So what's the problem with extended warranties? Also called service plans or maintenance agreements, the contracts are a form of insurance whereby the purchaser can fix and pre-pay the cost of anticipated product repairs. It sounds so simple, yet this seems to be the most controversial sector of the entire warranty industry.

In the United States, the main problem with extended warranties revolves around how they're insured and who picks up the coverage in the event of the seller's collapse. There are additional problems peculiar to the automotive sector, where anonymous dot-com outfits sometimes reach across state lines with their spam offers without disclosing as much as their locations. But the main issue always comes down to insurance: will the company outlive the policies it writes, and if not, who will pay claims?

In the United Kingdom, the government last month concluded almost 18 month's worth of investigation into the market for extended warranties sold by retailers alongside household appliances and consumer electronics items. What it found, and what its proposed remedies are designed to correct, is a situation where the retailers push extended warranties a bit too aggressively and charge much more than third party providers who can't as easily corner the helpless customer at the point of sale.

Not Much to Say About Insurance

UK investigators from the outset focused on behavior by the salespeople: what they offer, how it's priced, and what they tell consumers about third party alternatives. By design, investigators did not focus on the presence or lack of insurance or reinsurance in each plan, nor on the adequacy of reserves, nor on the complications of using the Internet to sell policies across borders. While its report outlined the differences between insurance-backed and self-insured plans, no remedies were advocated beyond a requirement that consumers be told which type they were buying.

As is the case in the U.S., some UK "high street" retailers self-insure their service plans and then park their reserves in offshore accounts. But this was not the focus of the UK's inquiry. Britain's Competition Commission, which inherited the inquiry from the Office of Fair Trading, was operating under the assumption that limited competition in the extended warranty market was keeping contract prices higher than they would be otherwise. That was the original complaint, which traces its beginnings all the way back to 1994, when the OFT began an investigation that ended with a voluntary industry code of practice that in hindsight proved itself inadequate.

In its comprehensive report, which is online, the Competition Commission found that the top retail chains (Dixons Group plc, Comet Group plc, the Argos Retail Group, Littlewoods Retail Ltd., and Powerhouse Holdings Ltd.) control around one-third of an estimated £15 to £20 billion annual UK market for domestic electrical goods (DEGs, including home appliances, consumer electronics, digital cameras, video games, home computers, and kitchen appliances). It also found that the top five retailers controlled around 81% of the market for DEG extended warranties, a market it valued at £900 million in 2001. It also found that roughly one-in-three households had bought an extended warranty, and that they were sold along with roughly one-in-five DEG items. [Editor's note: at current rates, £1.00 = $1.81, although in 2001 the exchange rate was more like $1.40 to $1.47 to the pound.]

Extended Warranties Found Desirable

In general, the Competition Commission accepted the industry's view that extended warranties were desired by some customers, that most buyers were more or less happy with their purchase and with the handling of subsequent claims, and that the availability of additional coverages besides breakdowns that protect against such mishaps as accidental damage, loss or theft were beneficial. It also noted that some extended warranty plans also provide for installation advice and the answering of operational questions.

Now what's the problem? The Competition Commission found that retailers tightly couple the products to the extended warranties, making up for vigorous competition and tight margins on the products themselves with higher prices for the service plans. How much higher? The Commission's report estimates that the top five retailers collectively earned between £116 million and £152 million more profit per year than if their return had equaled their cost of capital.

Also, because the retailers control the point of sale, third parties such as credit card companies, insurers, electrical utilities, and the product manufacturers themselves have much less of an opportunity to compete, in spite of their generally lower prices. And again, because retailers control the point of sale, buyers are sometimes pressured to purchase the extended warranties.

Bottom line, the Commission concluded that a complex monopoly exists in the UK marketplace for extended warranties, and that this situation has created a competitive advantage for the retailers in question, and higher prices for consumers in general. This, it concluded, was against the public interest.

Legal Remedies Expected

The Commission developed two sets of remedies, of which only the first set was forwarded to the UK's Department of Trade and Industry, which will now write the new laws governing extended warranties that are expected later this year. In brief, what the Commission calls Package 1 includes as remedies the requirements that:

1. Retailers must display the price of extended warranties alongside the price of the relevant products in both the storefront and in any advertisements,
2. Consumers must be told of their right to cancel the contract within 45 days and to expect a full refund if no claims have been made during that time,
3. Consumers must be informed in writing that the extended warranty being offered to them at the time of sale remains available on the same terms for 30 days, and
4. Consumers must be informed in writing that alternatives exist, both from third party extended warranty companies and the product manufacturer, and perhaps even from their existing household insurance provider.

Package 2, which was not forwarded on to the DTI, included additional remedies such as forbidding the sale by retailers at the point of sale of extended warranties and/or accidental damage policies with terms greater than one year (coinciding with the manufacturer's warranty and giving consumers time to shop around for longer-termed policies).

However, four out of the five Commissioners felt that Package 1 was sufficient for now. The one exception said the remedies in Package 1 relied too heavily on consumers canceling their contracts and reading what was handed to them, and too lightly on remedies that would actually increase competition.

Francis Royle, the Competition Commission's chief press officer, told Warranty Week that the big difference from earlier extended warranty investigations is that this one will result in new laws. "They are going to be implemented by statutory order," he said. "It's anticipated by the middle of this year. I'm afraid I can't be more precise than that, but hopefully by the Summer one would expect it to be put in place."

Royle said the Department of Trade and Industry will draws up the "statutory instrument," which they are working on currently. That instrument will then be published, and will be followed by a minimum of a 12-week public consultation period, during which companies or people that will be affected by the order have the ability to comment upon it. The DTI also will carry out a regulatory impact assessment this year, and a follow-up investigation in two year's time.

Depending upon the responses received by the DTI, the statutory instrument might be modified in some way, Royle said. "But once it's finalized, it gets laid before Parliament," he added. "And on that day the order comes into effect. It's a law that's policed by the trading standards that attach to each local council."

International Differences

The Commission's report, which is posted on its Web site as a series of PDF files, extends to 436 pages not including the numerous appendices. While some of the company-specific financials have been redacted from the public edition in the name of privacy, the work in its entirety rather comprehensively profiles the extended warranty industry in both the UK and elsewhere.

In an international market study performed for the Commission by PA Consulting, researchers found extensive variations between even adjacent countries. While one-in-three UK households have purchased an extended warranty, only one out of ten people in Denmark have done so. In the Netherlands, extended warranties are sold with roughly half of all purchases of electrical goods. But in Germany, extended warranties are almost completely nonexistent, although researchers found that reliability ratings for specific products are easily accessible in that market.

Prices for domestic electrical goods were found to be highest in the Netherlands, Denmark and France, and lowest in the UK and the U.S. The lowest prices for extended warranties, meanwhile, were found in the Netherlands and the U.S. Coverage plans in the UK, which may include anything from theft protection to cash back and discounts for trade-ins, were deemed to be the best in the world. However, the UK also registered the highest extended warranty prices of all, which is perhaps the best piece of corroborating evidence for the whole inquiry. Why are prices highest in the UK? Because a complex monopoly at the point of sale has impeded competition.

The American market, the report suggests, is as competitive as the UK's in terms of product price, but is more competitive than the UK in terms of extended warranty prices. This, it says, may be due to U.S. retailers' fears that aggressive sales tactics could backfire because consumers know their competitor is only "one click away." In one section, the reports notes that "in most cases, there was no evidence of high-pressure selling." In another, it finds "no evidence of misleading selling," although a direct relationship was detected between the price of the product and the eagerness of the salespeople to sell an extended warranty with it.

Extended warranty purchase rates for "brown goods" in the U.S., the report states, range from 37% for home audio equipment to 78% for camcorders. Reasons cited by extended warranty non-buyers include a belief that 1) electronic products that are going to fail will usually do so within the manufacturer's warranty period, and 2) technology is moving so fast that today's purchases may be obsolete in three to five years.

Without providing any detail or backup, the international portion of the study pegs the U.S. market for extended warranties at somewhere between $4 and $7 billion a year (excluding policies written on autos, home computers and mobile phones). We'll have more to say about this estimate in a future column, but suffice it to say that Circuit City Stores Inc., which PA Consulting named as one of the top U.S. retailers of domestic electrical goods (along with Best Buy Co. Inc., Sears Roebuck, and Good Guys Inc.), recently reported that its the total extended warranty revenue for the nine months ended Nov. 30, 2003 was $225.6 million. If the total market were indeed as large as PA's study suggests, Circuit City's share of it would be a mere 4.3% to 7.5%.

UK Retailers Respond

Curiously, among the major UK retailers only Dixons Group had anything substantial to say about the inquiry and the report. Dixons chief executive John Clare has served as something of a lightning rod for media coverage for much of the past year, and his competitors seem to prefer it that way.

Hamish Thompson, head of press and public relations at the Dixons Group plc, said he thinks the reason the company is most often quoted in regards to extended warranties is that it is the UK's market leader in electrical retailing. Upon that point, even the Competition Commission agrees, citing research that gives Dixons and its affiliates a 21.3% market share -- three times larger than #2 Comet's 7.1% share. But in addition to market share, Dixons also has a point of view that it wishes to defend.

"We believe very strongly in the value of the service agreements that we offer our customers," Thompson told Warranty Week. "The debate about the value of service agreements is often one-sided and fails to take account of the growing complexity of technology and the requirement of many of our customers to access an efficient, expert service. We provide a technical fix by phone every 15 seconds around the clock; we have two million spare parts in stock; we offer advice, guidance and support every day and our service agreements provide comprehensive cover. If we can't fix, we replace, and as many of the claims made are for accidental damage, our service agreements provide perfect peace of mind for customers who increasingly use their technology on the move."

Spokespeople at Argos and its outside public relations agency at first said a statement had been issued last month, and when that couldn't be located, said that no additional statement would be made. Besides Dixons, only one other retailer has made a public statement about the matter. Here's what the Comet Group posted on its Web site last month:

Simon Fox, Managing Director of Comet, said: "We welcome this end to the prolonged uncertainty that the inquiry has caused to our customers and to the business.

"We stand by our belief in our extended insurance cover offer which is fully insured with AIG one of the world's largest insurance companies. We welcome the Secretary of State's advice to customers to shop around, confident in the knowledge that Comet offers value for money in a highly competitive market.

"Our priority now is to work with the OFT to agree how the remedies will be most effectively and quickly implemented in our stores. Once we have agreed on the practical implications we will issue a further statement."

A Comet spokeswoman said that no additional statements have yet been made public.

Consumer Advocates Respond

Phil Evans, principle policy advisor at the UK's Consumers' Association, said he was generally pleased by the outcome of the Competition Commission's inquiry. "This is the first really serious attempt to take apart this market and work out how it really functions," Evans said, "and that is in itself a huge step forward. It's a phenomenally difficult market to do anything about. The fact that they have found some constructive things to do, I think, will help sort the market out. It's really a testimony to practical regulation."

If the OFT is analogous to a state department of consumer affairs or an attorney general's office in the U.S., the Consumers' Association is analogous to the Consumers Union, publishers of Consumer Reports. As such, it is their mission to look after the rights of consumers, and not so much the relationships between warranty administrators, insurers, and their sales agents.

"In many ways the fundamental problem with the [UK's extended] warranty market is that the companies that are in it just don't play the game by the proper rules," Evans said. "They oversell them, they overpromote them, and they make too much money out of them. It's very much a company behavior issue."

"Interestingly, most of the sellers of warranties have had a much harder time of late selling any," he said, "because of all of the publicity surrounding this investigation. And I think that's one of the great advantages of these investigations. People start to think about the issues much more. So selling the thing to the unwitting 'punter' at the checkout is more difficult."

Evans said he accepts the Dixons argument that some service contracts go above and beyond mere break/fix coverage, and noted that the Consumers' Association told the Competition Commission as much. But what he also said was that these various extras -- accidental damage, loss, theft, telephone support, etc. -- should be unbundled and priced separately from the basic service contract. The Competition Commission rejected that as a potential remedy.

However, Evans noted some disappointment that the Commission declined to delve into the insurance aspect of the extended warranty industry.

"It didn't go quite far enough," he told Warranty Week. "I think the problem the Competition Commission had was that the Treasury Department had already carried out a review of a number of insurance schemes, and said they were not going to do anything about extended warranties. Unfortunately, I think the Competition Commission's hands were effectively tied by the Treasury side."

That's not to say that other UK governmental agencies will have nothing to say about what after all is an insurance product. The Financial Services Authority recently released new rules governing the conduct of insurance companies, but curiously, retailers selling self-insured warranties are not classified as insurance companies. So they will remain able to define their own reserve levels, whether to place those reserves in a trust fund, and whether to base those funds offshore.

"What we wanted to do was basically make it impossible for firms to go offshore," Evans said, "because we've had a couple of cases ourselves recently where firms have gone bust and their warranties have become completely worthless. But most of the big guys that are left have set up these peculiar trust funds [called ringed-fence funds], so it's unlikely to happen again."

Still, he said it would have been better if the report had also looked at this aspect of the business. Evans noted, however, that the final rule is likely to at least mandate the disclosure of the nature of a plan's structure, explaining at a minimum whether it's insurance or not.