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By CYRIL TUOHY, managing editor of Risk & Insurance®.

Ahhhh ? the extended warranty. We've all had our distasteful bouts with auto dealers trying to hustle their way into selling us extra insurance. By now the pitch for extra coverage has become a sales cliché. But in the world of risk transfer, particularly in captive management, managing the risk of those warranties is big business.

You could, it's true. But the likelihood of having to bring your car in for that repair is remote, according to consumer surveys, which find that most consumers pass on extended warranty offers.

When it comes to extended vehicle warranties, the industry's profitable little secret is that what's covered typically won't fail because cars these days are so well made.

So, why are manufacturers, retailers and third-party providers intent on selling us stacks of extended warranties?

Extended warranties exist for everything from cars, to sewer systems, to underground pipes, to computers, to refrigerators, to furnaces, to commercial lawn maintenance equipment and even to townhouses. For manufacturers and for retailers that sell these products, extended warranties are big profit makers and have been for many years.

In the past few years extended warranties for cell phones in particular, in the words of one leading captive manager, are ripe for "true entrepreneurial opportunities."

With the cost of an extended warranty representing as much as 20 percent to 30 percent of a product's purchase price, the premium ends up in the hands of the captive, which reinsures the risk.

Captive owners, therefore, know there's plenty of premium income awaiting them with every extended warranty sold and the more control over the captive a manufacturer or distributor exerts, the more the profits flow their way instead of in the direction of the insurance company.

Managing the premiums isn't always as easy as it sounds, however and managers of captive companies said they have had more success with certain kinds of extended warranties than with others.

USA Risk Group, an independent captive management company based in Burlington, Vt., for example, has done well with extended warranties covering sewer systems and underground piping.

"But we've had issues with the auto warranties and that's why they come to mind," said Jeff Kenneson, senior vice president of business development for USA Risk Group. "The auto warranty can be pricey stuff that you have to pay off on."

Courts have also opened the door for plaintiffs to collect on bad-faith damages, including punitive damages, if contract issuers wrongfully deny consumers' claims, raising the stakes for any litigation.

In February, the Oklahoma Supreme Court ruled that service contracts are a form of insurance, opening the door for bad-faith damages, including punitive damages, according to a Feb. 14 blog posting by David Matthews.

Arizona and Utah treat vehicle service contracts as a form of insurance, while Ohio does not, Matthews writes on the posting of the website of the Automotive Warranty Consumer Institute International, a consumer warranty watchdog.

As a result, the domicile and the regulations governing the operations of captives in which it is located also make a difference. "Some (domiciles) will not protect you from yourself," said Brady Young, president and CEO of Strategic Risk Solutions, a large, independent multidomicile captive management firm based in Vermont.

Risk managers planning to underwrite extended warranties in their captives had better be dead certain of their data and loss ratios, Young said. The more reliable the data, the more accurately risk managers will understand the downside risk of assuming extended warranty programs.

"It's like everything else," Young said. "Don't be greedy, especially for people who get into it for the first time; walk before you run."

An extended soft market and the Great Recession have exerted new pressures on companies to generate income from their captive operations, some of which have either been merged or closed, captive managers said.

"What used to be immaterial for a lot of companies and where they would not be excited about a few million dollars, now if there is a way to make a couple of million dollars or save $2 million, why not," Young said.

"There's lately been more interest in expanding the use of captives, particularly after September 2008, when companies were having to cut costs in the wake of the financial meltdown," said Nancy Gray, regional managing director for the Americas with Aon Global Insurance Managers.

"That's why they are looking at capturing customer risk rather than having a third party pick it up."

And why not? Money that used to be going to an insurance carrier is now going to a company sponsoring the extended warranty program, be it a manufacturer or a retailer.

Big box retailers like Best Buy and P.C. Richard & Son are ringing up profits selling warranties on various products they sell and in some cases are willing to take on that risk in order to reap the reward.

"The difference is historically a lot of entities that sell those products have just been happy to market insurance products underwritten by others," Young said.

With loss ratios generally very low, extended warranties are a sure-fire way to boost profits as retailers cash in on the so-called "vertical integration," whereby the retailer sells a product and also sells the insurance in the form of the extended warranty around that product.

Retailers sell an extended warranty for, say, $5 or $10 a month and tack it on to a $150.00 smartphone. The result is a profitable annuity stream with little volatility over the term of the warranty, 12 months, 24 months, or even 36 months.

Even if you lose your phone after using it for a year or two, is it really worth it to turn in the warranty? The old phone is already out of date and the prices of new phones have most likely dropped in the interim.

"It's an annuity stream to the cellphone retailer and you forget to cash in when you have the opportunity, when it breaks or when you lose it," Kenneson said. "You just go out and buy a new one."

Insurance carriers remain in the equation, of course. They pay claims and help administer contracts. Regulators also require companies looking to enter into extended warranties to do so in partnership with an insurance carrier.

August 1, 2011

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