Frost Financial Services has been providing GAP and auto loan protection products and services to financial institutions for over 40 years. For more information on the risks facing your borrowers and your financial institution, visit www.visualgap.com or contact Jim Tenhundfeld at jtenhundfeld@frostinsure.com.

In the world of auto physical damage claims, the past year has seen profound changes. The wide-reaching scope of these changes is likely to have a significant impact on borrowers and auto lenders, not to mention auto insurers and GAP providers. In short, we are seeing an increase in auto accident frequency, an even greater increase in the percentage of accidents that result in a total loss, and yet an even greater increase in the percentage of borrowers left with a deficiency balance after total loss. Some of these deficiencies result in GAP claims, and some result in very unhappy borrowers and/or lender write-offs.

The research and findings that follow provide an overview of 1) the economic, regulatory and technological changes over the last 10 years that have precipitated these changes; 2) their significant impact on auto lending; and 3) what to expect in the next 10 years.

Key Findings:• Total loss GAP claims up >50%• Vehicle depreciation is at record highs, particularly in specific vehicle segments• Repair costs are increasing due to high-tech components, causing more accidents to result in total losses• Primary auto insurer loss settlements are NOT typically at NADA Clean Retail• Used car loans are often made assuming a vehicle value of NADA Clean Retail, but without CARFAX

and inspection, this can prove to be a costly assumption. 100% loan to value (LTV) does not always mean 100% LTV.

• Recent CFPB supervisory and state regulatory changes call for review of practices and products.

Moving forward, economic, regulatory and technological factors will continue to exert their influence, making it more important than ever to ensure that loans are protected with GAP coverage and that total losses don’t result in undue financial strain on borrowers, uncollectible debts for lenders, and the inability of borrowers to get into a replacement vehicle.

“More Auto Accidents = More Total Losses = More GAP Claims.”

Warning Signs for Your Auto Loan Portfolio

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Looking BackBefore getting into the specifics of what is driving these changes, it is worth taking a minute to digest how significantly our world has changed in the past 10 years. Here are just a few of the changes we have seen between 2006 and 2015:

Economy

• The Great Recession, which was the largest economic collapse since the Great Depression• The bailouts of the “Big Three” automakers and many large banks• The plummet and gradual recovery of new car sales since the recession• Cash for Clunkers program, which took vehicles off the road and temporarily boosted values on used cars

due to lower supply• Gas prices that peaked at well over $4 per gallon and subsequently fell to just over $2 per gallon• An extended period of low inflation and record low interest rates for borrowers

Regulations

• Introduction of Consumer Financial Protection Bureau (CFPB) – Predatory Lending and Disparate Impact have triggered multi-million dollar fines and forced reviews of lending practices and loan protection products

• Increased speed limits on most major highways – 55 no more

Technology

• The introduction of the Apple iPhone in 2007; smart phones are now operated by more than 200 million users in the U.S.

• ABS brakes and airbags are now present in most vehicles on the road.• GPS, navigation systems, and Google Maps replace folded maps, MapQuest, and stopping at the pay phone

to get directions to our destination.• Electric cars and hybrids emerge, fade and re-emerge.• Halogen headlamps, back-up cameras, and parking sensors are now standard features in vehicles.• User-based technology allows insurers to track driving habits and adjust premiums based on usage.• ALL MOBILE - ALL THE TIME

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TodayAll of this represents a pretty dramatic change in our world in a relatively short period of time. Combine this with some recent developments, and you have the makings of a pretty dynamic period for auto manufacturers, lenders and insurers. In particular, we are seeing a change in the number of vehicles experiencing total losses and the number of loans in a negative equity position at the time of total loss. Let’s look at a quick snapshot of what we are seeing in 2016:

• Back-to-back severe weather years laden with tornadoes, hail, and floods (Two 500-year floods already this year in Texas and a 1,000-year flood in West Virginia)

• Improved employment picture has more people back on the road, driving more miles and buying more cars.• Cheap gas (relative to $4/gallon) means more miles driven – particularly on interstate roads where speeds

are higher and accidents are more serious.• A continued move to the suburbs and to the Southeast and West where public transportation is limited

equals more vehicles on the road.• Many roads are in poor condition, and infrastructure is not keeping up with new traffic patterns.• Interest rates remain near record lows but so does equity in vehicles.• Leasing is returning to record levels due to higher average transaction prices; payment is king, and long-term

loans or leasing allow us to get into the vehicle we want.

Many of these factors contribute to the escalation in total loss numbers and deficiency loan balances, but there are some very specific factors that would indicate that these problems are not going away anytime soon.

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Increasing Rates of DepreciationFor a decade prior to the recession, used vehicles depreciated an average of 16% per year (NADA Q2 2015 Vehicle Equity). During the recession, vehicle depreciation dropped to a low of 5% annually in 2010-2011, thanks to the Cash for Clunkers program and plummeting new car sales numbers, and then rose back to 13% in 2012-2014, 14% in 2015, and 18% in 2016. Overall, depreciation rates are expected to average around 18% annually through 2017 as used vehicle supply continues to increase rapidly. However, as we saw with trucks and SUVs in the peak of the recession, compact and subcompact cars are seeing significantly worse depreciation. In fact, according to Black Book®, sub-compact cars have depreciated 26.1% over the past 12 months. This represents the largest 12-month drop of any segment over the past 10 years.

Graph A: Annual Depreciation

A recent claim provides a clear example of the impact of this extraordinary depreciation. In April of 2013, a 2011 Volkswagen CC was financed for 75 months at 96% of the then NADA value of $22,200. Three years later, the vehicle was totaled, and with depreciation that averaged ~24% per year on a used vehicle, the loan still showed a deficiency of over $5,400.

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While average depreciation among all segments might move up and down within a narrower band, individual segments and even particular vehicles can see dramatic swings in depreciation in response to ever-changing market conditions and shifting consumer preferences.

The following graphs help illustrate the significant increase in GAP exposure as vehicle depreciation increases from a more typical 15% per year to a 25% annual depreciation rate that we have been seeing over the past 12+ months on smaller car segments. The areas shaded in blue represent the negative equity in the loan as reflected in the difference between the amortized loan balance and the expected value of the vehicle over the course of the loan at the given annual rate of depreciation. Not only does the number of months that the loan remains under water increase significantly, from 36 months to 56 months on this 72-month loan, but the amount of the deficiency during that period also increases substantially.

Graph B: GAP at 15% Annual Depreciation Graph C: GAP at 25% Annual Depreciation

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In addition to changing consumer preferences, higher incentive spending by manufacturers, and increased off-lease volume, the growth in Certified Pre-Owned (CPO) sales also drives greater depreciation in the used car market. While CPO classification on used vehicles helps increase the market value of the vehicle at time of purchase from dealer lots, the value of the certification is all but gone six or 12 months later when the vehicle is back to being a standard used vehicle. For example, a two-year-old vehicle sold as CPO may get a $1,500 boost in valuation at sale time only to see that benefit disappear within a year, creating exaggerated depreciation that includes the normal vehicle depreciation PLUS the $1,500 credit for CPO. It is nothing more than having a short-term warranty that carries $0 value once the warranty has expired.

Top Factors Driving Increasing Vehicle Depreciation

• New car sales have increased to record levels• Increased incentives by manufacturers to grow or maintain market share• Dramatic rise in leasing is driving increase in supply of “off-lease” vehicles• Changing consumer preferences• Certified Pre-Owned

The impact of faster depreciation is significant – not only relative to the number of loans in a deficiency balance, but also in how it impacts negative metrics on loan portfolios. An increased number of loans with a deficiency balance unquestionably drives higher GAP losses. Having more loans under water and for a longer period of time greatly increases the potential for GAP claims. Highlighting that impact, we have seen the average months from loan inception to GAP claim increase from a low of 13.3 months in 2014 to nearly 22 months in 2016. This is a clear indication that more loans are staying under water for a longer period of time.

In addition to a dramatic jump in GAP claims, loan portfolios are slowly seeing the impact of strained car values. First, lower car values today mean less equity (or more negative equity) for borrowers when they want to move out of their old car and into a new one. Ultimately, that will contribute toward increasing average LTVs and longer loan terms. Importantly, less equity in vehicles also drives higher default rates – if not seen yet, it is on the near horizon. The probability of repossession is 10.3% when there is negative equity of just $2,000 and increases to 16.4% with negative equity of $5,000 (NADA Q2 2015 Vehicle Equity).

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Technology Advances & TrendsMore than ever before, the old saying “they don’t make ’em like they used to” rings true in reference to automobiles today. While we still might have a love for the muscle cars of the ‘60s and ‘70s, they don’t match up very well with the cars today in terms of safety, fuel efficiency, power, comfort, durability, dependability or longevity. Cars are made better and last longer! Given the price of cars, that’s a good thing.

Advances, however, do come at a cost. All of the features that make vehicles safer – airbags, cameras, sensors, lightweight construction, halogen headlamps and computers – also make them much more expensive to repair. Note that the headlamp assembly for a 2015 Dodge Dart is $1,100. (I think the cost of replacing the headlamp assembly on our 1972 Dodge Dart was closer to $11.) Not only are distracted driving, higher speed limits and having more vehicles on the road causing more serious accidents, but those accidents also cost more. What used to be a low-cost fender bender now results in thousands in damages.

The combined average age of all vehicles on the road was 11.5 years in 2015 (IHS Automotive) and is projected to be 11.6 years for 2016. This is both a reflection of improved quality as well as the drop-off seen in new car sales during the recession. CCC reports (CCC 2016 Crash Course) that repair costs are rising at 2-3% per year. Couple this with increasing rates of depreciation and an increase of older vehicles on the road, and you have the formula for more accidents that will result in total losses.

Non-auto technology is also impacting the number and severity of accidents as well. With more drivers texting, reading an email, looking down at a smartphone to get directions, or glancing away to find a new tune, distracted driving remains on the rise and a major concern on our roadways.

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Lending Practices & Consumer BehaviorThe life of a vehicle isn’t the only thing that is increasing. We are also seeing the length of time consumers own/retain their vehicles increasing. In the 10 years since 2006, average months of ownership has increased over 50% and now stands at over 5.5 years (Graph D).

Additionally, and more importantly for lenders and risk managers, loan terms are increasing rapidly. In just two years, the percentage of used car loans with terms of 61 months or longer increased from 51.1% to 57.5%, with 16.2% of the used car loans now in the 73-84 month bucket. The numbers on the new car side are even more pronounced with 72-month loans now the norm. (Manheim 2016 Used Car Market Report)

Graph D: Length of Vehicle Ownership

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Longer loan terms certainly help borrowers achieve more affordable payments, but they also dramatically increase the likelihood that the loan will be under water for a significant period of time. Extending a loan with the same amount financed and interest rate from 60 to 72 months can increase the amount of time the loan is in a negative equity position up to an additional two years.

While competition for auto loans is intense and there is temptation to loosen lending guidelines (higher LTVs, lower FICO, longer terms, etc.), risk sometimes increases even without any changes to guidelines or noticeable changes to the loan portfolio’s apparent risk profile. The fact is that 100% LTV does not always mean 100% LTV. Here are a few common scenarios:

• Lender finances 100% of MSRP of $35,000 on a 2016 Dodge Ram with $8,000 of manufacturer/dealer incentives. This loan is actually being financed at 130% ($35,000 / $27,000 actual value) LTV based on the off-the-lot value of the vehicle. If the same lender finances a 2016 Acura TSX with an MSRP of $35,000 and no incentives or reductions, then that loan is indeed financed at 100%. Which loan carries higher risk?

• Lender finances a 2012 Honda Accord for $15,000 because the NADA CLEAN RETAIL is $15,000. As is the case with most lenders financing used vehicles, the condition of the vehicle is not verified or maybe even asked about beyond how many miles are on the odometer. (At a minimum, used vehicle financing should require a CARFAX® Vehicle History Report.) Two months later the vehicle is totaled, and the primary auto insurer values the vehicle at $10,000 due to poor condition of the vehicle and some prior damage that actually existed at loan origination. In effect, this loan was not made at 100% LTV, but closer to 150%. This scenario is particularly relevant on loans financed on person-to-person sales or refinances. These vehicles are typically not “front-line ready” and certainly don’t fall into the category of CLEAN RETAIL. Note that a majority of used vehicles sold on franchise dealer lots fall into the CLEAN RETAIL bucket. In terms of vehicles on the road, however, only around 10% of vehicles fall into the CLEAN RETAIL category.

To illustrate this impact, we recently processed a GAP claim on a 2006 Ford F150 that was financed at 114% of the presumed value ($16,075) of the vehicle. Less than two months later, the truck was totaled, and the primary carrier provided a settlement of $8,740. The NADA CLEAN RETAIL at time of loss was still $16,075. However, condition and mileage adjustments made by the primary carrier meant the settlement left a deficiency balance on the loan of $9,700. Fortunately for the lender and borrower, this loan had GAP, and the deficiency was covered.

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• A lender makes a loan on a used vehicle at a time of year or in a market cycle when used vehicles or vehicles in that particular segment are high (i.e. four wheel drive SUVs in December). In six or 12 months, market conditions have changed, and that particular vehicle experiences excess depreciation. What might have been assumed to be a loan made at 90% to value has now, in effect, become a vehicle that was financed at well over 100% to value. We are seeing this currently with compact cars that were financed last year at what appeared to be conservative LTVs and are now proving to be aggressive and very risky loans.

We hear frequently from lenders that they don’t lend over 100% of the retail value of the vehicle so they don’t see the importance of GAP for them. As we see every day with GAP claims where LTVs were well below 100%, LTVs are only as good as the accuracy and stability of the value of the vehicle being financed.

Primary Carrier PracticesAs with most industries, primary auto insurers continue to expand the use of data and technology in adjusting auto claims – both liability and physical damage. For example, photos and predictive analytics are used to determine if a vehicle is repairable or should be totaled. This helps speed the time to adjust a claim and helps insurers reduce costs associated with working through repair estimates.

Additional tools available through sources such as CCC help insurers determine market value of vehicles at time of accident. Through detailed condition evaluations and automated market comps of similar vehicles, insurers are able to quickly assign values, weigh a vehicle’s salvage potential, and determine if repairing or totaling the vehicle is the most economical settlement. While the automated tools can speed the process and also seemingly take the subjectivity out of the settlement process, this does not always work in the favor of the insured. In fact, if the automated settlement tools and processes didn’t help save claim costs for insurers, then they would be less likely to utilize them. The detailed condition adjustments typically result in deductions off of valuation. Additionally, the market comps usually also reflect a downward adjustment to the market retail values provided to account for the assumed lower-than-retail price that the buyer would be able to negotiate.

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Next 10 YearsThe world of automobiles and the associated accident and total loss picture has unquestionably changed significantly in the past decade. The rate of change, however, will only continue to increase. Here is a glimpse of what we might expect to see in the next 10 years, particularly with regard to the auto market.

• Self-driving cars will continue to emerge in greater numbers. At a minimum, driver-assisted technology will become more prevalent in vehicles.

• Because Millennials see vehicles as nothing more than transportation, shared vehicles will become more common.

• Automatic Emergency Braking (AEB) and other collision avoidance technology will become standard. By 2026, it is projected that over half of the vehicles on the road will be equipped with front crash avoidance technology (CCC 2016 Crash Course).

• Lighter-weight materials will be more prevalent in all vehicles.• Halogen lighting will be replaced by LED and laser lighting.• We will see an increase in 0-5 year-old vehicles, a decrease in 6-10 year-old vehicles as the low volume

production of the recession years works through the market, and an increase of 10+ year-old vehicles as vehicles continue to last longer.

• Both technology and regulation will emerge to help harness and control the distractions of smartphones and other technology while behind the wheel.

• Gas prices are projected to remain moderate – but projections over the past few years have been less than accurate as the market continues to be at the mercy of OPEC, the world economy, global political instability, and various other market forces.

• Inflation and interest rates will return to more pre-recession norms.

While picturing a world that looks like the Jetsons (a cartoon set in the Space Age, for those who are too young to recall) might be a stretch, it is safe to say that things will be quite a bit different than they are today. Cars will be better, they will have more technology, they will cost more to repair, and we will likely be buying them via different means than we typically see today.

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Forward: What does all of this mean to lenders and borrowers?This increasing rate of change means greater uncertainties and greater exposure to those uncertainties. For those buying cars and making auto loans, it means be prepared. The likelihood of a vehicle getting into an accident that will result in a total loss is greater than ever, and the likelihood of the loan being under water at time of total loss is greater yet. To that point, the frequency of GAP claims has increased nearly 50% in the past year. And importantly, the average time between loan inception and total loss date for GAP claims paid has increased from 14 months to nearly 22 months. This is a dramatic increase and one that shows that there are more loans under water than ever before and they are remaining under water for longer periods of time.

Escalating depreciation patterns, aggressive lending practices, technology advances, increasing costs to repair, and evolving settlement practices by primary carriers are among the factors contributing to these increases in GAP claim frequency. Regardless of the cause or causes, it is more important than ever to make sure that loans are protected with GAP coverage and that the increasing number of total losses don’t result in undue financial strain on borrowers, uncollectible debts for lenders, and the inability of borrowers to get into a replacement vehicle. GAP coverage is an inexpensive way to protect loans and to provide borrowers with the peace of mind of knowing that their loan will be paid off if they total their vehicle. Relying on the primary settlement to fully cover their loss is very risky for the lender and the borrower.

While it is certainly important to include GAP protection on your auto loans, it is equally important for both the lender and the borrower to have GAP coverage that has the coverages and limits to adequately cover them if they do experience a total loss and have a deficiency loan balance. Saving a few dollars on the front end only to have to explain to a borrower at claim time that the warranty that they bought to protect against the cost of mechanical breakdowns put them over the LTV limit in their GAP waiver will make for a very difficult conversation. While the lower limits may seem adequate to cover loans within lending guidelines, “exceptions” are made, and those are the loans that depend most on the coverage provided. Moreover, with the CFPB continuing its scrutiny on lending practices, it is critical that borrowers receive the coverage that they believe they were told they were buying. It is not worth saving a few dollars per GAP contract for your financial institution only to have a lawsuit or fine levied because a customer feels they were promised their loan would be paid off.

With vehicle depreciation, accident and total loss frequency all on the rise, GAP coverage is a protection your borrowers need more than ever. Protect your financial institution from collections issues and borrower dissatisfaction by taking the following steps:

• Educate them on the risks (rapid depreciation, technology advances adding to the cost of repair, and low total loss settlements by primary auto insurers).

• Provide examples of borrowers who would have incurred significant financial stress had they not purchased GAP.• Ensure that your practices and coverage provided in your GAP program are appropriate.

Frost Financial Services has been providing GAP and auto loan protection products and services to financial institutions for over 40 years. For more information on the risks facing your borrowers and your financial institution, visit www.visualgap.com or contact Jim Tenhundfeld at jtenhundfeld@frostinsure.com.