GAP: Back from the Brink

In 2008, many administrators were concerned about the profitability of the GAP business. Not only was the frequency of claims increasing, but the severity of GAP claims were going through the roof. Used-car prices were collapsing as demand dried up – and insurance companies were settling total losses at a significant haircut from one year ago. But just as quickly as things got bad, losses improved in 2009. What happened?

Before we answer that question, it might make sense to think about how a GAP program works.

Since GAP covers the difference between the book value and the loan value, the book value acts like a very high deductible in a traditional insurance policy. As the table below shows, changes in used-car values are significantly leveraged into changes in the GAP severity.

So in this hypothetical example, a 10 percent change in the underlying value of the vehicle will cause a 37 percent change in the GAP severity. Drops in used-car pricing can even make the ratio worse as vehicles that were previously repaired are declared total losses.

Another issue is shifting vehicle preference between types of cars, such as a definite relationship between small car prices and gasoline. Alternatively, there is an inverse relationship between large trucks and gasoline prices.

Changing consumer preferences will cause spikes or drops in used-car prices. For example, assume that large trucks have been popular for the last several years but now are experiencing a drop in popularity – perhaps due to petroleum prices. There is both an increase in supply (as these vehicles are traded or sold) and drop in demand. These “double whammies” may tend to cause the used-car pricing to be more unstable than you would expect.

By far, the biggest uncertainty with the analysis of a GAP program is the future direction of used-car pricing. Used-car prices are subject to volatile shifts. This occurs because of economic shifts which can impact the market value of used cars.

It is important to note that for GAP pricing, late-model used-car prices are more important, as the sale prices of older vehicles (more than 3 years from the current model year) will not be subject to significant GAP claims.

As the chart above shows, the index of used-vehicle prices is subject to significant variation. Vehicles in the index are compiled from auction sales which focus mostly on late-model used vehicles.

For example, in the aftermath of 9/11, car manufacturers began to heavily incentivize the purchase of new cars through “zero percent financing” and other enticements. The result was a strong decline in the value of used cars, as these prices adjusted to the corresponding new car price.

The "great recession" officially began in December 2007, which is the beginning of a decrease in the price of used cars.

In mid-2008, the decrease was so sudden and violent that it briefly appeared that all GAP programs might be severely underpriced.

Surprisingly in late 2008, used-car prices began to show a major improvement. While the forces behind this increase are not fully understood, there is some evidence that this increase may be more due to a lower supply of late model used cars in the marketplace rather than an increase in demand. This increase has continued and in April 2010 the used-car price index was at an all time high.

This supply constraint is due to decreased new vehicle sales in the prior years, as well as less leasing of vehicles (which generates a sale when the lease terminates). In addition, rental car fleets (who are a major source of late model used cars) purchased fewer cars.

The chart below shows the relative changes since 2001 for a few popular vehicle segments. As you can see, compact cars have shown significant price appreciation since 2001. Note that the index spiked in mid-2007 with the significant increase in petroleum costs.

In conclusion, GAP is a leveraged product in which small changes in the underlying book value of the asset will cause large swings in projected results. In addition, private passenger vehicles are subject to dramatic and somewhat unpredictable changes in price due to economic forces, petroleum prices, and consumer preferences. Also, future regulatory requirements such as increased mileage standards may impact asset prices. For example, if mileage requirements limit the supply of larger SUVs, then used-car prices for this segment may be expected to rise.

For a GAP administrator, this volatility is part of the product and can be expected to continue. Administrators should be careful about extrapolating recent trends and be cautious about pricing based on current results.