The financial benefits of premium reduction and tax reduction for owners of captives are well documented. But many of the less obvious benefits are underemphasised and not well celebrated, and certain types of captives offer much more than profit preservation for the owner, says Darren Lossia of Innovative Computer Systems and Direct Claim Solution.
This article is focused on warranty captives formed by consumer goods retailers. It highlights three of the less tangible but positive and powerful forces that go to work when a retailer takes ownership and control of its programme.
“With its self-insured, self-administered service programme, the retailer is armed with years of clean, reliable and robust information and metrics on every aspect of model failures.”
Because we are referring to a programme offered through the retail channel, rather than the warranty of the product manufacturer, the more legally accurate name is an extended service contract. This term distinguishes it from the product warranty that is inseparable from the product purchase. The common theme of these three benefits fits the spirit underlying the key captive concept: control.
What are extended service contracts?
An extended service contract is a contract between a goods purchaser and an obligor, a company required to satisfy the duties of repair, maintenance or replacement of the purchased product. Satisfaction can be accomplished by direct performance with an in-house service team or outsourced to local companies. The terms and conditions of the service obligation are set forth in the extended service agreement.
Unlike a manufacturer’s product warranty, which attaches to the physical item at the time of purchase and without a separate price, an extended service contract is optional. It is separately priced and sold as a distinct line item on the customer’s receipt. In many cases, it is the goods retailer who offers this add-on at the point of sale. In other cases, the extended service is offered by a third-party warranty administrator not affiliated with the retailer through common ownership.
These contracts are in demand for higher value consumer goods such as large appliances, consumer electronics, and vehicles. They are also in high demand for expensive medical diagnostic equipment such as MRI and CT scanners, as well as other types of commercial and industrial machinery.
Each of these physical items typically comes with a manufacturer’s warranty limited in time and scope with no added cost. The extended service plan extends the term of coverage and often expands the scope of coverage. Consumer arrangements are frequently consummated at the checkout counters of hardware and appliance stores, as well as car dealerships. New home builders offer these products to cover a number of items and systems included with the home sale.
A common example of an extended service contract may be the purchase of a three-year extended service plan sold for $129.99 on a $1,200 television set. The three-year plan may cover certain costs and expenses in the first year that are not covered by the manufacturer’s warranty.
For example, first-year coverage for this plan may give free in-home service calls or free shipping costs on repairs so that its scope of coverage is larger than the basic manufacturer coverage. It’s this expanded coverage that makes the deal attractive even to those who believe the duration of the manufacturer’s warranty is sufficient.
Home and kitchen appliances, along with heating and cooling equipment, are almost always sold with an offer of an extended service plan. These plans include additional coverages during the manufacturer’s term so that the first year of coverage does not duplicate the manufacturer’s warranty.
Enhanced customer relationships
Owning the warranty insurer is better for customer relationship-building. When the retailer is seen by the customer as the product seller and the quality guarantor, the relationship is strengthened. The ideal place for a retailer to occupy is the inside of the customer’s advisory circle with something to lose if things go wrong.
Selling an ongoing relationship is usually preferred to selling a transaction when one considers the true cost of gaining a customer. The extended service programme can certainly be funded through a commercial carrier but this takes away the key benefit of control. The ability to make the final decision on whether your customer gets a fourth repair visit or a new replacement product is powerful. With ownership, the retailer can protect the relationship and set policies that serve long-term goals. With this alignment between insurer and retailer, the brand becomes more valuable as goodwill increases. Few things validate a consumer’s choice like a retailer that stands behind its sale.
Negotiating power with manufacturers
Knowledge is power. When a retailer owns and controls its own scorecard on the types of defects occurring, the timing of the defects and the relative failure rates by model and manufacturer, real knowledge translates to negotiating power.
Take a retailer that carries six brands of refrigerators. With its self-insured, self-administered service programme, the retailer is armed with years of clean, reliable and robust information and metrics on every aspect of model failures, including frequency, severity and timing.
The predictive value alone is useful, but leveraging that information during supplier price negotiations can boost margins and the bottom line. Imagine that same retailer walks into the negotiation with a spreadsheet comparing defect rates and average costs by manufacturer. The manufacturer has been shown that its burden on the warranty programme is significantly higher than that of other suppliers, even adjusting for sales variations.
That failure rate directly impacts the servicing costs assumed by the retailer’s warranty obligor. Would a $10 million account be able to obtain a purchase discount when this is revealed with actual data?
Table 1 shows a manufacturer with a defect rate on washing machines that is clearly an outlier (Manufacturer E). This manufacturer’s warranty loss costs far exceed its share of warranty sales as a percentage of the total warranty costs. Ownership of the warranty programme means the information necessary to present this argument is under the control of the retailer.
An additional negotiating strategy is to protect your business with a guarantee agreement that requires your suppliers’ products not to exceed a pre-determined defect experience. If a certain make or model does not perform up to the standard during long-term use, the manufacturer is required to fund all or some of the excess loss incurred by the captive.
With this type of agreement, the manufacturer becomes a de facto reinsurer and gains valuable information about design and defect issues evident only with information about the long-term use of its products. Without the participation of the retailer in the extended service programme, the manufacturer may not have a strong monetary interest in long-term design defects. Product guarantee agreements are one way to get the finance team and the design engineers on the same page as the end user.
Diversification with higher margins
Consumer goods is a highly competitive space. The volume at stake allows companies to sharpen pricing, but this environment makes retailers less focused on the long-term goal as it races margins to zero and beyond. Thin-margin businesses require creative marketing programmes, special offers, and gimmicks, and this often leads to the need to diversify in order to survive.
An extended service programme is a creative way to take the sales of your primary business and turn it into capital surplus and margin. Properly run programmes generate both short and long term profits for the risk owner that are typically in excess of the consumer goods margins. Additionally, the time value of money offers a warranty captive owner the chance to partially fund losses on a mature programme with investment income. Would a high volume retailer really want to surrender the most profitable part of the business to a commercial insurer?
Before launching a warranty captive, one of the first questions to ask of course is whether the consumer goods retailer knows whether the existing warranty programme managed by a commercial carrier generates an underwriting profit. For many programmes, the question may be difficult to answer. The long term nature of a programme that offers three, five and ten year promises means that the final score first year business is not known until half a generation has passed. With the benefits of a such a programme comes cost and risks. An experienced programme advisor and captive manager can make a significant difference.
The warranty captive of a retailer is much like other captives with financial benefits. But with retailers, the organisational benefits and control aspect makes the argument compelling.
There will be an organisation that will interface with the customer and provide the guarantee and the servicing. That organisation will be rewarded with profits in exchange for taking risk. So which organisation should handle the programme? The customer likely prefers the organisation with a long term relationship in mind.
Darren Lossia is director of risk management services at Innovative Computer Systems and the creator of the Direct Claim Solution system. He can be contacted at: firstname.lastname@example.org
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