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?
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.
One reason that total losses are increasing is that drivers are driving an increasing number of miles. The total number of miles driven in the US has increased about 6% since 2010. This is due to a combination of an improving economy and lower gas prices. The impact of additional miles is felt in both the frequency and severity of claims. Additional miles means the probability of an accident is higher (frequency), and higher mileage vehicles will be settled by the primary insurance carrier at a lower settlement rate (severity).
Distracted driving also has an impact. We are all aware of the impact of texting and other technology on driver awareness. There has been a lot of attention on distracted driving because distracted driving is increasing the frequency of accidents.
Perhaps most importantly the amount for repairing a vehicle is also increasing. Labor rates for repairs are increasing as repair shops are busier than ever before. More importantly, the amount spent for replacement parts is increasing – in some cases dramatically. Some examples are noted below and the increase is from the 2014 Model Year to the 2015 Model Year:
Why the big increases? Technology. Sensors and cameras are increasingly incorporated into mirrors and bumpers. Headlights now move with the driver and use more expensive systems such as LED.
It is important to realize that insurance companies have some leeway on declaring total losses. Increases in used car prices will impact their settlement and make it less likely they will declare a claim a total loss, since a repair will be less expensive than settling the claim.
The Used Car Market
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 5 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.
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. The OCC in their Semiannual Risk Perspective - Spring 2016 specifically noted the increased risk to lenders from increased loan-to-value ratios. The impact of increasing loan-to-value 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.
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 and not likely to 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.