For those dealers who participate in reinsurance and follow loss ratios, you’ve probably seen a spike of increasing Guaranteed Asset Protection contracts within the last couple years. At EFG Companies, we have been analyzing this trend very carefully. Let’s review what’s happening in the market to cause this trend.
But first, let’s give this topic some historical context. GAP was introduced in the 1990s to protect the value of an automotive loan in the event a vehicle is totaled in an accident. The GAP policy pays the difference between a consumer’s outstanding balance owed on a vehicle at the time of the accident and the insurance settlement. Exclusions to GAP insurance vary by state.
Some exclusions include a maximum loss limit of $50,000, while others require a loan term of less than 84 months. While it is an optional purchase, many states require a car dealership to offer GAP at the point of purchase and some finance companies require GAP as a condition to obtaining a loan. Furthermore, the Truth in Lending Act excludes GAP premiums from financial charges if GAP was not required by the creditor, the premiums were disclosed in writing, and the consumer provides a written request for the insurance.
Now, let’s look more closely at the increasing loss ratios on GAP contracts. Last fall, at the F&I Reinsurance and Product Conference, GPW Actuarial Services shared some data I found interesting. Before the Great Recession in 2007 and 2008, GAP losses peaked well above historical norms. In 2009, we saw significant reductions in GAP losses as financing tightened. However, since 2014, we have seen a return to 2007/8 levels. Puzzling isn’t it? But there are several factors impacting GAP loss.
TRENDS IMPACTING GAP LOSS
Some regions of the U.S. have experienced catastrophic weather events this past year. From massive snow/ice storms in the Southeast to flooding in the Houston/S. Texas area, these types of events always have an impact on vehicle collisions and losses. While it’s easy to blame Mother Nature, this does not tell the whole story.
Low gas prices and increased drivers on the road also could play a part in the overall trend. According to the American Automobile Association (AAA), gas prices during the summer of 2016 hit an 11-year low. Gas prices for the 2016 Memorial Day holiday were the cheapest since 2005 and were down 42 cents per gallon versus last year’s holiday. For the Independence Day weekend (June 30 – July 4), AAA estimated that 36 million people drove on the nation’s highways, a 1.2 percent increase from 2015. Clearly, more drivers on the roads enjoying inexpensive gas would increase the percentage of accidents.
Beyond weather and cheap gas, I have another theory on why we are seeing spikes in GAP losses. And it portends a number of adverse outcomes for auto dealers. In simple terms, as lenders became lax with lending practices in recent years and loan terms lengthened, the timeline for customers to file GAP claims lengthened, with larger gaps between insurance payouts and vehicle values. Here’s my theory:
In 2009, the real estate market was issuing loans to people who shouldn’t have been getting loans. The economy suffered and the Great Recession was born. The painful wake-up call for better lending practices spilled over into auto lending. As a result, auto lenders tightened their practices and banks were not as generous or lenient. The market was righted and credit in general strengthened in 2012-2013.
As we emerged from the Great Recession, consumers grew more confident and auto manufacturers/dealers were eager to see sales rise. Incentives were offered, the used car market surged and over the past two years, car sales have peaked. This increased sales volume did not go unnoticed by auto lenders. Over time, lenders have become more aggressive. Loan terms have steadily grown longer to cover the increase in vehicle prices. In many recent cases, lenders have become excessively generous, advancing greater than 100 percent of invoice. I am afraid we are approaching a slippery slope.
LAX LENDING’S SLIPPERY SLOPE
How does this impact GAP losses? Consider this scenario: A buyer finances a car for 84 months at 110 percent of the $20,000 invoice, totaling $22,000 of financing. He consistently makes his payments, but a larger percentage of that payment is going to interest – not the principal of the loan. Then one day, he is in an accident and totals the vehicle. And suddenly, the value of the loan is greater than the total loss valuation of the vehicle. Voila! – GAP loss.
Let’s consider a second scenario. A buyer finances the same car for 60 months at 90 percent of the $20,000 sticker, leveraging a down payment to reduce the overall cost of the vehicle. Financing is $18,000 with a larger percentage going toward the principal of the loan. Same accident, but a $3,000-less exposure for the GAP claim versus the first scenario.
TIGHTENING THE GAP
While implementing good lending practices will surely help the GAP market, there are a few other areas of improvement. The recent Detroit Auto Show offered lots of bright, shiny new models, some relaunched brands along with plans for autonomous vehicles. What we didn’t see were any declines in prices. New car prices continue to rise resulting in a faster rate of depreciation. This equates to a greater spread in valuation and a larger GAP to cover on claims.
While used car inventories were high in 2016 – and prices found strong support with heavy purchase traction, the jury is still out for 2017. Will prices dip below 2016 levels? Will inventories continue to grow or will “yesterday’s” vehicles sit dormant on the lot? Either way, the same lessons should be considered when factoring in the potential for GAP losses.
OVERHAULING GAP PRICE STRUCTURES
I also believe that GAP pricing structures need to be overhauled. Originally, when GAP was introduced into the market, it was sold under a two-tier structure of 0-61 and 62-84 month terms. In 2003/4, the three-tier structure was introduced with 0-60, 61-72, and 73-84 month terms. This change reflected lender’s growing term flexibility and a zealous approach to the market.
Rather than basing GAP pricing on term, I would prefer to base pricing on long-term valuation or the type of vehicle purchased. We’ve clearly seen how loan length increases GAP exposure. By changing the pricing structure, we would lessen the impact of term and help mitigate some of the loss exposure.
Another avenue for determining GAP pricing could be based on the purchaser’s driving habits. While we can’t assume the fault in this scenario’s accident, driving habits and total loss frequency do play a role in GAP exposure. For the sake of argument, let’s say one driver has a history of driving too fast and has been involved in several wrecks. In fact, three out of five of his previous vehicles owned were deemed a total loss due to a wreck. The driver in the second scenario has a “safe driver” record with a history of zero total losses due to accidents. The risk of GAP loss is much higher for the driver in scenario one versus scenario two, which could affect how much each driver pays for GAP – just like with traditional insurance.
Clearly, GAP will remain a staple of the auto lender and dealer portfolio. But a few adjustments might make everyone’s life a little easier as we enter a topsy-turvy 2017.