Common Questions on Warranty Risks and Coverages

Brian LePage, ACAS, MAAA

Can you provide a basic definition of warranty coverage?

Without getting into the terminology yet, “warranty coverage” typically covers a product that fails to work as intended before it reaches its operational life expectancy. This is different from the product wearing out from normal use. The common term for a product failing to operate as intended and having a warrantable repair is related to a defect in materials and workmanship. This implies that there was some defect in either the materials used to manufacture the product or the way those materials were assembled that contributed to the product failing to operate correctly for its expected life. Warranties may be expressed or implied, i.e. implied warranty of merchantability or express warranty for specific use purpose.

For example, you buy a brand new TV, take it home, set it up, and enjoy the amazing picture. After a few days, the TV won’t turn on. Since most consumer goods like TVs come with a “warranty,” you may be able to take the TV back to where you bought it or send it to the manufacturer, and they will either fix it or replace it without any cost to you.

What is the difference between an extended service contract and a warranty?Free Actuarial Advantage Book

This is where we address the terminology. This is more of a legal discussion and, since I am not an attorney, I will give you an understanding based on my actuarial experience. As I understand the terminology and the legal position, a “warranty” can only be provided by the manufacturer of the product or an entity directly involved in the distribution of the product. Many products that we as consumers purchase come with some sort of manufacturer’s warranty.

Regarding the distributor, the seller or distributor must have a direct relationship with the manufacturer to be able to provide a warranty. This would imply that the distributor must purchase the product directly from the manufacturer or its representative and sell it directly to the consumer.

If the entity selling the product does not meet either of these two definitions, then that entity cannot “warrant” the product. This is where the term “extended service contract” comes into play. An extended service contract may provide very similar coverage to a warranty, but it is the relationship of the distributor to the manufacturer that changes the coverage from a warranty to an extended service contract. Additionally, an extended service contract may include coverage not included in the manufacturer’s warranty, which also turns the resulting contract into an extended service contract. For example, when a consumer purchases an automobile, the dealer will often attempt to sell the consumer an extended service contract. Some common terms of this agreement will “extend” the coverage of the manufacturer’s warranty but also provide additional services like oil changes, tire repair, roadside service, and other items that are beyond the warranty coverage.

Additionally, there is no separate charge for a manufacturer warranty which comes with the product. Extended service contracts (warranties) have a separate consideration from the purchase price of the product and may be sold by third parties that are not the manufacturer, distributor, or seller.

What are some examples of products that may have warranty coverage?

Except for food and other items that either perish or meet their useable life quickly, most products purchased by consumers have some sort of warranty. The most common items that consumers would be familiar with are referred to as “brown and white” goods like electronics, appliances, televisions, and other similar products. In addition to brown and white goods, many other products, such as automobiles and lawn mowers, also come with a warranty. The consumer can often purchase an extended service contract on many of these products from either the distributor of the product or some third-party provider.

How do insurance contracts for warranties differ from more traditional property casualty coverages?

The primary difference is in the perils covered by the contract rather than the structure of the policy. For example, a typical property policy will often cover damage due to fire regardless of the cause of the fire. Where an extended service contract will only cover fire damage if the fire was caused by a defect in the product that ignited the fire. Otherwise, an extended service contract will include sections similar to other insurance contracts, such as Policy Holder Responsibilities, Definitions, Coverages, Optional Coverages (endorsements), Exclusions, Terms and Conditions, Policy Limits, Cancellation Requirements, etc.

How does the methodology for analyzing warranty risk differ from more traditional property casualty coverages?

When completing an actuarial analysis for an extended service contract (warranty) coverage, the most important difference is an understanding of the policy term. Extended service contract claims behave much like common property claims. Since they are generally short tailed, the amount of the claim is typically known at the time of the reporting, and very little time passes between the occurrence of the claim and the reporting of the claim. For these reasons, there are typically very few Incurred But Not Reported (IBNR) claims and very little development on case reserves.

However, “development” on extended service contracts is driven by the term of the coverage. If the term of the coverage is longer than one year, then claims will come in over the term of the coverage, and loss triangles should be set up to measure the development. The loss triangles differ from most property and casualty coverages in that the periods are related to the start date of the coverage rather than the occurrence date of the claim, and the claim development is measured over periods following the start date of the coverage.

Are there any special considerations when signing the Statement of Actuarial Opinion for a company that writes extended service contract business?

As mentioned above, the IBNR and case reserve development are typically not material related to extended service contracts. However, extended service contracts can provide coverage for several years, and the premium is typically collected at the beginning of the extended service contract coverage with no opportunity to collect additional premium, regardless of the loss experience. Therefore, the Premium Deficiency Reserve required by both GAAP and SAP accounting has the potential to become a more material element of the SAO. For a company that writes primarily extended service contracts, the statement within the SAO which states “makes a reasonable provision for the unearned premium reserves for P&C long duration contracts” becomes the primary source of liabilities as compared to loss and loss expense reserves, which includes IBNR.

Determining a reasonable exposure base for a warranty coverage is crucial for proper analysis. What is the difference in tracking an exposure base relative to manufacture year versus calendar year?

From a liability reserve perspective, the most critical date related to extended service contracts is the effective date of the service contract. This date will determine when coverage expires and plays a critical role in the development triangles as discussed above. From a pricing perspective, as is typically the case, more data is always better. Since many extended service contracts cover the same perils that a manufacturer’s warranty covers, the manufacture date can be a critical date in both pricing of the contract and underwriting new business. Segmenting the loss data by manufacturing period can help identify manufacturing issues impacting the loss results and should be considered in pricing or underwriting.

Why would companies choose to place warranty risks into captives? Are there any advantages to doing so?

Regarding the manufacturer’s warranty, the advantages of a captive are limited. A manufacturer’s warranty cannot be considered as an insurance contract for tax purposes and liabilities are typically short term which minimizes the tax advantages of a captive. In special circumstances where the warranty exposure is longer term (i.e. Home Warranties) a captive may be structured to provide a tax advantage through the captive. Regarding an extended warranty (or service contract), there are a few potential advantages to a company that places their warranty (extended service contract) risk into a captive. Some of these advantages are the same as those for more traditional coverages, such as potential tax benefits and separation of liabilities from the manufacturing business. Separating the extended service contract business from the company’s core business can help in providing an additional source of profit beyond the core business and allow the company to offer more traditional insurance products in conjunction with the extended service contract.

If you have questions regarding warranty risk and coverages or would like to discuss any other actuarial topic, please contact us at:support@SIGMAactuary.com

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