See update, Jan. 20, 2004

While the charlatans and fly-by-nights have largely been weeded out of the American market for extended warranties and service plans, in the United Kingdom they haven't even begun to regulate the bad guys. For Americans accustomed to the European tendency to regulate everything from job openings to closing times, it is astonishing to discover that there is no British law that specifically regulates extended warranties.

British consumer advocates, meanwhile, are certain that extended warranties as sold by the major retailers do not offer value for money, because the appliances and consumer electronics items they cover are typically more reliable than expected.

The UK's Consumers' Association said the probability of a claim within five years on the items they researched was between 9% and 25%. They also said that the manufacturer and insurance companies typically offer more fairly-priced plans, but they can't compete because the retailer shuts them out from the point of sale and pressures the consumer to buy their own plan. Furthermore, many retailer's in-house plans are unlikely to be backed by insurance in the event of the retailer's insolvency, although some plans are financed from a special-purpose trust fund.

An 89-page Outline

The intense nature of the debate is reflected in the detail at which regulators are now reporting upon it. On Feb. 28 the UK's Competition Commission delivered an 89-page document about its preliminary investigation of the market for extended warranties in the electrical products retail channel. The document was supposed to be an "issues letter" that outlined their interim findings, but those letters are more typically four or five pages in length. One can only imagine how many trees they'll kill to print their final report, which is due by July 1. We caution our readers to avoid downloading the Commission's own PDF-formatted document and instead to look at our HTML-formatted mirror page of the issues letter.

The Competition Commission, which replaced the Monopolies and Mergers Commission four years ago, carries out inquiries into matters referred to it by the other UK competition authorities concerning monopolies, mergers and the economic regulation of companies. Like the U.S. Dept. of Justice and the Federal Trade Commission, it has the power to investigate allegations of abuse of monopoly power, and to recommend massive structural changes in the market, if necessary. For instance, it would be the entity in the UK that would advise the government to break up AT&T, or to let Microsoft remain whole. It has so far declined to suggest anything so drastic to fix problems in the extended warranty business, however.

Limited Competition Found

This current extended warranty investigation was referred to the Competition Commission last July by the Office of Fair Trading, a government agency that works on behalf of consumers. The OFT made the referral finding in its own study that the effectiveness of competition is limited, that the retailer's point-of-sale advantage is a significant barrier to entry for competitors, and that industry self-regulation generally had not worked. The CC's issues letter more or less confirms those findings, although only in a very preliminary fashion.

The OFT report said more definitively in last year's report that a voluntary code of conduct developed for sellers of extended warranties by the British Retail Consortium in the mid-1990s has not been widely followed. The OFT reached that conclusion after sending its own investigators into shops, checking to see if pamphlets about the service plans were available for take-away ahead of time, if there were signs detailing the terms and conditions of the plans, and if salesmen could describe extended warranty plans offered by the manufacturer or other entities in competition with the retailer's own.

Between a quarter and one half of all shops were deemed out of compliance with the code. Ironically, that code of conduct was the self-regulation alternative worked out to avoid regulation after an earlier pair of OFT reports on extended warranties in 1994 and 1996 found many of the same problems in the industry. (See OFT report, ¶ 5.3, p. 20)

Nothing had changed, so the OFT basically threw up its hands and passed the matter on to the Competition Commission for some regulatory action. Voluntary agreements hadn't worked in the two previous cases, and would not work in this case either, the OFT said. Besides, by the OFT's own admission, the remedies available to regulators following a CC investigation were "significantly more extensive" than anything an OFT report could accomplish. "A reference to the CC," the report concluded, "provides the best prospect for making this market work better," through increased competition, information, and consumer choice.

British Monopoly Laws

British monopoly laws do not require massive market shares for action to become possible. The UK's Fair Trading Act of 1973 states that a "scale monopoly" may exist when one firm has at least a 25% share of a given market. The law says a "complex monopoly" exists where two or more firms together account for at least 25% of a market and they engage in similar conduct. It is up to the Competition Commission to report on such matters, and most importantly, to decide whether the monopoly operates against the public interest. If it is deemed to be against the public interest, then it is up to the UK's Secretary of State to outlaw the practices that led to that monopoly, and/or to break up the companies that held it.

Making heavy use of indefinite modifiers, the Competition Commission's Feb. 28 issues letter said a scale monopoly "may exist" regarding the Dixons Group plc, Europe's largest electronics retail chain. It also said that one or more complex monopoly situations "may exist" in the electrical goods retail segment. But that sounds worse than it really is. The CC is merely stating that it has determined that Dixons probably has greater than a 25% market share, and therefore most likely fits the prerequisite for a scale monopolist. "This does not imply any adverse findings relating to the conduct of the Dixons Group," the letter quickly adds.

Similarly, the CC finds that conditions are right for the existence of a complex monopoly, based upon its finding that numerous retailers acting similarly are in control of more than 25% of the marketplace. And again, the letter notes this does not imply any adverse findings regarding any particular company. But it certainly puts the industry on notice that the final report this time around may result in significant changes within the UK's extended warranty industry. During hearings next month, retailers will have an opportunity to dispute these preliminary findings and put their own spin on market conditions, but it seems as if momentum is building for some sort of structural change at the end of this third go-round.

If there is a monopoly, the OFT said, its existence impacts the public interest because consumers already are so badly outmatched at the point of sale. The OFT's study found, and the CC's letter has confirmed (in a preliminary fashion), that consumers generally do not shop around for extended warranties, that they have limited information on its terms, and that they are easily led by aggressive salesmen. They don't know much about a product's reliability or the cost of likely repairs, and they can't judge a fair price when it comes to insuring it or buying a service plan. They don't know much about alternative sources of extended warranties besides the selling retailer. And though half enter the store fully intending to purchase an extended warranty, few did any research ahead of time about the alternatives to the retailer's own plan.

Impacts Manufacturer's Warranties

The CC added in section 3.20 of its letter that the retailers' monopoly on the offering of extended warranties was in fact making it difficult for manufacturers to boost the term of their basic warranties from one to two years or longer. In the UK, all manufacturers of electrical goods must offer at least a one-year warranty, which the report for some reason refers to as a guarantee. The British define electrical goods as products that run on either house current or on battery power, so this rule includes not only consumer electronics, but also many home appliances, tools, and toys.

Simply put, the retailer has no reason to tell the consumer about the basic warranty, because that reduces the appeal of a five-year extended warranty. Longer basic warranties therefore have no appeal to the manufacturer, because it increases their cost in a manner that can't be compensated through higher prices (assuming the consumer won't be told why the price is higher).

Most importantly, the OFT report and CC letter found no British legislation specifically applicable to the sale of extended warranties or service plans. There is no Service Contract Industry Council in Britain, and there's no model law, as Warranty Week spotlighted in last week's issue. Neither the OFT report nor the CC's letter had much to say about the U.S. example, however.

British insurance companies that sell extended warranties are regulated by the Financial Services Authority, and through the bylaws of their insurance associations. But electrical retailers who sell service plans are not regulated to any equivalent extent.

Last year by closing a tax loophole, British tax authorities made extended warranty revenue kept in offshore accounts subject to higher domestic UK tax levels. However, even after this change in tax rates, the sale of self-financed service plans by electrical retailers remained unregulated by insurance laws. Only if their plans are insured are they subject to FSA rules. And not even the insurance industry regulators have anything to say about a code of conduct at the point of sale. That's up to the British Retail Consortium.

Two Markets: One Insured, One Not

Therefore, there are really two markets in the UK: one where regulated insurance companies sell insurance policies for consumer appliances, and another where electrical goods retailers offer service plans that may or may not be insured. These two markets sell products that outwardly appear to be the same, despite the difference in risk. To further complicate matters, retailers are almost always the sales agent in any case, whether they are selling their own plans, reselling those of a manufacturer, or offering those of a third party insurance company. Therefore, in any given sales situation, there is usually one and only one seller, one source of information, and no opportunity for comparison.

British consumers are generally unaware of the differences between the plans. The OFT commissioned a survey of 2,000 heads of household and found that 85 percent had no idea about the different level of risk between an insured plan and one self-financed by a retailer. All they know is what the retailer chooses to tell them. When asked who offers extended warranties, 7 out of 10 consumers the OFT surveyed mentioned a retailer, while only 1 in 4 mentioned a manufacturer, and only one in seven mentioned an insurance company. Consumer awareness, the OFT study said, was "disappointingly low".

Market Size Dispute

The OFT report found an extended warranty market worth well over UK£500 million per year, while the CC said it's actually closer to £800 million (US$1.28 billion). Note that under British law a 25% market share is the magic number when it comes to discussions of monopolies.

Dixons Group estimates that if PCs and mobile phones are counted along with older types of electrical goods, the British market for extended warranties could total twice that amount (and Dixons' share would therefore fall below 25% -- hence no scale monopoly). Kellie Evans, spokesperson for the Dixons Group, said that actual market size is one of the first issues the company plans to take up with the Competition Commission when individual hearings begin.

"Potentially, the market could be double the size of what they're estimating here," she told Warranty Week, "which of course would put an entirely different complexion on our role within it.

"We're looking forward to giving our evidence to the Commission."

The bottom line, Evans said, is that even the regulators' own research finds that 76% of extended warranty buyers are satisfied with their purchase, only 18% regretted having bought an extended warranty from a retailer, and under a tenth of those who purchased extended warranties had considered canceling the plan (CC letter, ¶ 2.14).

Safety Valve for Sales Pressure

Evans noted that the CC's letter also failed to mention that Dixons gives consumers a 14-day "cooling off period," during which they can cancel the purchase of an extended warranty for any reason. They can cancel the policy because they discovered that product reliability is much better than they first thought, because they discovered competing plans that were less costly, because they read somewhere that extended warranties were not worth their cost, or because they just basically had second thoughts.

Evans also points out that there is a middle alternative to the extremes of complete insurance or complete risk. Dixons advocates the use of what the British call a "ringed fence fund," which is basically a special-purpose trust fund that's set aside to cover future claims. It is not insured, although that would only matter if Dixons was unable to pay all claims for some reason.

In practice, the opposite has happened. Evans noted that in 2001 Dixons picked up coverage for around 400,000 customers left stranded when an uninsured extended warranty plan sold by a competitor named Tempo collapsed after that retailer went out of business.

"We stand behind the service that we provide," she said. "And obviously, from a very basic perspective, we want to have long term relationships with our customers. We want to provide them with products and services that they enjoy and appreciate, so they come back to us again."

The Ringed Fence Fund

Dixons said in its interim financial report for the half-year ended Nov. 9 that extended warranties comprise only 7.5% of sales now, down from upwards of 9% in past years. The company did not announce the size of its "ringed fence fund," at that time, though financial statements from the 2000-2001 fiscal year sized it at £280 to £285 million -- roughly 6% of sales. Playing with those numbers, one could conclude that Dixons holds in its reserve fund an amount equal to somewhere between 65% and 80% of its total annual extended warranty revenue.

Evans, however, notes that extended warranties are not merely a source of revenue, nor is their sole purpose to pay for repairs. Extended warranties also finance a certain amount of advice and assistance, in that Dixons will help a customer muddle through the installation and setup, if necessary. What if a customer buys a digital TV, a set-top box, and a DVD, all at once? What if the sound suddenly stops working? Is that a product defect or a misconfiguration?

Even when a product stops working, it may not always be the fault of the manufacturer. Dropped your mobile phone in a bucket of water? Dixons might cover it while other plans might not. A virus wiped out all your computer's files? Which PC maker or insurance company would cover that claim?

"We say to a lot of customers that we don't want the relationship to end when they walk out of the store," Evans said. "We would rather customers to start their relationship with us when they walk into the shop. That's why we hope that extended warranties are seen as a quality service rather than as a disadvantage for customers. Ultimately, we want people to come back to us again and again -- not necessarily with their faults but hopefully with a positive view that we've solved their problems."

Phil Evans, principle policy advisor with the UK's Consumers' Association, may share a surname with Dixons spokesperson Kellie Evans, but that is where their agreement seemingly ends. He told Warranty Week that the problems with extended warranty plans sold by major retailers has been a long-standing issue for the Consumers' Association, and their advice to consumers has been consistent over the years: don't buy them.

"When we first went to the Competition Commission, we said to them, 'Look, there's an issue here primarily about prudential regulation,'" Evans said. "The initial scope of the complaint was very much along the lines of this market isn't working. The things are being hard-sold. People are buying things they don't need."

The group concluded in an article published in the Feb. 2003 issue of its Which? magazine that extended warranties as sold by retailers are usually too expensive, generally go unused, and are probably not as good a deal as is available from other sources. Using rather colloquial descriptors such as "rip-off," the article also described the "dodgy" sales tactics used in "the great warranty swindle."

Dueling Missives

That article triggered an angry response letter from Dixons chairman John Clare in which he set out to correct some "quite serious misunderstandings," which in turn inspired a follow-up article in the Daily Telegraph newspaper.

Consumers' Association director Sheila McKechnie then delivered her own zingers back to Clare in a Feb. 26 response letter of her own. A sample: "It's high time this £800 million market is cleaned up and that consumers no longer face hard sales tactics for extended warranties when buying household appliances." Or how about this: "Our advice to consumers is simple -- just say 'no' to extended warranties. It's time to turn up the heat on electrical retailers."

What if copies of those all those letters and articles were nailed on the wall next to the cashier for all to read, and some people still bought extended warranties? What if a little old lady who couldn't install a new toaster without assistance always buys an extended warranty, and is always happy she did so? What if she thinks of the people in the Dixons Coverplan call center as her personal lifeline? What if she refuses to read the negative articles, throws away the insulting letters, and disregards the advice of consumer advocates? Is it the government regulator's job to make her unhappy? What if, as the UK government's research suggests, only 20 out of a hundred customers actually buy an extended warranty, but 15 out of those 20 are happy they did so? Is it the regulator's job to make the last 5 happy or the 15 unhappy? What about the 80 who did nothing?

Recent Uninsured Collapses

The Consumers' Association also worries what would happen if a retailer or other entity backing an uninsured extended warranty plan went bankrupt, rendering those plans worthless. An Oct. 2002 article in Which? magazine documented the recent collapses of not only the Tempo chain, but also Tiny Computers and Dan Technology. Evans said the association advocates the need for some kind of protection scheme, be it insurance, separate accounts, or some other alternative.

"We weren't too bothered about how that was done, provided it was delivered," he said. Ringed fence funds are a viable option, but the problem is that the retailer itself decides how big that trust fund should be, and how it should be administered. In contrast, for insured plans, the UK's Financial Services Authority makes sure insurance companies have enough funds to meet any claims. If the insurance company itself goes under, the UK's Financial Services Compensation Scheme will pay the claim. And if a customer is unhappy with how an insurance company handled their claim, they can take the matter to the Financial Ombudsman.

Another issue of concern was the relationship between the price of a product and the price of its extended warranty. Some say Dixons will only discount the price of a product if the buyer also purchases an extended warranty contract. Others say Dixons rarely discounts the merchandise, but is quite willing to haggle over the price of an extended warranty for it. Either way, the suspicion is that the total price would be lower if the product and its service plan were sold separately.

In the U.S., the type of "tying" that's prohibited is where the seller says the warranty on a vacuum cleaner is void unless the customer buys the seller's own brand of overpriced vacuum bags. Giving a discount on additional vacuum bags purchased with a vacuum cleaner, or discounting the price of the vacuum cleaner if the buyer also purchases the full-priced bags, is not prohibited. One can always say no. In addition, when the product being bundled is the service plan itself -- as in the case of 50/50 warranties for used autos -- U.S. regulators recently explicitly permitted the practice. Furthermore, there's no ban on the use of extended warranties as deal sweeteners.

Excessive Profit Margins?

Some say extended warranties in the UK command 30% to 50% margins, as opposed to an operating profit on all electrical goods more typically in the range of 5% to 10%. It's possible that extended warranties are among the biggest profit producers of all. The Consumers' Association, in fact, cited recent evidence in an investment magazine that said extended warranty sales may account for as much as 47% of Dixons' pre-tax profits, and 80% of a competitor's. Therefore, it's no surprise to find more price flexibility on a product bought in combination with an extended warranty than on the basic product bought alone.

However, that unusually high margin also deepens the mystery: if these extended warranties are so profitable, why isn't everybody and their brother trying to sell them? The answer is perhaps that everyone is, but nobody else can compete with the retailer. Nobody else can sell inside the shop.

All agree that the strongest pressure to buy an extended warranty is exerted at the time and point of sale, before the customer takes the product home. And there's some agreement about the lack of choice, or at least about the lack of information about choices. But what's most disturbing is the consumer's lack of interest.

Consumer Apathy?

If there were one and only one make and model of television available in a given retail shop, most would agree this would be of some concern to shoppers. But the UK government's own research seems to suggest that when it comes to extended warranties, the consumer's favorite answer is "don't know/don't care."

Evans noted that it will be within the Competition Commission's mandate to examine whether market conditions present such a significant barrier to entry that alternatives to extended warranty plans sold by the retailer at the time and point of purchase are not viable. Perhaps, he said, extended warranties are such a "cash cow" for retailers that they might never voluntarily allow a competitor's plan into their shops? In that case, a structural solution will be required -- one that goes far beyond requiring signs and pamphlets.

"I think the problem is, the vast majority of consumers don't actually go out to buy an extended warranty," he told Warranty Week. "They go out to buy a washing machine, or a fridge, or a DVD player. And it's only when they get into the store that they then get flogged this product that they may not need or want. So the ability of an independent to get in there and sell a competing warranty that's a fraction of the price is basically zero."

Manufacturers Must Get More Involved

Evans said what he thinks what British consumers want is a level playing field where other providers of warranty or insurance products have a chance to make their case to the consumer at the point of sale. Most obviously, he wants to see the manufacturers get more involved, because they know best when it comes to quality levels and failure rates. But he also wants the opportunity enhanced for independent sellers to get into the market.

How can that best be done? Will it require that retailers must be banned from selling their own extended warranty plans, or at least that they shouldn't profit from their sale? Will it require some kind of equal access/equal opportunity scheme under which a retailer becomes a neutral sales agent offering multiple plans/providers? It's a big leap to say that because little old ladies need protection from a retailer's high prices and aggressive sales tactics, that the products they buy should be banned. And it would be unusual to require a company to sell the goods of its competitors. But it's also clear that the mere existence of the ability to say no is not the same as actually saying it.