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By Cyril Tuohy

Higher tax rates and the auto industry rebound are pushing auto dealers to take on more of the risk associated with vehicle service contracts. And many of those auto dealers are relying on captive insurance companies to fund the losses.

Haskell Garfinkel, a financial services tax partner with PwC in Chicago, said auto dealers' interest in utilizing captives has had its ebbs and flows, but that recently auto dealers have entered a "flowing stage," in their use of captives in the wake of the Great Recession and the subsequent strong recovery for the U.S. auto market.

That's because financial transparency has increased among dealers, he said. Plus they're seeing how service contracts are reinsured and who benefits, leading them to want a bigger piece of the business.

"The more a dealer understands how money is being made by the various parties in the chain, the more a dealer wants to retain a portion of these profits," Garfinkel said. "The more competitors for sale and servicing of these products bring to light who's making what, the more dealers want to control that transaction and retain underwriting and investment profits."

Auto dealers are also interested in using captives for income tax and estate planning strategies. Big companies have utilized captives as part of their overall risk management and tax strategy for years, but specific provisions in the Internal Revenue Code including Section 831(b), give smaller companies an added incentive for forming a captive.

With vehicle sales volumes on the increase and dealership profitability on the rise, dealers feel more confident in deferring their income for tax purposes and participating in the captive's profits. Dealers, in effect, are willing to take on more of the risk in exchange for more of the profits.

Why not? Individual dealerships around the country, having consolidated in the wake of the GM and Chrysler Corp. bankruptcies, are more profitable than they have been in years.

And they are selling more cars and trucks. U.S., Asian and European car makers sold 1.03 million units in the U.S. market in January, up 14.3 percent compared with January 2012, the National Automobile Dealers Association reported.

All those new vehicle sales offer dealers fresh opportunities to sell the vehicle service contracts to customers at the point of sale.

Under the best original equipment manufacturers programs, as many as 30 percent to 40 percent of new cars sold leave the dealership with a service contract issued by the vehicle manufacturer, said Gregory Myers, managing director for the Atlanta-based commercial insurance broker Beecher Carlson.

In other cases, it is closer to between 5 percent and 15 percent, he said.

Auto dealers who choose to underwrite the contracts then must decide whether to use a captive to capture the underwriting results, Garfinkel said. Dealers also have the option of selling service contracts on behalf of the auto manufacturer, a third party -- usually an insurance company -- or a national provider of vehicle service contracts.

Dealers that charge retail, profit by selling the contracts on behalf of someone, but are off the hook when it comes to repairing the vehicles. Selling a vehicle service contract on behalf of a manufacturer or a third party means less risk for the dealer, but also less profit if the loss ratios turn out favorably.

"There's an advantage to using a coverage program from the manufacturer because you know that the manufacturer will stand behind its products," Myers said.

In the 1980s and 1990s, he said, some independent companies went belly up and weren't around to pay claims.

As auto dealers warm to the idea of taking on more risk with their service contracts, options to create onshore captives of other kinds have also multiplied over the last few years, according to an industry benchmark captive report issued by Marsh last year.

Utah in particular has seen a "healthy number" of captive formations, "particularly in the micro/mini (Internal Revenue Section 831(b)) captive arena," said Marsh, in a report titled Integral and Mainstream: Captives in 21st Century Risk Management. These are not the same captives being increasingly used by auto dealers, necessarily.

Over a five-year period ending in 2011, auto warranty lines performed better, on average, than seven other lines underwritten by captives, according to A.M. Best & Co. data. In 2011, net premium earned on the auto warranty lines from Best-rated companies came to $469.6 million.

Contracts of All Shapes and Sizes

Vehicle service contracts, which generally are not regulated by states as insurance policies, make up the lion's share of the aftermarket assurance products and they come in all shapes and sizes. The most popular contracts are those that agree to repair vehicles after the original equipment manufacturer's warranty has expired. These extended service warranties cover the breakdown of mechanical parts like water pumps and transmissions.

But other types of vehicle service contacts abound. Dealers sell wheel-and-tire contracts, which cover the repair costs to fix tires and rims damaged by potholes. Then there are the windshield contracts, which cover repair or replacement of glass damaged by rocks or other debris.

Dent removal and protection contracts cover light damage sustained in parking lots, or from hail. Then there are the extended wear and tear protection contracts which cover vehicle lessees for excess vehicle wear and tear that they would otherwise be liable for at the end of a lease term.

Service contracts offer a natural fit for dealers that employ mechanics, so long as the dealer can manage the risk, said Brady Young, president and CEO of the captive management company Strategic Risk Solutions.

"It makes a lot of sense to me that dealers are doing it and should be successful in doing it," Young said. "You need a good spread of risk."

More recently, dealers have sold key fob protection coverage, said Myers. With the keyless entry of many news cars on the road today, a lost fob has to be reissued and reprogrammed to open the door.

That item can easily set vehicle owners back by as much as $500.00, Myers said.

Dealers have also made a point of advertising prepaid maintenance plans, which include oil changes and brake replacement over three to five years, as an incentive to get auto buyers into the showrooms.

Service contracts, said Mary Harrington, director of risk management for Subaru of America Inc., in Cherry Hill, N.J., have become "big business because cars have become so complex."

Indeed, it's not unusual to come across models with as many 50 microprocessors that control everything from seat temperatures to headlamp intensity. As anyone who's ever visited the dealer knows, fixing a minor part can become an expensive proposition.

All those service contract premiums add up. Nissan Global Re in Bermuda, for example, is writing approximately $500 million in annual premiums, and the majority of that amount is for service contracts, Myers said.

Another permutation of service contracts sold by dealers is the Guaranteed Auto Protection program, also known as a debt waiver, which covers the difference between what the vehicle owner still owes the lender and the market value of the vehicle.

In the event the car is totaled and the owner's personal line of insurance isn't sufficient to cover the note, he or she will be relieved of the obligation to pay the gap between what insurance will cover and what is still owed on the note.

GAP programs have been around for more than a decade, but several years ago suffered from adverse loss ratios.

"In a down economy, cars may disappear and then be found at the bottom of a lake," Myers said.

In a strengthening economy, however, GAP programs' loss ratios have improved.

GAP programs are now the second most common product sold by dealers behind extended warranties, he said. "We're seeing a lot more of this on the dealers' side as opposed to the original equipment manufacturers' side," said Myers. "We're seeing them more involved with the captive."

CYRIL TUOHY, managing editor of Risk & Insurance®, can be reached at ctuohy@lrp.com.

March 1, 2013

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