Guest commentary: Residual value risk in transition to EVs must be reckoned with

In Levi Tillemann’s book, The Great Race: The Global Quest for the Car of the Future, he tells a story of Ford’s then-chief technology officer hearing an investment pitch in 2007 for an improved internal combustion engine. Afterward, the executive told the young inventor that Ford’s powertrain road map had been written and it “will end up in battery land in about 15 years.”

Fifteen years later, based on the amount of attention and investment received by electric vehicles compared with internal combustion vehicles in the industry and some symbolic events favoring EVs, the former Ford chief technology officer may not be off by much. By the end of 2022, the U.S. government passed favorable legislation to promote EVs under the Inflation Reduction Act.

Ahead on the transition curve, China phased out its 10-year-old nationwide subsidy program to manufacturers as EVs are now deemed competitive with internal combustion vehicles in total cost of ownership and desirability. And this year started with the news that during the first two months, Honda, a manufacturer born out of high-quality internal combustion engine production, found its sales in China dropping more than 30 percent from the same period in 2022. 

In contrast, electric-vehicle-only BYD, an also-ran domestic automaker in 2018 when I last visited Shenzhen, China, became one of the dominant players in the passenger vehicle market in that country in 2022. We don’t need to read the tea leaves to guess where the trend is heading. Battery land appears to be the case at least in the world’s largest passenger vehicle market.

The situation in the U.S. is not clear or rosy. There are still a few key obstacles to be dealt with, including the availability and reliability of charging infrastructure. Another pain point is the residual value risk of EVs during the transition period. 

As a result, auto finance companies have less confidence in guidebook residual value forecasts and insist on extremely low contract residuals for EV leasing. Investors interested in startups of mobility business models set extremely low values for used EVs, thereby lessening the value of the collateral and leading to a low advance rate and/or a high funding cost.

Used-vehicle prices are intrinsically unstable because of the interplay between prices and supply in the leasing business. When used-vehicle prices experience a negative shock, low prices increase used-vehicle supply because of more consumers returning vehicles, which 

further reduces the price. Such a downward spiral will not stop until used-vehicle prices become irrationally low, which we have observed during economic downturns.

In the past two years, we had the rare chance to observe this strong relationship working in the positive direction for used-vehicle prices because of inventory shortages of new vehicles. 

Given the nature of the used-vehicle market, there will likely be other shocks that send prices up or down during the transition period to EVs. These shocks result from multiple causes, such as sudden change on the demand or supply side, government policy changes or technological breakthroughs.

Residual value risk is particularly acute in the U.S., where a significant portion of new-vehicle sales have been through leasing. The local content rules in the Inflation Reduction Act make EV leasing more attractive because it is interpreted as commercial use, therefore subject to much less stringent local content requirements for tax credit. After all, commercial insurance’s value is to take away uncertainty not within a business organization’s control so they can focus on things at which they excel. Unfortunately, because of the bad experience insurance companies had, they are reluctant to participate.

Those who are familiar with the history of residual value insurance in the U.S. may question whether the insurance industry can avoid repeating mistakes. This skepticism is understandable given the large losses some prominent insurance companies suffered, causing them to exit the market. Many banned residual value insurance rather than investing in their underwriting capability. 

We believe the root cause for the failure is those insurance companies relied on traditional property and casualty underwriters to underwrite residual value insurance without in-depth knowledge about the automotive industry, particularly used-vehicle market dynamics. Almost all insurance companies dabbled in residual value insurance hoping for some quick wins. But in the U.S. market, there is limited supply of insurance capacity for residual value risk.

In contrast, insurance companies in China have been playing a more active role. Manufacturers worked closely with insurance companies to provide residual value assurance to consumers even though true consumer leasing is still in its infancy stage. To alleviate consumers’ concerns about their vehicles’ residual values, manufacturers issue a certificate that protects trade-in value, TVP, at various future dates. Then large insurance companies — such as Ping An P&C, PICC, CPIC, among others — stand behind manufacturers with insurance policies. 

Such programs can be specific for certain financing products or blanket all retail sales. In China, almost all manufacturers either have considered, are considering or have already implemented a TVP program. Insurance companies can be more active players in helping the automotive industry transition from the internal combustion age to the EV era. If insurance companies in China can learn from the experience in the U.S., they can play an important role in a sustainable fashion.

As the automotive market in the U.S. shifts back to a buyers’ market after the supply-chain squeeze, used-vehicle prices can experience a period of rapid decline along with a flood of new EV models. Manufacturers and auto finance companies will be looking for a solution for their residual value risk. 

We believe insurance companies’ attitudes will change in the U.S. and will join with RVI Group to participate in this great race for the car of the future, a race that will change the fortune of all major economies.