Probing the Gaps in GAP Insurance

What Is GAP Coverage?

GAP contracts pay the difference between what a primary insurer pays in the event of a total vehicle loss, including theft, and the outstanding loan balance on the vehicle. (Approximately 2.5 million vehicles are totaled annually.) It is a form of credit insurance similar to credit life, credit disability, and credit property insurance. To illustrate, GAP operates in the following manner.

New, used, and leased vehicles and motorcycles are eligible for GAP. GAP pays for losses up to a certain amount ($100,000 for example) and, unlike the example above, it may not include the deductible. Further, the term of coverage may be coextensive with the term of a loan or it may be of shorter duration.

Notable Exclusions

A review of GAP policies shows remarkable similarity in both coverages and exclusions. Notable exclusions include the following:

• Overdue lease/loan payments
• Financial penalties imposed under a lease for excessive use
• Security deposits not refunded by the lessor
• Costs for extended warranties, credit life insurance, or other insurance purchased with the loan or lease
• Amounts deducted by the primary insurer for wear and tear, prior damage, towing, and storage
• Carry-over balances from previous loans or leases
• Equipment added to the car by the buyer, meaning that only factory-installed equipment is covered

Readers will quickly note that "GAP" may still leave a gap in one's financial obligations once the exclusions are applied.

How GAP Is Regulated

GAP regulation is somewhat confusing and haphazard. Who offers it determines largely how it is regulated. If a national bank, credit union, or other federally chartered depository grants the loan, GAP is typically not considered insurance for regulatory purposes. Further, to place state depositories on an equal footing with their federal competitors, state banking regulators have adopted rules allowing state depositories to offer GAP contracts free of insurance regulatory interference. A June 17, 2004, opinion of the New York Department of Insurance Office of General Counsel provides a detailed analysis of why financial institutions offering GAP contracts are not regulated by state insurance departments.

As part of a credit transaction, GAP is subject to federal Truth-in-Lending laws and Regulation Z of the Federal Reserve Board. If the purchase of the GAP plan is not a condition of the loan, if it is voluntary, and if the borrower acknowledges in writing that the purchase price and the program are disclosed, the amount paid for GAP is placed in the "Amount Financed" category.

Automobile insurers, however, offer GAP policies and are subject to all of the form and rate filing requirements state insurance codes.

Sales and Marketing Methods to Watch Out For

Automobile sales and service are perennial sources of consumer complaints and abuse. Typically, the areas of controversy entail Truth-in-Lending, Lemon Law violations, odometer rollbacks, bait and switch, loan packing allegations, force placed insurance, and selling previously wrecked vehicles without disclosing vehicle history. Here are some reasons we may soon add GAP to the list of auto sales abuses.

First, as indicated above, GAP does not always completely fill the gap between one's financial obligation and the primary insurer's settlement. Consequently, any representation that it pays "full cost" or all the difference between what one's primary auto insurer pays and the outstanding loan obligation could be false. Similarly, if a federal or state exempt depository institution represents GAP as insurance when in fact it is not, that, too, would be a misrepresentation.

Second, vehicle dealers who offer GAP work with an insurer in much the same way as they do in selling other forms of credit insurance. One important difference, however, seems to be that traditional types of credit insurance, while expensive and of dubious value to many consumers, nevertheless comply with all insurance form and rate filing requirements. This includes prohibitions on varying the premium for the insurance.

In contrast, GAP arrangements with vehicle dealers may include a rate that apparently consists of the insurer's rate on file with regulators but may also be accompanied by a "suggested retail price" to be charged by the vehicle dealer. When a GAP contract is sold to a borrower, the vehicle retailer remits the insurance company's filed rate but pockets the difference to cover administrative or other acquisition costs. For example, an arrangement may list the insurer's "amount to be remitted" to the insurer as $90 and the "retail price" as $495, a difference of $405. If the car dealer succeeds in selling the GAP for the $495, the dealership pockets this $405.

While this practice may be characterized as an "administrative fee" or some other designation, it looks a lot like a commission on a premium for insurance to me. By definition, "premium" is consideration for insurance and includes commissions.

Third, since the $495 figure is merely a suggestion, the actual price may be more or less than $495 depending on the negotiating skills of the buyer. Since consumers are not accustomed to negotiating insurance costs, one can pretty easily predict the outcome of the negotiations: the buyer loses. Of course, under state insurance laws, it is an unfair trade practice for any selling agent to charge a premium higher than that on file with state insurance regulators. It is also an unfair practice to charge like risks different premiums for the same coverage or unlike risks the same amount for the same coverage (it is called "unfair discrimination" in insurance jargon).

How much knowledge insurers have of the auto dealer practice of charging what the market will bear while remitting a lesser amount to the insurance company is an open question. Insurers participating in such schemes, however, may find themselves defending allegations of rate filing violations, tax evasion, unfair trade practices, and fraud.

Fourth, some of the GAP contracts I have reviewed contain binding arbitration clauses under which borrowers forego all access to judicial remedies. Some states, Georgia's arbitration statute for example, do not permit such agreements in insurance contracts while other states, Louisiana for example, prohibit binding arbitration provisions in insurance contracts.

Fifth, a GAP contract may include a provision for resolving a claim in the event that a debtor's primary insurance is not in effect. (Indeed, an underlying primary insurance policy is not necessarily a condition of signing up for GAP.) GAP policy language may dictate specific sources that will be used to determine actual cash value, such as Kelley's Blue Book or the National Automobile Dealers Association Guide, should a total loss occur. Some states, however, have specific regulations governing procedures to be followed by insurers in determining the value of a totaled vehicle that are at odds with the GAP policy's procedures.

Sixth, GAP policies may stipulate that the borrower is subject to the laws of a foreign jurisdiction, even though the product is purchased in the buyer's home state. Such a provision, common in credit transactions, may place heavy burdens on the borrower.

Seven, many GAP contracts are single premium policies, i.e., the premium is paid in full up-front for GAP. However, at some point the borrower will pay down the loan to the point at which the gap disappears. Despite the fact that the GAP policy may cover the entire period of the loan, as a practical matter it ends at the point at which the gap disappears. That's why it makes more economic sense to buy GAP on an annual basis, not all in one premium.

Eight, with respect to cancellation provisions, state insurance laws governing conventional forms of credit insurance, such as credit life, generally stipulate how refunds of unearned premium are determined. The regulatory gap between traditional credit insurance and GAP, however, is illustrated by a provision in an Alabama policy. According to the policy, "The insurance provided herein may be canceled by You upon written notice to the lender or to US stating when thereafter such cancellation shall become effective. Return premium, if any, will be computed using the Pro Rata refund method after first deducting the applicable Certificate fee as fully earned."

Since "Certificate" is capitalized, one might reasonably expect a definition somewhere in the policy, but there is no definition. One is left guessing whether the unearned premium refund is based upon a "Suggested Retail Price" or what the insurer actually received. If the latter is the case, the unearned premium provision is almost farcical.

What to Do

In my opinion, then, there are significant gaps in GAP policies and regulation. Fortunately, some auto insurance companies now offer GAP directly to consumers. Until consumer protections catch up with GAP, buyers are probably best advised to ask their insurance agents about purchasing GAP as a rider to their auto insurance policies instead of buying from a vehicle dealer. In pursuing GAP coverage, however, consumers should take the initiative to inquire about its availability since there is no mandate to offer GAP endorsements. Washington State, for example, allows insurers to sell GAP but does not permit insurers to advertise its availability.

The advantages of buying directly from insurers are that the cost is relatively cheap, insurers may not deviate from the rates they have on file with departments of insurance, and a buyer does not forfeit important consumer protections.