Deconstructing the GAP Crisis
Deconstructing the GAP Crisis

It should come as no surprise that GAP underwriters are having a tough time. Years of excellent profitability following the Great Recession have been replaced with monumental losses and underpriced rates from many insurers. The first half of 2017 was by far the worst six months in the history of GAP, and there is little relief in sight. Vast amounts of data at Allstate allow us to measure the interactions between the residual cycle and underlying trends, explaining past changes and allowing us to plan for the future.

GAPs in History

Allstate began administering GAP in 1998 and became a GAP insurer in 2001. For the 10 years prior to the Great Recession, the industry had steadily increasing GAP losses. As loan terms began to increase over 60 months, we introduced the three-term band-rating plan that is still standard today.

Lending was the primary driver of losses during this period. Finance sources became gradually more willing to finance negative equity. To keep payments down, 72- and 84-month terms became increasingly popular. These longer terms resulted in even more negative equity at trade-in, which lenders became eager to finance. The average loan-to-value ratio for GAP waivers peaked in 2008, creating the largest exposure at the worst possible time.

The 2008 gas crisis and the Great Recession that followed exposed just how significant residual values could be for GAP losses. Demand for trucks and SUVs plummeted as a result of $4 per gallon gas, which drove the residual values of in-force GAP waivers to the lowest levels ever seen. The values of cars soon followed as the financial crisis reached its critical stage in September 2008. In 2009, the unemployment rate hit 10%, lenders weren’t lending, and buyers weren’t buying. New-vehicle sales hit a 27-year low. Auto manufacturer bankruptcies and bailouts soon followed.

The fall in new-vehicle sales had a secondary effect that would lead to years of GAP profitability. People can only put off buying cars for so long. As the economy began to improve and the average age of registered vehicles continued to increase, demand for automobiles began to return. The lack of new-car sales in 2008 through 2011 resulted in a shortage of used vehicles. Consequently, used-vehicle prices rose. According to Black Book, depreciation rates of two- to six-year-old vehicles was only 8.3% in 2011 compared to an average of 16% to 18% prior to the recession.

What followed was a period of great profitability. Losses were excellent and new carriers entered the market with lower rates. They assumed the good times would continue or, at worst, they would see the bad times on the horizon and have time to act. Years of low losses lulled the market.

Falling Residuals

Residual values are the largest driver for GAP losses. We have developed our own depreciation model at Allstate, using the value of totaled vehicles from personal auto claims and GAP claims. Our data shows the average value at time of total loss for a three-year-old car in 2012 was more than 62% percent of its original MSRP. In 2014, it was 60%, and for total losses that occurred in the first half of 2017, it was 51%. On a car with a $25,000 MSRP, that’s potentially an extra $2,500 gap at claim time.

This fall in residuals impacts both frequency and severity. Waivers that had positive equity during the period of high residuals now are more likely to have negative equity, increasing claim counts. Those waivers, which had negative equity during the high residual period, now have much larger gaps, resulting in claim size increases.

This fall in residual values explains the majority of the increase in GAP losses since the Great Recession. A GAP waiver on a new mid-size car purchased in 2011 with a loan-to-value ratio of 112% would have had a loss cost of $25. That same vehicle purchased in 2015 has an expected loss cost of $150, a six-fold increase caused primarily by changes in residuals.

Trucks, SUVs, and to a lesser extent crossovers, have seen much lower depreciation than cars. While truck residuals reached a bottom of 52% in the beginning of 2009, they recovered to 65% by 2011 and remained at that high level through 2015. They have since fallen to 60% for the first half of 2017. While this may not seem like a huge drop, the impact on the average waiver is still a doubling of loss cost.

Auto Accident and Total Loss Frequency

Increased auto accident frequency, combined with a rising likelihood of total losses, is the second largest driver for the recent increases in GAP losses.

The years 1995 to 2013 brought nearly 20 years of steadily declining auto accident frequency. The trend was driven by improved vehicle safety, graduated drivers licensing and harsher drunk driving laws and enforcement. In 2014 this trend began to reverse. Lower gas prices, increased employment, record car sales and large increases in distracted driving resulted in the first sustained spike in auto accident frequency in 20 years. Over a period of just two years, auto accident frequency increased 10%, resulting in 10% more opportunities for a GAP claim.

More concerning than the rise in overall auto frequency is the increase in the proportion of those accidents resulting in total losses. In 2006, 13% of auto collision claims resulted in a total loss. This increased slightly during the recession but fell back to 13% in 2011. The proportion rose steeply to 16% in 2015 and then 17% in 2016. The combined effect of the rise in accident frequency and the higher likelihood of those accidents resulting in a total loss was a 45% increase in total losses in just five years.

Understanding what’s driving the increase in total losses is key to determining if this is a cycle that will reverse or a continuing trend. From reviewing personal auto claims data, it’s unfortunately the latter.

Manufacturers have added new standard features such as LED headlamps, front and rear parking sensors and cameras, safer and more numerous airbags, and aluminum and carbon fiber bodies and frames. These features designed to make cars safer, more fuel efficient and more luxurious, are adding significantly to the cost at claim time.

Accidents that, in the past, were simple fender benders can now result in tens of thousands in damages by deploying multiple airbags, destroying expensive sensors and damaging those beautiful yet costly LED headlamps. We see claim after claim of what visually appears to be minor damage resulting in total losses. Airbags in the seatbacks of Hyundais, unrepairable frame rails on Lexus sedans, $5,000 sensors and cameras on Audis, and even $965 transparent symbols on the front bumper of a Toyota Corolla are but a few examples.

Loss Outlook

Residual values and total losses are the two factors having the largest impact on GAP losses. Lending variables, including loan-to-value and interest rate, have remained largely unchanged over the past five years. While differences in these lending variables can result in significant differences in losses between dealers, it is not the underlying cause of the loss trend.

With the factors known to produce changes in GAP losses quantified, we can improve our outlook for the future. Car residuals have fallen sharply over the past three years. There may be hope for a rebound; however, the market has yet to experience the effect of peak leasing reached in 2015 and 2016. Those vehicles will be coming off-lease in 2018 and 2019, putting continued pressure on the values of all cars. While we hope car residuals won’t get much worse, we find it unlikely they will improve much in the next few years.

Trucks and SUVs have retained their value much better, though recent increases in production and competition have resulted in large manufacturer incentives. The effect of these incentives is already being felt on used truck pricing. There remains plenty of profit in trucks for manufacturers, however. New supply resulting from the expansion at the Toyota plant in Baja, the retooling of the current Focus factory to manufacture the returning Bronco and Ranger pickups, the Jeep Wrangler pickup, and the always increasing supply of crossovers will further depress residuals.

Higher total loss frequencies are here to stay for the foreseeable future. New and costly technology will continue to permeate the fleet leading to more and more total losses. Unless gas prices rise significantly, employment falls considerably or the distracted driving problem somehow improves, underlying accident frequency will remain at the current high levels with potential to worsen further.

GAP losses are unlikely to get better anytime soon. With significant portions of the market underpriced, administrators, agents and dealers with lower cost GAP providers can expect drastic changes once their underwriters’ tolerance for significant losses finally wanes.