Stephen Chisadza

Most of us have at some point or another heard a person exclaim how someone they know was involved in an accident and “that the vehicle was a write-off but ‘amazingly’ no one was hurt!” This is because most people associate an insurance write-off with a vehicle that has sustained significant mechanical damage. The implicit assumption in this statement is that the insurer will always act in the best interests of their client, the insured, and would never take away their client’s vehicle unless they absolutely had to. In truth, however, the interests of the insurer and the insured are not always perfectly aligned and may at times be diametrically opposed to each other.

In South Africa, the industry definition of an insurance write off is not about the usability of the vehicle but rather about whether or not it is “uneconomical” for the insurance company to repair one’s vehicle^[1]. In other words, is it in the best interest of the insurer to repair the vehicle? The South African industry code defines vehicles that have been written off as “motor vehicles where the insurance company decided not to repair the motor vehicle (e.g. where the damage exceeds 60% to 70% of the value of the motor vehicle)”^[2]. Furthermore, one of South Africa’s leading car insurance companies states the following on their website:

“…..we may need to write off your car if it’s going to cost us more to have it fixed (back to its original roadworthy state) than actually just calling it “quits” and paying you the insured value (minus the excess) in cash”.

This means that if a vehicle that is insured at full replacement value, is involved in an accident, the insurance company must decide whether to repair the vehicle to its original condition or replace it according to the vehicle’s value[3]. Like any profit seeking business, the insurer will opt to repair their client’s vehicle only up to the value of the vehicle at which point it becomes more economical for them to replace the vehicle rather than repair it. So for example, if an old pick-up truck insured for R45 000 is involved in an accident, it is economical for the insurance company to repair the vehicle up to a maximum of R45 000. Beyond this point it makes more economic sense for the insurer to pay-out R45 000 than continue with the repairs, i.e. it would be in the interests of the insurer to write off the vehicle at R45 000.

Experience however shows that the drivers of older vehicles, particularly those that are well maintained, would typically prefer to repair damages from minor accidents on their own. This is partly because of the excess fees that insurers charge in order to deter their clients from making minor claims and share risk with the customer. But the owners of older vehicles are also deterred from making claims because their cars generally have a lower value, such that the costs of repair can easily outweigh the value of the vehicle, resulting in a write off.

The low value of older cars however also means that the pay-out after a vehicle is written off is usually not enough to buy a similar replacement vehicle especially where the insured amount is substantially below the replacement value of the vehicle. In other words, whilst it may work out cheaper for the insurance company to pay the insured the value of the vehicle rather than try to have it repaired, the insured would have preferred to have the vehicle repaired than to be paid out as it will be more costly to purchase another vehicle in the same condition. The nature of insurance therefore discourages the owners of low value older vehicles from submitting a claim because their reparable, perfectly usable and reliable old vehicle may be uneconomical for the insurer to repair.

The example above is an illustration of a “principal-agent” relationship, where a person or entity (in this case the insurer) acts as an agent and can make decisions on behalf of a “principal” (in this cases the insured). If the agent is motivated to act in their own best interests and not those of the principal, this creates the agency dilemma (also known as the theory of agency).

In the example discussed above, the agency problem is easy to identify. However in recent years the use of “salvage values” in the South African motor insurance sector has created an additional agency problem, that is far less conspicuous. We illustrate this by beginning with the basic formula for calculating if a vehicle is a write off, i.e.:

1. Cost of repair>Value of the vehicle 

In the equation above, the left hand side (LHS) represents the costs to the insurer of repairing the vehicle whilst the right hand side (RHS) is the cost to the insurer of replacing a vehicle that has been written off. The right hand side is capped at a maximum of the insured amount.

In practice, however, the actual cost of repair is not known until the full repair work has been done. So after an accident, the insured vehicle is taken to an assessor who will independently estimate the cost of repair based on the visible damages. Not all damages can be identified by visual inspection and so insurance companies will generally write off vehicles that have sustained damage in the region of 65 to 70% of their value, as repairing them would be potentially uneconomical. This rule of thumb is called the write off threshold:

2. Cost of repair>70% of the value of the vehicle

Alternatively, this can be expressed as:

3. Cost of repair+30% or 35% of value of vehicle>Value of the vehicle

Once an insured vehicle is written off, the insured vehicle owner is paid the value of the vehicle and, the ownership of the now damaged vehicle or salvage is transferred to the insurance company. This salvage is disposed of by the insurance company usually through a salvage auction. This changes the formula for calculating if a vehicle is a write off from the basic model above to the following:

4. Cost of repair>Value of the vehicle-Value of the salvage

The left hand side of the equation still represents the costs to the insurance company if the vehicle is repaired, whilst the right hand side shows the net value to the insurance company if the vehicle is written off. The insurance company must incur the cost of paying the vehicle owner the value of the vehicle but benefits from sale of the salvage. Holding everything else constant, if the value of the salvage increases this increases the possibility of the cost of repair (the LHS) being greater than the net cost of a write off (i.e. the RHS). In other words, an increase in salvage value increases the probability of a vehicle being written off because the insurance company stands to benefit from the sale of the salvage.

Through basic mathematical manipulation, the above equation can also be represented as:

5. Cost of repair +Value of salvage>Value of the vehicle

Comparing equations (3) and (5) suggests that if the same vehicle is insured under a policy where the threshold is determined by the salvage value as opposed to a fixed percentage, this could result in a significantly different write off threshold. This is because the salvage vehicle is usually disposed of at an auction; hence the value of the salvage is less predictable and is subject to supply and demand dynamics. So if the value of the salvage exceeds 30% of the vehicle value, then the effective threshold becomes less than 70% of the value of the vehicle. As the threshold decreases, the incentive to write off the vehicle, for the insurer, also increases.

This begs the question, under what circumstances is the value of salvage likely to exceed 30%?  To answer this, one needs to consider the supply and demand factors that affect the value of a salvage. These are:

· Demand for the vehicle and model in question. When a particular make or model becomes very popular, a waiting list of up to four months is not uncommon. Under such circumstances, the focus of manufacturers is on supplying components for complete units and not on the parts market.

· The cost and availability of parts. For example, the 2012 floods in Thailand highlighted the fragility of the automotive supply chain. The floods in Thailand had a severe impact on parts imported for the build pack bakkies such as the Ford Ranger, Toyota Hilux and Isuzu KB.

· Type of damage to the salvage i.e. a salvage that has not rolled or where the impact was at the rear has a greater salvage value.

· New vehicles must be repaired with manufacturer-supplied parts as they are still under warranty. This makes their repair more expensive and increases the likelihood of a write off.

This suggests that under the salvage value approach, a popular new model in which there is a high demand for parts  could potentially get written off at an effective threshold as low as 45%. Under these circumstances the principal agent problem shifts from being peculiar to older vehicles to potentially newer vehicles as well.

In the United States, insurance laws are state specific, however some states strictly prohibit the use of salvage values in the determination of write off thresholds. The reason being that it is in the best interests of consumers is to have a more predictable method of determining whether or not a vehicle is a write off.

In South Africa, the insurance sector is exempt from the Consumer Protection Act and is regulated by the Financial Service Board (FSB). The interests of South African insurers are represented by the South African insurance Association (SAIA) whose mission includes encouraging the fair and ethical treatment of consumers. In this regard the association annually publishes a Code of Conduct for short term insurers. This Code of Conduct includes a section on the Code of Salvage whose purpose is “to establish a common approach when dealing with motor salvage”. Section 2.1.1.5 of the Salvage Code defines uneconomical to repair as:

A vehicle is “uneconomical to repair” when, costs of parts, the availability of parts, the repair duration and motor vehicle rental costs or other costs associated with the repair are high in relation to the value of the vehicle.

Furthermore, in section 4.2.1.3 the code defines economical to repair (Not written off) as:

Have not been declared uneconomical to repair by an assessor (e.g. damage does not exceed 60% to 70% of value of motor vehicle).

Although this definition makes no mention of the salvage value method of determining whether or not a vehicle has been written off, the insurance Ombudsman has on a number of judgements ruled that the salvage value approach to “determining the write off threshold is a method now commonly used in the insurance industry and the 70/30 threshold is no longer the norm used”^[4].

The calculation of write offs by the insurance industry is clearly a complex and in most instances nontransparent business. Different countries and companies adopt different approaches, and most consumers only become aware of how these rules and decisions may impact on them after an accident.  We can only advise policy holders to speak to their insurers and clarify how write off thresholds will actually be calculated in the event of an accident; and to ensure that this is correctly reflected in their policy documents.