Chris DiLullo (left), senior vice president, and glenn Fischer, chief operating officer, of Tri-Arc Financial Services.
Insurance underwriters are not the only people who see things through rose-tinted glasses when a competitive market strikes. Auto manufacturers and financial institutions that provide capital for automobile leases also have been known to take optimism to an almost absurd level when faced with severe competition.
In the mid-'90s, auto leasing grew dramatically as buyers found that leasing an auto could be cheaper than a purchase. In fact, an estimated 30% of new automobiles are leased today. And as the demand grew, companies providing the leases started to compete for the business by using higher residual values to lower the monthly payments. The residual value of an auto is the forecasted wholesale value of the auto when the lease ends. The reason a higher residual value lowers the monthly payment is because the purchaser is financing a lower amount during the term of the lease. For example, if the leased auto has a total purchase price of $30,000 and the residual value at the end of a three-year lease is $15,000, then the purchaser would be financing $15,000 during the three-year period. However, if the lessor raises its estimate of the residual value to $17,500, then the purchaser has to finance only $12,500 for the three years.
Glenn Fischer explains that if a lessor chooses a full risk transfer for its residual value exposure, "this is typically written as a one-year policy" with the insured providing monthly reports.
--Glenn Fischer
The problem for the lessor comes at the end of the term when the actual value of the used automobile is less than the residual value projection. In the above example, if the actual value turns out to be $15,000, then the lessor breaks even in the first case but loses $2,500 in the second case. Multiply that loss over thousands of leased automobiles and you can imagine how serious this problem can become. In fact, according to a compilation by Tri-Arc Financial Services, Wayne, Pennsylvania, the leasing industry wrote off more than $1.7 billion this year in potential future losses, with the majority of those losses coming from overstated residual values. And that doesn't include the amounts covered by self-insurance reserves set aside for anticipated losses.
"We are seeing more banks and other financial institutions purchasing this coverage."
--Chris DiLullo
Tri-Arc is a program manager and provider of specialty insurance and financial services products. It was founded more than 50 years ago as an agency providing property/casualty coverages to financial institutions. In 1993, Tri-Arc entered the collateral protection business by adding a contingent and excess liability program. Tri-Arc continues to write this program and serves as National Program Manager for it. Tri-Arc entered the residual value insurance market for autos in 1996 and has insured in excess of $4 billion of residual values since inception of the program. In addition to the Wayne home office, Tri-Arc also has offices in Maryland, New York and Texas.
We talked to Chris DiLullo, senior vice president, and Glenn Fischer, chief operating officer, about Tri-Arc's residual value insurance product. Tri-Arc entered the market at a time when "many lessors were self-insuring the risk," Glenn explains. "Throughout most of the early to mid '90s, it was mostly gains for these institutions. This attracted more people into the business (from 1995 through 1998), at a time when residual values were set at overly optimistic levels. Then in 1999, the values were not there and lenders started taking huge hits." The cyclical nature of residual values is clearly shown by published Index figures which show that, in comparison to levels benchmarked against residual values in late 1995, residual values were 2.3% higher in 1996, 8.7% higher in 1997, 5% higher in 1998, and 2% higher in 1999. By 2000, residual values had returned to the Index level of 100 and this year, the Index is forecasted to drop to 96.5. In effect, residual values varied by more than 12 points during the latest five-year period, reflecting a market where used car prices reached a high in 1996 and then began to drop precipitately. That drop, along with overly optimistic residuals, is the greatest factor attributable to the aforementioned billion-dollar projected losses.
Needless to say, the self-insured losses have sparked a renewed interest in residual value insurance. "We are seeing more banks and other financial institutions purchasing this coverage," Chris says.
There are "multiple motivations for lessors to purchase," notes Chris DiLullo. One reason is related to the accounting treatment of lease transactions from the lessor's perspective. "Under FASB 13, if you meet certain accounting standards, a lessor may choose to account for a lease transaction in a manner that is similar to a sale (financial lease) and benefit from an acceleration of earnings recognition. Basically the guideline requires that lease transactions conform to a 90% test, where the present value of future lease payments combined with a guaranteed residual equals, at a minimum, 90% of the fair market value of the vehicle at the inception of the lease. This results in the lease becoming a financial lease rather than an operating lease, where the earnings are typically amortized over the life of the lease."
Other companies want to protect their bottom line in the event of a sharp drop in used auto prices and purchase aggregate residual value insurance over a large deductible or SIR.
Still others look for full-risk transfer that "covers them for the entire residual value exposure," Glenn says. "This is typically written as a one-year policy. The insured provides a report every month and vehicles are boarded and insured on a monthly basis. If the insured chooses to set residuals above the parameters of the policy, that becomes a self-insured piece."
The securitization market is another way to protect the bottom line. Lessors bundle assets and
sell off pieces. "Inside those securitizations are insurance pieces to cover any drops in value," Glenn points out.
"This is becoming a really hot market," Chris says, noting that "rating agencies and investment bankers seek to manage loss exposures through insurance as a means to enhance the security. It could become a lucrative niche for agents with clients in this field." He concludes that residual value coverage is not limited to auto leasing. "It can cover any leased asset."
Tri-Arc operates as an MGA for the residual value insurance program, which is written on an admitted basis with highly rated companies. It is available to any licensed agent or broker. The program includes multiple asset classes. *
For more information:
Chris DiLullo
Phone: (443) 259-0153
Glenn Fischer
Phone: (443) 259-0150
Web site: www.triarcfs.com