Tracing the money trail for a service contract goes like this. An automobile dealership sells a five-year service contract to a customer for $700. The dealer keeps $200, and $500 is sent to the obligor to abide by the contract terms.
Of that $500, let's say $200 goes to cover administrative costs and $300 is used to fund loss reserves to pay for future claims. This $300 balance may ultimately find its way to a dealer-owned captive insurance program through a reinsurance contract between the obligor and the captive.
Assuming claims come in at $275, the dealer captive is left with $25 in profits. But if claims come in at $350, the dealer captive experiences an underwriting loss.
Since the contracts are often outstanding for up to eight years, the dealer retains the ability to invest the loss reserves and earn investment income.
--By Cyril Tuohy
March 1, 2013
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