership Summit, organizers announced Monday. The two-day event begins on Tuesday, Aug. 30, at Paris Las Vegas.

The highly anticipated session, “Current Trends Affecting GAP Losses,” will begin at 4:10 p.m. on Tuesday, Aug. 30.

“We look forward to discussing factors that are impacting GAP results, such as financing trends, used-car prices and instabilities in the underlying private passenger insurance market,” Bowron said.

“Lee and Chris bring years of experience and hard-won expertise to our event,” said David Gesualdo, show chair and publisher of P&A magazine. “It’s an important topic, and we simply could not have asked for a more qualified duo to take it on.”

Registration for the 2016 P&A Leadership Summit is open now. Attendees who register by August 5 will save $100. To inquire about sponsorship and exhibition opportunities, contact David Gesualdo via email hidden; JavaScript is required or at 727-947-4027.

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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

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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Vehicle Technology Creates Rate Uncertainty in VSCs

Vehicle technology can be defined in a number of different ways, each of which can have a different impact on the vehicle service contracts (VSCs). We spoke to a few VSC providers to get their take on the subject, but first we had to define the technology.

For this article, it’s actually going to be defined in two ways. First, as the technology that surrounds the engine, from the components themselves, to the technology used to drive them and make them more efficient. And second, as the consumer-facing technologies, such as GPS systems, flat panel displays, or DVD/infotainment systems.

With that in mind, how does technology impact the VSC? The short answer, surprisingly, is that it doesn’t. Across the board, providers noted that while they might not cover everything in their lower-end contracts, when it comes to the exclusionary versions, nothing is off the table. In a few cases, there are additional surcharges specifically for hybrid vehicles, with their advanced engine technologies, but the providers themselves were split as to whether that was a necessary addition or not.

Their bigger concern, rather than look at whether to cover or not, centered more on the uncertainty behind the rates. “My biggest concern is us not having any idea how to properly rate the contract until we know how those components will hold up,” said Kelly Price, president, National Automotive Experts. “We don’t want to raise rates if don’t have to, but we will all be caught off guard if these become problematic. But that will be everyone, because no one knows how to rate them.”

Alan Bond, vice president, National Sales, GSFSGroup, agreed, noting that technology items — of both types — have a low frequency of failure at this point in time. But when they do fail, it’s a very high cost for the consumer to replace. Part of the problem, he and others noted, is that many of these systems are new, and still in their manufacturer warranty. So no one really knows, ultimately, what the fail rate or replacement costs will be down the line. “That means we have to be more diligent on the loss side to keep an eye on claims, to make sure contracts priced appropriately, taking those items into account,” he noted.

“What you need to find out from our point of view is how to price the product correctly,” agreed Curt Johnson, senior product, risk & compliance manager, NAC. “We need to see how the failures are going to occur or when they will occur with new technologies.”

From the actuary side of things, all this technology is a good thing, noted Lee Bowron, partner, Kerper Bowron. “From a real fundamental perspective, to the extent that you’re moving away from fuel and liquid based stuff, the electric is good. There are less moving parts, and those parts seem to last longer in general.”

But, Bowron noted, he sees the same issues the providers do — namely that no one really has anything more than a good guess as to how often these parts will fail, and how much it will cost to repair them. “It takes a while to work through the system,” he noted. “OEMs introduce these technologies, then they have to break, then it has to get outside the manufacturers warranty to get any real data. So it’s difficult. Everyone just sort of has fingers crossed. In the future, I believe a lot of those things will go from being a luxury surcharge to being part of the exclusionary coverage [in cases where it’s not already] because it’s so pervasive. These technologies are getting to the point where it’s not a special upgrade to the vehicle.”

Right now, Bowron noted, most of those surcharges are either around the hybrid vehicles, or for things that aren’t necessarily integrated into the vehicle. As more and more systems like GPS become standard, integrated systems, he sees it as being a moot point. What he does see as remaining excluded are things like the batteries. Starter batteries right now aren’t covered even in most exclusionary policies, but hybrid batteries, he noted, are expensive to replace — but also last for quite some time. So this is one area he’s keeping an eye on.

“We in our industry evolve based on manufacturer,” said Johnson. “As they become more technically advanced, we have to match with them stride for stride. Service contracts 20 years ago were power train or powertrain plus, but there weren’t many electronic components. But its nearly impossible today to find a car without power windows or locks today, that were a luxury then. So the things that are luxury items today, like WiFi hotspots, in another 20 years will be common. It is moving fast, it’s based on the consumer and what they want. As long as they have thirst for technology that makes their life easier, we as service contract providers will need to match that.”

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Interview with Kerper-Bowron, Actuarial Insurance Consulting Firm

The actuarial and insurance consulting company of Kerper-Bowron took time out of their schedule to provide P&A Magazine with an overview of the company. The company specializes in evaluating property and casualty exposures, including extended warranty, vehicle service contracts, personal and commercial lines, and environmental reserving. Their client list includes insurance companies, state governments, reinsurance companies, managing general agencies, and Fortune 500 companies.

Tell us about your company and the services that you offer.

We are an actuarial firm with a strong emphasis on the F&I market. We analyze books of business to see where they are profitable. We do this both for pricing and loss reserving purposes. In addition, we help our clients file their rates with state insurance departments.

How does your service offering differ from other providers?

Our focus on F&I means that we often have more experience with these lines than other actuaries. In addition, we have invested heavily in developing advanced analytical tools to help us understand large blocks of business. We are able to incorporate more contract level data in our analysis than we have seen in other firms, which typically rely on overall averages.

Who are your target markets and what message would you like to give them?

Our target markets are generally administrators and insurance companies in this space. Our clients range from very large insurance companies to entrepreneurs. We help our clients in a wide variety of ways, from providing full analysis and loss reserving opinions to assisting their own staff with a project.

Tell us about yourself and how Kerper-Bowron was created.

John Kerper and Lee Bowron created Kerper and Bowron in 2003. We had both been company actuaries for a number of years. Consulting work has allowed us to work with great people on interesting projects.

Looking back over the past 5 years, how has the industry changed and how do you see it changing in the future?

We are seeing new products being developed for the F&I market and see this continuing in the future. There is an increased regulatory focus on the business, and this will likely continue as well. In the future, we expect to see more products developed for the “after sale” market, and more products which are paid monthly and do not have to be financed.

What services do you believe will drive your future success?

In addition to the services we currently provide, we are developing a projection system. This system will allow our clients to effectively analyze and distribute not only their current results but also a projection based on their current distribution as well as “what if” capabilities for future production.

Tell us a little more about yourself. What do you like to do to relax and what outside interests and hobbies do you have?

Since we live in the South, we are both huge college football fans. In addition, John has 4 children and Lee has 3 children, so most of our free time is spent keeping up with them.

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