Residual Value Pricing

1. Residual Value Pricing Casualty Actuaries in Reinsurance July 8-12, 2001 Chris Steinbach

2. Residual Value Pricing Survey of Automobile RVI

3. Residual Value Pricing • Recent Automobile Residual Value Insurance (RVI) experience has been horrific. The auto leasing industry has suffered $2B in known Residual Value losses in the past 6 months. Several hundred million of that was insured...

4. Residual Value Pricing • Residual Value guarantees that the value of an asset is at least ($) on (date). • The asset must be tangible • The asset must be specific and named • The date is a single point in time

5. Residual Value Pricing • Auto RVI (USA): • The most common coverage insures leased vehicles. It indemnifies the lessor if a vehicle is returned at the end of the term and it is worth less than its booked residual value. • Leases that do not run full term and vehicles that are not returned at lease end are not covered. • Valuation can be Book:Market or Book:Book. • Coverage can be per-vehicle or per-fleet.

6. Residual Value Pricing • Trends in the auto leasing industry affecting used vehicle prices: • The number of vehicles coming off lease is at record levels and still rising. • New car production is still historically high. • Projected residuals have plummeted. • Unprecedented RV losses (both frequency & severity). • Many lessors cutting back or leaving the business.

7. Residual Value Pricing • Trends in Residual Value Insurance: • Insurers & reinsurers withdrawing or cutting back significantly. • Rates hardening and coverages tightening. • Paper quality increasingly important. • Naive capital still dominates. The economic environment is being used to explain away a lot of bad underwriting. • Losses expected to continue throughout the 2001 originations. • Regulators and rating agencies becoming stricter.

8. Residual Value Pricing Modeling Auto RVI

9. Residual Value Pricing • Benchmark Rating (full coverage @100% of ALG) • Assuming ALG is unbiased, then there is a 50% chance of loss. • ALG’s historic accuracy ranges from -10% to +10% of RV. Thus, the average loss, given there is a loss, is about 5% of RV. • Assume that the return rate is 75%. • Assume that the average lease duration is 3 years and that the discount rate is 5%. • Thus, the discounted loss cost is 1.62%.

10. Residual Value Pricing • The most important part of RVI pricing is identifying all of the potential exposures and charging for them accordingly.

11. Residual Value Pricing • Specific Issues to Contemplate: • Data Quality • Moral Hazards • Threat Scenarios • Ancillary Coverages • Variance of the Projections • Cost of Capital

12. Residual Value Pricing • Data quality is a significant source of bias: • [Residual Value $] = [MSRP $] x [Residual Value %]. • The MSRP usually does not capture the characteristics of that specific car very well. • The Residual Value % is an average of that model and all related models. • Missing and corrupt data needs to be statistically extrapolated.

13. Residual Value Pricing • Data Quality: MSRP • The ALG MSRP varies by make and model, but not by different trim or options. Thus, one ALG MSRP value applies to an entire category of vehicles. This MSRP represents the mode of the category, not the mean. • Lessors often argue that the most common leased vehicle is not the same as the most common vehicle. Leased vehicles tend to have better trim and more options than average. Thus, ALG’s MSRPs undervalues the average leased vehicle.

14. Residual Value Pricing • Data Quality: MSRP • However, not all options add to the resale value to a vehicle (IE: purple pin striping). Therefore, you have to be careful as to what portion of the lessor’s MSRP you are willing to include in the calculation. • Also be careful as to what the lessor permits the dealer to include in the MSRP. Dealers have been known to add the Extended Warranty and junk fees to the lessor’s MSRP. This should be investigated in the audit.

15. Residual Value Pricing • Data Quality: Residual Value % • Lessors often argue that ALG has historically been too conservative. Thus, they should be allowed to enhance. • Leased vehicles tend to be returned in better condition than owned vehicles, increasing the RV%. ALG does not reflect this. • Options lower the RV% because they do not hold their value as well. Many options do not retain any value at all. ALG does not reflect this.

16. Residual Value Pricing • Data Quality: Residual Value % • Seasonality: Vehicles coming off lease in summer have better resale performance than vehicles coming off lease in winter. • Territory: Vehicles in southern states wear better than vehicles in northern states. • Credit Scores: Lessors that have higher credit scores return their vehicles in better condition. • Economic Forecast: The effects of your microeconomic model flow through the RV%.

17. Residual Value Pricing • Moral Hazards can be a problem. For example: • The first RVI policies insured each vehicle individually. But, the insureds learned how to increase the variance of the risks, increasing the losses. • Later policies insured the pool as a whole. But, the insureds then learned how to cherrypick the better risks out of the portfolio, leaving only the vehicles with losses. • Rules were then implemented to prevent cherrypicking. Recently, insureds have been understaffing their remarketing departments.

18. Residual Value Pricing • Moral Hazards: • RVI guarantees future prices, but “price” is affected by everything. The automotive industry has a sophisticated understanding on how to manipulate prices and a reputation of being slippery. Are you naive capital? • It is critical that the motivation of each party is understood and incorporated into the pricing. • Who’s watching the insured?

19. Residual Value Pricing • Threat Scenarios: • Economic: ALG was systematically off by 5% to 7% of RV in the late 1980’s. It appears that ALG will be systematically off by 10% in the late 1990’s, and off by up to 30% on certain models (SUVs). It appears that Cap-Monitor (UK) will be systematically off by 15% in the late 1990’s. • Operational: A review of the large losses that the insurance industry has suffered over the past 10 years shows that a large component of them is due to operational issues. (Insurer, Lessor & Legal.)

20. Residual Value Pricing • Note that RVI can provide a wide range of coverages. These must be underwritten and priced, or removed. • Obsolescence (computers) • Liquidity (railroad) • Performance Guarantee (windmills) • Property (specialty equipment) • Economic (oil wells) • Popularity (SUVs) • Political Risk (ships)

21. Residual Value Pricing • Variance of the projections: • This is not a derivative. We are guaranteeing the quality of the appraisal. The record of the appraiser must be reviewed and the variance measured. • Do not be fooled into thinking that the economy has little impact on residuals. We have only 10 years of historical data and the economy has been steady for all 10 of those years. • The terms and conditions of the policy must be modeled. Are there sublimits by vehicle class? Is it pooled coverage? What control does the insured have? Etc.

22. Residual Value Pricing • Cost of Capital: • Is there a statutory, regulatory, or rating agency required capital for the deal? RVI often has a huge statutory impact. Talk to your CFO about the effect this deal will have on your financials and what the fair price is. • Residual Value Insurance on a 3 year lease results in the insured borrowing your balance sheet for 3 years. Each year must be paid for.

23. Residual Value Pricing REMEMBER We are selling financial products to used car salesmen.