GAP – Where Do We Go From Here?

While publicly available data is not available for GAP writers, it is clear of that 2011 will go down as a profitable year for GAP Insurance.

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.