Negative equity adds to GAP losses

Guaranteed Asset Protection claims — and losses — are on the rise, and ballooning negative equity appears to be partially to blame.

Losses on GAP coverage have spiked in the past couple of years after several years of restraint from lenders in the wake of the Great Recession, according to EFG Cos. In fact, losses have returned to around the historic peak in 2007 and 2008.

What's driving the spike? To be sure, low gasoline prices and a healthy economy are combining to put more people on the roadways, thus increasing the risk for accidents and totaled vehicles.

According to an October 2016 study by the nonprofit Insurance Information Institute, collision claim frequency rose 2.6 percent between the first quarter of 2014 and the first quarter of 2016. Meanwhile, total loss costs gained 13 percent during that period.

But another factor is also at play: a rise in negative equity.

As credit loosened and loan terms lengthened in recent years to counter increasing vehicle prices, the value of a loan has become more likely to exceed the value of a totaled vehicle, EFG CEO John Pappanastos said.

Longer loan terms, often as long as 84 months, mean that consumers are more likely to be in a negative-equity position at the time of an accident, leading to more GAP claims and higher losses on them.

Pappanastos said the issue pertains especially to subprime borrowers, who are already more likely to have negative equity. Subprime borrowers typically have higher interest rates and longer loan terms than prime customers, leaving the industry further exposed to losses on GAP coverage.

"Most of the early payments go toward interest, not principal," Pappanastos said. "The car is depreciating while the principal balance is depreciating much slower. So the exposure over the life of a GAP contract actually increases for a subprime customer."

The rise in GAP claims and losses comes as the insurance industry deals with what S&P Global Ratings called "consistent" underwriting losses each year since 2009. S&P said in a June 6 note that it will likely take "another two or three years for auto insurance performance to return to profitability."

GAP losses are a problem that's only likely to worsen in the near term, Pappanastos said. That's because falling used-vehicle prices, driven by excess dealer inventory and a glut of off-lease vehicles returning to market, will put the industry further at risk for GAP losses, he said.

"That's what scares me up ahead," Pappanastos said. "Inventories on dealer lots are building, and they're jamming the rental-car channel with excess inventory now. There's going to be pressure on used-car prices, so the claim severity should increase."

The problem is further compounded by the rising age of light vehicles on U.S. roads. The average age hit 11.6 years in 2016, according to a November study by IHS Markit.

"Vehicles are made so much better than they have been," Pappanastos said. "Dealers are carrying cars with much higher mileage on their lots. They're reselling them and they're putting GAP coverage on them. And the older the vehicle, the more likely it is that it will be totaled when it's in an accident. It's much harder to total a $25,000 car than it is to total a $5,000 car."

While acknowledging the cyclical nature of GAP coverage, Pappanastos said it is imperative for the industry to change how it sells GAP. He said there are typically three rates for GAP coverage, based around the length of a loan term: 0-60 months, 61-72 months and 73 and more months.

Instead, Pappanastos said, GAP coverage should be sold based around the loan-to-value ratio: the higher the ratio, the higher the rate.

"I don't think the industry has priced this at any level of precision," he said. "We're getting there by force of necessity, though."

Anil Goyal, an analyst at Black Book, said the industry could also develop new F&I products to help keep negative equity in check.

"This is an opportunity for the industry to come through. New products could be developed because this is a need, to protect consumers from getting to deep into it," Goyal said. "Dealers may have to adjust their strategies and how the F&I department helps consumers through their negative equity situation."