Published: 27/02/2003

06/03 27 February 2003 EXTENDED WARRANTIES MONOPOLY INQUIRY: ISSUES UNDER INVESTIGATION INTRODUCTION The Competition Commission (CC) has today sent a letter setting out the issues under investigation in its inquiry on extended warranties (EWs) on domestic electrical goods (DEGs). This "issues letter" is attached. It has been addressed to those we currently understand to be involved in the provision of EWs in the UK, including retailers of DEGs, insurers and manufacturers. They are listed in Table 1 of Annex 1 to the issues letter. The letter has also been published on the CC website, with commercially confidential information removed. We were asked to undertake an inquiry into the supply of EWs on DEGs under the Fair Trading Act 1973. The terms of reference require us, in summary, to investigate and report on whether one or more companies is involved in a monopoly situation in the supply of EWs on DEGs in the UK; on any steps being taken to exploit or maintain such a situation; and on whether this operates or may be expected to operate against the public interest. An issues letter is always sent to the main parties in an inquiry and is designed to highlight those matters that have been identified by the investigating group for further consideration, and to ensure that no relevant matter has been overlooked. We will shortly hold hearings with a number of the main parties individually to discuss these issues. We are also planning to hold a public hearing in London on 25 April, to which we are inviting all interested parties. The purpose of making the issues letter public is to give all interested parties an opportunity to put any points to us that they may wish to raise. No findings on any of these issues, nor any conclusions as to whether any matter operates or might be expected to operate against the public interest have yet been reached. Nor has the inquiry yet reached the stage when (if at all) it comes to consider any remedial action that might be appropriate. We have commissioned a survey from NOP on consumers' experience of EWs. The results of this survey are referred to in the letter, and are published on the CC website. POSSIBLE MONOPOLY SITUATIONS On evidence received so far, we consider that a scale monopoly situation may exist, as Dixons Group plc appears to supply at least 25% of EWs on DEGs both by number and value. This does not imply any adverse findings in relation to Dixons Group plc. We also consider that one or more complex monopoly situations may exist, in favour of those providers of DEGs who supply EWs at the point of sale of the relevant DEGs. This could arise from practices that act to prevent, restrict or distort competition, where the providers involved supply more than 25% of the supply of EWs. Only the larger providers of EWs have been individually identified (in Table 2 of Annex 1 of the issues letter); these are the larger retailers of DEGs (Dixons, Comet, Powerhouse, Argos, Littlewoods and MFI, together with the insurance companies involved with them in providing EWs: Cornhill, Landmark, Pinnacle and London General). It is possible that others involved in providing EWs may also be part of a complex monopoly. This does not imply any adverse findings in relation to any company. Many EWs are sold at the same time as the DEGs to which they relate (at point of sale). We consider that this may provide an advantage which, taken with the practices outlined below, may amount to a course of conduct that has the effect of preventing, restricting or distorting competition. EXTENDED WARRANTIES EWs are supplied by most DEG retailers (including mail order and internet sellers), manufacturers, some insurance companies, and to a lesser extent, some banks, credit card providers and utility companies. We estimate the annual sales of EWs on DEGs to be in the region of #800 million. EWs extend the initial manufacturer's or retailer's guarantee in time (usually for a further two or four years after the typical initial one year guarantee), and may also extend the scope of risks covered, for example, to include cover against accidental damage, theft or frozen food loss. In some cases technical or other support services, such as a PC helpline, may also be included. POSSIBLE UNCOMPETITIVE PRACTICES The Commission has not yet reached any conclusions, but is investigating whether some or all of those companies involved in providing EWs at the point of sale of the relevant DEG are engaged in any of the following practices, and whether this gives rise to any outcomes which operate or might be expected to operate against the public interest. A. Restricting choice Consumers may, at point of sale, be offered only one provider's particular combination of cover and related terms on EWs. If so, this may restrict their choice of cover and may mean, to some extent, that they have to take cover they would not otherwise have bought. On the other hand, there may be practical limits to what can be offered. B. Contracting in advance Consumers are often required to contract and pay in advance for services, some or all of which will not be provided for some time. Repair services (and in some cases other elements of the EW) are already provided during the first year (and occasionally longer) under the manufacturer's initial guarantee. In the case of EWs provided at point of sale, this may restrict or distort competition, because information about alternatives may not be readily available until after a purchase has been made. On the other hand, consumers may find it convenient to buy the EW that is offered at the same time as the DEG. C. Setting prices above competitive levels If there is a lack of effective competition at point of sale, this may mean that consumers are paying more than they would otherwise. In assessing this, account needs to be taken of costs, how they relate to the pricing of different elements of EWs, and how prices are set. If there is scope to make profits in excess of competitive levels on EWs, the issue arises as to the broader impact. If the result is lower prices than otherwise in other competitive areas of business such as DEG retailing, then this may cause further distortions or restrictions on competition in these other areas. D. Restricting information about alternatives Information available to consumers at the point of sale about alternative EW offerings may be restricted. Information is generally available at the point of sale about the main features of the DEGs available and their price. It appears that, in contrast, there is very little, if any, information provided to consumers at the point of sale to enable them to evaluate EWs of other providers. There may be very limited scope for such alternative providers to obtain or challenge a point of sale advantage. There could be competition problems if consumers cannot make a reasoned and informed choice about which EW to buy (or whether to buy one at all) because information on alternative EWs is not made available, particularly at the point of sale. Consumers' awareness of statutory rights may also be low. E. Selling practices Retailers may engage in selling practices such as providing misleading or incomplete information or excessive selling pressure designed to increase the sales of EWs sold at the point of sale of the DEGs. The consumer may have little, if any, directly useful information on matters such as likely reliability, potential repair costs, probability of theft or accidental damage. If so, consumers may be more susceptible than otherwise to any statements made by sales staff at the point of sale, and some practices could amount to pressure selling. The point of sale context, with the potential for bargaining over credit and DEG prices, may affect sales behaviour in relation to EWs. Sales targets and commissions to staff may be factors. F. Unfair terms EWs may include terms or conditions that are not fair to consumers and would not be sustainable in fully competitive conditions. Possible examples are: the termination of EW cover following a claim; disproportionately small repayment on cancellation in relation to the cost of the EWs; applying depreciation rates, or using reconditioned products for replacement in a way which was not sufficiently highlighted and therefore expected by some consumers. A further practice, which we understand may have been largely discontinued, has been offering cash back to consumers for making no claim during the life of the EW, but with conditions that mean many consumers in practice fail to meet the terms. G. Uninsured cover EWs may be offered in the form of uninsured service agreements rather than in the form of insurance contracts in order to obtain preferential tax treatment. Such agreements may provide consumers with a lower level of protection in the event of insolvency. Many EW providers have established ring-fenced trust funds that are intended to mitigate this risk. We are considering the extent to which, if at all, these arrangements fall short of providing in practice the degree of protection afforded by insured schemes. Notes to Editors 1. The reference was made by the Director General of Fair Trading under s.2 of the Fair Trading Act 1973 on 2 July 2002 (see Press Release 34/02). The Commission has been asked to report by 1 July 2003. 2. The inquiry is being carried out by a group of five Commission members led by Sir Derek Morris, the Commission Chairman. The other four members are Christopher Clarke, Dr Diane Coyle, Peter Hazell and Dr Elizabeth Monck. 3. Further information can be found on the Commission website: www.competition-commission.org.uk/inquiries/warranty.htm ISSUES LETTER PART 1 - INTRODUCTION 1.1 The Director General of Fair Trading referred the supply of extended warranties (EWs) for domestic electrical goods (DEGs) within the UK (the reference services) to the Commission on 2 July 2002 for investigation and report. This letter is to notify you of the issues that the Commission has identified at this stage in its inquiry. 1.2 The Commission invites your views on the issues set out in this letter. You need not repeat points made in earlier submissions, although you may refer to them if you wish. 1.3 This letter is set out as follows: Part 1 explains the overall position; Part 2 presents the market and economic issues that form the context of the inquiry; Part 3 indicates the issues that the Commission is considering in order to establish whether there is a monopoly situation, and how the conduct of those involved might relate to that situation; and indicates the public interest issues that are under consideration; Annex 1 Table 1 lists the companies which we understand are involved in the supply of the reference services; Table 2 lists the companies currently identified as providing EWs at the point of sale of the relevant DEG (point of sale), and having more than 1% of the supply of the reference services. These, together with others who provide EWs at the point of sale and are listed in Table 1, may be involved in a monopoly situation; Annex 2 gives background information on the market and economic issues; Annex 3 gives further detail of the evidence relating to the possible uncompetitive practices under consideration, on the basis of information available at this stage; Annex 4 gives the text of section 7 of the Fair Trading Act 1973 (FTA), which sets out the circumstances in which a monopoly situation is taken to exist in relation to the supply of services; and the terms of reference for the inquiry; Annex 5 gives information on some relevant tax issues. 1.4 Under the terms of reference for the inquiry, the Commission has to determine whether there is a monopoly situation, and if so, in favour of what person or persons that monopoly situation exists, and: (a) whether any steps (by way of uncompetitive practices or otherwise) are being taken by members of this group (those involved in the monopoly situation) for the purpose of exploiting or maintaining the monopoly situation and if so, by what uncompetitive practices, or in what other way; (b) whether any action or omission on the part of members of this group is attributable to the existence of the monopoly situation and, if so, what action or omission and in what way it is so attributable; and (c) whether any facts found by the Commission in pursuance of this investigation operate or may be expected to operate against the public interest. 1.5 If the Commission does find facts which operate, or may be expected to operate against the public interest, it has to consider what action should be taken for the purpose of remedying or preventing those adverse effects. 1.6 The Commission currently considers that a scale monopoly situation may exist in relation to the supply of EWs for DEGs within the UK, in favour of Dixons Group plc (the Dixons Group). This is based on initial evidence that the Dixons Group may supply at least one quarter of the reference services. This does not imply any adverse findings relating to the conduct of the Dixons Group. 1.7 The Commission also currently considers that a complex monopoly situation may exist in relation to the supply of EWs for DEGs within the UK. Companies currently identified as suppliers are listed in Table 1 of Annex 1. Of these companies, the Commission currently believes that those that are involved in supplying EWs at point of sale may be members of a group that supplies at least one quarter of the reference services. Of this group, those currently estimated to have more than 1% of the total supply of the reference services are listed individually in Table 2 of Annex 1. This does not imply any adverse findings relating to the conduct of any of those companies. 1.8 The Commission currently considers that members of this group may conduct their respective affairs in a way which prevents, restricts or distorts competition in connection with the supply of the reference services, and that the resulting complex monopoly situation may exist in favour of the members of this group. The conduct that the Commission considers may have this effect is set out in Part 3 of this letter. (It may be that the Commission will identify further possible complex monopoly situations during the course of the inquiry; in which case they will be notified to you if you may be affected, and you will be given a further opportunity to comment.) 1.9 The issues that the Commission has identified to date as being relevant to these matters are listed in Parts 2 and 3 of this letter, with explanatory material set out in Annexes 2 and 3. If other issues arise during the course of the inquiry you will be given an opportunity to comment on them. 1.10 The Commission has not yet reached any conclusions on any of the issues arising in the inquiry, on whether any monopoly situation exists, on whether the parties concerned are taking any such steps, actions or omissions as are identified in this letter to exploit or maintain a monopoly, or on whether there are any facts that operate or may be expected to operate against the public interest. Should any conclusions be reached on the basis of which the Commission considers that there might be a case for remedial action, you will be given a further opportunity to comment on the practicability and effects of any such action that the Commission might recommend. 1.11 I would be grateful if you would check that material relating to your company contained in this letter is factually correct and if you would inform the Commission of any developments that might affect the accuracy of the information during the rest of the inquiry period. 1.12 All those companies listed in Annex 1 will be receiving the same information as that contained in and attached to this letter, except that which is commercially confidential to other companies. For this reason you will see that some figures relating to individual companies have been excised. 1.13 In order to inform other parties that may be interested in putting forward their views, the Commission has decided to publish this letter (with commercially confidential material excised). It is proposed that it will be published on the Commission's website (www.competition-commission.org.uk) at 7 am on 28 February. It will remain confidential until published and should not be disclosed in whole or in part or referred to publicly before that time. 1.14 NOP has also conducted a consumer survey on extended warranties for the Commission. The results of this have been made publicly available on the Commission's website. 1.15 The Commission has also asked PA Consulting to undertake an international comparisons study, comparing extended warranty provision in a number of countries. The results of this will also be made publicly available in due course. PART 2 - MARKET AND ECONOMIC ISSUES The reference services 2.1 The reference services consist of extended warranties (EWs) for domestic electrical goods (DEGs). An EW is defined in the Commission's terms of reference as- "a contract, whether backed by insurance or otherwise, which for a specified period provides consumers with cover beyond that provided by a manufacturer's, retailer's, or importer's1 guarantee, to meet the cost of repairs or replacements that may become necessary. It includes both contracts that provide cover during the period of the manufacturer's, retailer's, or importer's guarantee, and contracts where cover commences after this period. A contract may provide cover beyond that provided by a manufacturer's, retailer's or importer's guarantee where for example, the cover is for a longer period or the cover extends to costs and risks other than those covered in the manufacturer's, retailer's or importer's guarantee." The market context 2.2 As background to the Commission's current assessment of the possible monopoly situation, some explanation of the market context for the reference services, and the relevant economic issues may be helpful. The inclusion of any particular issue means that it has been raised for consideration, but it does not imply that any associated problem has necessarily been identified with it or that there is currently evidence to suggest this. Material and evidence, so far available, which is relevant to the market context and economic issues, is summarised in Annex 2 (material mainly covering market issues) and Annex 3 (material mainly covering issues of conduct). Statutory consumer protection 2.3 Consumers have statutory protection that requires retailers to compensate them if goods were faulty at the time of sale2. The provisions of this requirement extend for up to six years after the date of purchase. However, the consumer is required to show that the fault existed at the time of sale. It may therefore be difficult for the consumer to make a claim successfully after an extended period. Many faults develop from wear and tear, accidental damage or the natural limited lifespan of some components, even where there was no fault existing at time of purchase. Legislation does not protect the consumer from such problems, although a lack of reasonable durability may mean the product might not be regarded as fit for its purpose at time of purchase. Retailer/Manufacturer guarantees 2.4 Consumers may also have the benefit of initial guarantees from retailers and/or manufacturers. These offer repair or replacement of faulty DEGs, for a mechanical or electrical failure or similar, irrespective of whether it can be established that the fault existed at time of purchase, for a defined period, usually the first year. The scope of the guarantee will be set by the manufacturer's or retailer's terms and conditions: typically this will exclude misuse and abuse, or wear and tear on items designed to be replaced. Some manufacturers provide longer guarantee periods, or may provide free parts for repairs. Types of EW and sources of supply 2.5 EWs on DEGs extend the initial manufacturer's or retailer's guarantee in time (usually for a further two or four years in addition to the typical original one year guarantee), and may also extend the scope of risks covered, for example, to include additional cover such as against accidental damage, and to provide insurance against theft or frozen food loss. In some cases technical or other support services, such as a PC helpline, may also be included. The EWs that are offered on the range of DEGs within the terms of reference of this inquiry are broadly similar, although EWs on some DEG products may have distinct characteristics, such as PCs (where assistance may be provided to the consumer via service helplines) and mobile phones (which typically include insurance cover for theft, loss and accidental damage). 2.6 We currently consider that service contracts on fixed installations such as central heating and alarm systems, the primary purpose of which is to provide regular service and maintenance, are not part of the supply of EWs because they are materially different from EWs that primarily offer cover against mechanical and electrical failure. Similarly, we consider that home insurance or other policies that solely or primarily provide insurance cover against risks such as accident, theft or loss, are not part of the supply of EWs, because they do not provide cover against mechanical and electrical failure, and are not extending the original manufacturer's, retailer's or importer's guarantee. Non-EW insurance is not necessarily irrelevant to the market analysis. Cover for theft or loss is being included where such additional cover is provided as an integral part of an extension of an original guarantee. 2.7 An EW covers consumers against the risk of unpredictable expenditure to repair or replace a DEG were a fault to occur, whether or not this would be covered by statutory rights, and sometimes against other risks. The EW usually provides quick and easy access to guaranteed repairs. It also obviates the need for consumers to establish whether their statutory rights apply to their particular case. 2.8 Risks such as theft and accidental damage may already be covered under a consumer's household insurance policy, though making a claim may have the consequence of bearing an excess and/or being charged a higher insurance premium on renewal. Some statutory and contractual protection may also be available if consumers buy the DEG using some types of credit card. 2.9 EWs are supplied by most DEG retailers (including mail order and internet sellers), manufacturers, some insurance companies, and to a lesser extent, some banks, credit card providers and utility companies. Some EWs are contracts underwritten by insurance companies, and some EWs are uninsured contracts, often referred to as service contracts3. Both broadly provide similar cover with similar terms and conditions, and are sold in the same way. Some EWs involve a mix of insured and service elements. Insurance contracts are generally made between the consumer and an insurance company, although a retailer, manufacturer or other party may act as the agent. Service contracts may be made between the consumer and a retailer or manufacturer, or another company appointed by the retailer or manufacturer to administer the EWs, and may be backed by a trust fund (a ring-fenced fund which is intended to provide security to consumers that the EW will still be honoured even if the retailer were to cease trading). In both cases the party that provides the EW will often insure, or reinsure, itself against the cost of claims. Some of the larger providers use captive insurance or re-insurance companies that are part of the same group. It may be a condition of business with third-party insurers that they re-insure risks with a captive insurer. 2.10 Business models for the provision of EWs vary; for example, a retailer may act as an agent for an insurer, or it may appoint another company to sell service contracts, or it may sell service contracts itself and cover its own risks with an insurer. The contract with the customer may be with an insurance company or another party rather than with the retailer. Often, several companies are jointly involved in the provision of the EW. Nevertheless they are all parties that may be involved in the sale of the EWs concerned. Therefore we have linked the various parties that are involved in the provision of each EW (where, for example, an insurance company sells EWs through a high street retailer, both are included as parties), and refer to these collectively as the EW provider. We do not include in this other companies who may provide ancillary services which allow for the providers to discharge their obligations under the EW, such as repairers or claims administrators. 2.11 In recent years, many of the larger EW providers have structured their operations to take advantage of tax or other benefits available from the use of off-shore companies. In November 2002 the Chancellor announced changes in legislation which will affect these arrangements. These are discussed further in Annex 5. The relevance of these arrangements to the inquiry is discussed in paragraph 2.50. 2.12 Most EWs are sold by retailers of DEGs at the point at which the DEG covered by the EW is also sold, in the same or an immediately connected transaction ('at point of sale'), see Annex 2. This may be in a store, or as part of a phone, mail order or internet sale. EWs are also sold by DEG manufacturers or associated insurance companies following the return of the initial guarantee card to the manufacturer, or through direct sales by insurance companies. However, these sales need not be made when the DEG is new, and some insurers (and occasionally other providers) offer multi-appliance policies which cover a variety of existing DEGs, usually subject to some age limit on the DEG, typically 5 or 8 years. There may be a small number of sales of EWs by retailers after point of sale, some of which could be on products bought elsewhere. One- year EWs are sometimes offered as a free benefit by a few credit card issuers. Finally, a small number of other entities (such as utility companies) offer EWs. Consumer behaviour 2.13 According to the NOP survey one in three of those who had bought an electrical product for over £50 from a shop in the past twelve months had purchased at least one of the items with EW cover, but overall, based on OFT estimates, it appears that around 80% of DEG purchases are not covered by an EW sale. Several large retailers provided evidence of the proportion of DEG sales that were also covered by an EW sale at the same time; these typically varied from just over 5% to just over 15% (but these figures may depend on the extent to which sales of smaller items such as DEG accessories are included in DEG sales). However, in some categories of DEG, the rate of sale of EWs is higher, particularly for higher-priced DEGs, or ones incorporating new or complex technologies (see Annex 2). In the NOP survey, 46% of respondents who did not take EW cover said it was because the EW was too expensive, and 13% because they thought the cost of repair was likely to be less than the cost of the EW, 13% spoke of improved product reliability, and 12% were 'happy to take a chance'. The rate of renewal of EWs on expiry seems to be low, with figures under 20% being common. 2.14 The NOP survey of consumers found that 76% of those who had recently purchased a retailer EW were happy with the cover they had obtained. We asked those who had purchased EWs the reasons why: based on Commission analysis of the NOP results, we found among other reasons, 27% said because the cost of repair was likely to be high, 20% because of convenience, or the time and trouble involved in arranging repairs, and 18% for peace of mind. Overall, 42% said that having an EW made arranging repairs easier, compared to just 3% who said it made repairs more difficult. For respondents with EW cover, the expected repair cost for a product failure was nearly #85, compared with just over £71 for those without EW cover. However, this may have arisen because the value and type of DEG purchased differed between these two groups. 18% of the consumers surveyed regretted having bought a retailer EW; under a tenth of these had considered cancelling the cover. 2.15 The available evidence suggests that there may be some features of consumer behaviour that could allow retailers to benefit from their point of sale position (see paragraphs 2.28 to 2.32). Whereas consumers will often shop around for DEGs and compare prices, they seem to be much less willing to do this for EWs, and appear to give less thought to planning this purchase. Moreover, we have found that many consumers seem to have little or no awareness of where EWs could be purchased other than at DEG retailers. In any case, even if a consumer were aware of an alternative source of supply, it may not be regarded as an effective substitute, for example if they regarded it as inferior or were unwilling to investigate it. Consequently the availability of an alternative source of supply does not necessarily mean that it is an effective competitive constraint. We have also found that many consumers do not make up their mind to buy an EW until they are in the store to buy the DEG. Some of these will have given the matter no thought until the issue is raised by sales staff. In such circumstances, the purchase of an EW can be essentially an afterthought. Market definition 2.16 In conducting our inquiry, we need to determine the economic markets in which EW providers compete. Specifically we need to establish the range of services where effective competition could occur, for example all EWs, or a sub- set of these. We also need to establish the geographic extent of the region in which competition occurs. The limits of the market are defined by the ease with which, in response to a change in relative prices: * consumers could substitute other products or services for these EWs (demand substitution); and * suppliers could easily transfer production between different products or services (supply substitution). EW providers have generally put it to us that all types of EW are in one, single EW market. 2.17 There are several types of EW product available: multi-appliance policies as well as single appliance policies, and policies - usually applicable to relatively low-value items - that provide for the replacement of faulty items rather than their repair. The Commission is considering whether all these types of policy are in the same economic market. Evidence to date suggests that it is fairly easy for suppliers to move between offering different products of this type, ie there is substantial supply-side substitutability. EW policies may be service schemes or insurance-backed policies. Survey evidence suggests that consumers are largely unaware of the difference between such schemes, which usually offer similar terms and benefits to the consumer. This suggests substantial demand-side substitutability. 2.18 Renewal policies, offered where existing policies have expired, and hence applicable to older equipment, involve providers assessing the same kind of risks and maintaining the same kind of service infrastructure as for regular policies. However, it might be difficult for potential providers to identify consumers to whom such renewal policies might be sold. We note in this regard that retailers and manufacturers may sometimes sell their EW customer lists to insurers to enable them to offer renewal policies in their name. The Commission is considering whether these facts may indicate that such policies could be in a separate market. 2.19 On the usual single-appliance policies, consumers cannot substitute between EWs on different types of DEG, eg an EW on a washing machine is no substitute for one on a television. However, most suppliers provide EWs on a wide range of DEGs, suggesting easy substitutability on the supply-side. There are also multi- appliance policies available where consumers can easily cover new DEGs of differing types. EWs on some products have different characteristics. For example because diagnosing the differences between hardware, software and compatibility problems may be difficult for many PC users, EW schemes for PCs are often primarily based around helpline services. EWs covering mobile telephones may primarily offer cover against theft, unauthorised calls and accidental damage, with repair of mechanical or electrical faults making up only a small part of the service offer. The Commission is considering whether the supply of any such product, and the skills or resources required, are sufficiently different in type from other products that there is less easy substitutability in supply, in which case they may be in a different market. 2.20 It could be that the additional cover (such as cover against accidental damage, or insurance for theft and for frozen-food loss) bundled with some EW policies could differentiate these sufficiently to make these a different market. However, retailers have not suggested this, and the NOP survey evidence indicates that consumers tend not to place a great deal of weight on these features (see paragraph 2.55). It appears that home insurance or similar products, which offer cover similar to the additional cover attached to EWs, are unlikely to be part of the relevant market, because they do not replicate the primary purpose of the EW (to provide cover against breakdown), and because the terms and conditions of home insurance differs (eg making a claim under home insurance may also be subject to an excess and a loss of no claims discount). 2.21 EWs offered on some credit card accounts require the consumer to register the product, may not be available on all DEGs, and usually only run for one year. Some retailers or manufacturers may also offer free EWs, in that there is no explicit charge to the consumer. Free EWs may be used as a temporary promotional tool, or may be a permanent feature of a retailer's strategy. The Commission is considering whether credit card EWs and retailer free EWs are part of the same economic market as other EWs. In general, if some kind of alternative extended cover were available to consumers automatically then we are likely to regard this as a constraint on an EW market rather than as being a service supplied within the market and a substitute for other EWs. 2.22 Whether EWs from retailers, manufacturers, insurers and other providers are all in the same economic market is addressed in the section on point of sale advantage, in paragraphs 2.28 to 2.32. 2.23 In determining the extent of the relevant geographic markets, it appears that all parties who offer EWs in the UK provide cover to consumers regardless of where they live. While it may be necessary for the provider to make arrangements with several repair organisations in order to cover all areas, we have not seen any evidence that EW providers place geographic restrictions on their services. The distribution of retailer EWs may be constrained by the location of the retail outlets, but several retail chains have broad geographic coverage; internet and mail-order retailers sell country-wide, and insurers, credit card providers and others also have a national presence. EW providers generally do not market abroad or offer cover for goods used abroad (except temporarily), and generally do not provide cover for DEGs obtained abroad. This suggests that the relevant market should cover the whole of the UK. 2.24 Some retailers have argued that they offer a range of DEGs and associated services, including EWs, and compete on the basis of the full range. Their DEG retailing business strategy is one of providing suitable premises and infrastructure, generating consumer visits to the retail stores,, the sale of the DEG, and presenting and selling the after-sales support options and services (including EWs) as an integrated operation. Thus they have suggested to us that retailers compete across the whole range of their activities, and so identifying a stand-alone EW market is inappropriate to an assessment of the level of competition. In particular, they have argued that there is intense price competition on DEGs, leading to low profit margins on the sale of DEGs, and higher margins on sales of EWs are then necessary in order to support the business overall. 2.25 While this may be some firms' strategy, this does not necessarily mean that the relevant economic market for a particular product or service is the same as the market in which companies consider themselves to be competing. There are providers of DEGs who do not supply EWs, and vice versa. Some types of EW, such as multi-appliance EWs, are not targeted at simultaneous purchases of new products. Few retailers appear to offer an all-inclusive DEG and EW package; rather these products are priced and sold separately. The exception is where a 'free' EW is included, and such retailers usually still provide a price match promise on the DEG alone. As well as insurers, some retailers have begun to attempt to sell EWs on DEG products purchased from other retailers, or which are up to a year old. 2.26 We also have evidence that consumers rarely perceive EWs and DEGs as a package; most perceive them as separate. It appears that consumers' preliminary information gathering prior to purchasing a DEG does not often include EWs, and very few consider and compare EW offers before the decision to purchase a DEG. As already noted, in only around a fifth of cases are EWs purchased with a DEG. 2.27 Some parties have argued that there is considerable convergence and intermingling of technologies between different categories of DEG, for example between audio/visual equipment, TVs, camcorders, DVD players, PCs etc. They told us this was a growing factor in terms of the support services they provide to DEG customers. We will consider whether any such developments impact on the appropriate market definitions. Point of sale advantage 2.28 As noted under 'consumer behaviour' (see paragraph 2.15), many consumers may only consider the purchase of an EW at the time when they are purchasing the DEG to which it would relate. The retailer of the DEG is therefore able to target potentially interested consumers, who may have little or no opportunity or inclination to compare the EW sold at the point of sale of the DEG with that of any alternative providers. This could apply to mail-order, telephone and internet sales as well as to retail outlets. This situation gives rise to a point of sale advantage. 2.29 It is possible that a point of sale advantage in relation to EWs creates an environment where competitive pressures for the sale of the EW are limited, thereby allowing higher prices to be charged than would otherwise apply. The point of sale advantage may be sufficient to prevent the alternatives of purchasing EW cover from other providers being an effective constraint on the pricing power of providers at the point of sale. That is, such alternative providers could be outside the economic market for point of sale EWs; alternatively, some providers may be able to use point of sale advantage to set higher prices than others within a more widely defined market. We will assess the evidence for and against such propositions, where possible using the standard SSNIP test methodology. 2.30 To express the point of sale issue in another way, whereas retailers typically sell a variety of DEG manufacturers' products, even where they stock own-label brands, many retailers have vertically integrated into the supply of EWs and choose to distribute only their own EWs, or alternatively have contracted for the supply of EWs to just one provider. Such retailers only supply one brand of EW, and information on alternative EWs is unavailable to consumers at the point of sale, and other EW providers do not have access to the point of sale of the DEG. We are therefore considering whether there is effectively a degree of foreclosure in the supply of EWs, in that most customers are offered only one provider of EW at the point of sale of the DEG. 2.31 We are investigating whether there is evidence of active competition between providers of EWs at the point of sale of the DEGs, and between all providers of EWs. In contrast to the widespread promotion of DEG sales by retailers, there is little advertising of EWs other than in store. Retailers appear to have made very few EW sales on DEG products purchased from rivals, and some major retailers do not offer EWs except on products purchased in their own stores, which may imply retailers do not seek any market other than their own point of sale market. 2.32 From the consumer's perspective, the purchase of an EW at point of sale is convenient and means they do not have to worry about any terms in the small print that could exclude their particular purchase. However, we are considering a number of related points: (i) we are looking at whether consumers may be encouraged to buy an EW at point of sale through sales techniques which might be perceived as exerting 'high- pressure' on the consumer. (ii) there is also evidence that the average discount on DEG prices tends to be higher where the consumer is also purchasing an EW. We are considering whether this may also be a factor that exerts pressure on the consumer to purchase EWs. (iii) there may also be issues arising from the facts that consumers generally pay in advance for an EW4, see paragraphs 2.36 and 2.57, and Part 3. Information and sales practices 2.33 Consumers may face difficulties if they try to compare prices and coverage of EWs, particularly at the point of sale. Different providers offer different terms andconditions, such as cover against additional risks (primarily theft and accidental damage); prices may be set in relation to product descriptions or DEG price bands which are not comparable between providers; and other factors such as cash-back provisions5 or depreciation policies6 may differ. Price comparisons may also be complicated as some consumers report that it is possible to negotiate discounts, but these may be part of a combined purchase of DEG and EW; and which, although relating to the EW, may be applied to the DEG. Such behaviour does not appear to be retailer policy in many cases, but may be retailer practice. 2.34 Consumers may be unable to make an informed assessment of whether an EW provides good value for money in their case. There tends to be no information available to consumers from either manufacturers or retailers on the absolute or relative reliability of brands or of particular models, or repair cost for different types of fault. This may reflect the difficulties of compiling or presenting such information; there can be considerable variability in reliability over time and there may be no history of reliability for a particular model, as model ranges are usually updated frequently. Some information is available from the Consumers Association, which conducts a survey of members' experiences of product reliability and, sometimes, repair costs. Such surveys may be useful background information for consumers, in allowing them to assess the suitability of an EW. However, they do not necessarily provide the information necessary to make an assessment of the value for money of EWs. For example the surveys make no allowance for the costs of replacing a DEG which has failed and is beyond economic repair. The cost of such replacements may account for around 20% of the cost of claims under an EW scheme. Some companies have provided evidence which suggests the incidence and cost of repairs have been substantially understated in such surveys. 2.35 The consumer is therefore likely to be reliant on whatever information on prices, cover and related terms and conditions is available in the form of written material, and advice from the sales staff on EWs and DEG reliability. There would be concerns if this were misleading or incomplete. Since 1996, there has been a British Retail Consortium Code of Practice which requires that clear information should be made available on the prices, scope of coverage, and terms and conditions of EWs, and that staff should follow clear guidelines on sales practices. However, the OFT found that the code was not always followed. Major retailers have told us that all their staff are trained to observe the BRC Code of Practice, and that mystery shopper visits are used to check that it is being observed. However, some noted that across the industry as a whole there is scope for improvements in adherence to the code. Sales staff are usually offered incentives to sell EWs. Although in general these are not paid at a higher rate than on other products, in some cases these may include additional incentives to reach threshold targets. The sales staff training programmes we have seen show there may be scope for an undue bias in sales techniques. 2.36 EWs are usually paid for in advance in full, even when some or all of the cover provided by the EW does not start until after the expiry of the manufacturer's guarantee. Purchases using store credit are still likely to require full payment within a year and will attract interest. Some insurers provide for annual payments, this is common for renewals and multi-appliance policies. 2.37 The consumer could look around for a better deal after purchase, and most providers offer a cooling-off period. However, this is usually only 2 to 4 weeks for retailer EWs. In practice few consumers seem to search for alternatives in the given time, even if they are aware that such alternatives exist; no information on alternative providers is normally available at the point of sale (see annex 2). Consumers will usually be sent an offer of an EW from the manufacturer or an approved insurer if they return the product registration card. The rate of return of such cards is low, and any subsequent approach by the manufacturer may not arrive until after the expiry of the cooling-off period. No other EW provider will have the opportunity specifically to target the consumer at this stage, apart from perhaps a credit card company, as they will have no knowledge of the consumer's DEG purchases. In general, access by other suppliers to this market will be difficult as they can only raise consumer awareness of their policies through general, untargeted advertising. 2.38 After the expiry of the cooling-off period it may be difficult or impossible to get a refund of all or part of the cost during the life of the EW (although one provider told us it was willing to make refunds during the first year of a policy provided no claim had been made). Consequently there may be little opportunity for consumers to change their mind, given the limited availability of information on alternative providers, and any psychological barriers to moving once a financial commitment has been made to one provider (such as a need to contact the provider and a reluctance to ask for a refund). Price setting 2.39 The process by which providers set EW prices is often quite complex, and may differ between different types of provider. 2.40 Evidence received from large retailers suggests that most monitor their competitor's pricing, monitor unit penetration rates for EW sales by particular categories of DEG, and pay attention to forecasted claims costs on a category by category basis, although they do not usually break down claims by manufacturer or model. Retailers do not offer price-matching guarantees on EWs whereas they may do so on DEGs. We were told by some providers that they consider that their EW pricing needs to be comparable to that of their competitors but, in contrast to their policy on the related DEG market, they do not see it as a priority to avoid being undercut. Even where different EWs are broadly similar, the existence of different features makes comparing prices difficult. Generally we were told providers try to avoid pricing EWs below cost on any individual DEG product category, although initial evidence suggests there are occasional examples of this. 2.41 Some retailers said that the ratio of EW to DEG prices could have a significant impact on sales-rates, and so they have target price ratios for EWs, relative to DEGs, depending on the length of the period of cover. 2.42 Smaller retailers may market an insurer's EWs. In some cases the insurer will set and publish list prices for EWs, although the retailer may have freedom to deviate from these list prices. The retailer also has the option of approaching other insurers who may offer different suggested EW retail prices and different retail margins. 2.43 Insurers have indicated to us that although competitors' pricing is monitored, in contrast to retailers they said this is of secondary importance, pricing being primarily determined by an assessment of overall risks and costs on a category-by-category basis, and the addition of a target margin. The extent to which insurers break down risks within a DEG category varies; some will consider risks by price-band, or by the type of technology in the DEG, but none appears to consider individual manufacturers or models in assessing risks for their own or retailer EWs, preferring instead to pool these risks. 2.44 Manufacturers may offer service-scheme EWs, but most offer insurance backed EWs. The insurer will then establish an appropriate risk-premium based on the risks for that particular manufacturer, and the anticipated reliability of particular models. The final consumer price will usually be set by the manufacturer noting risk premiums and competitor pricing. 2.45 EW prices need to cover the expected cost of claims, which will in part reflect the number of claims made by consumers. There are three reasons why consumers who purchase EWs may be more likely than average to suffer their DEG breaking down. The first is where particular consumers know in advance that they are at high risk of product failure as they are likely to use a DEG intensively, under adverse circumstances or without appropriate care. Second, there are consumers who do not expect in advance that they will be more likely to make a claim, but subsequently in using the DEG discover with experience of that particular DEG that this may be so; for example they may find a DEG is more useful than expected and use it more intensively, or they may suspect that there is some latent fault in the product which could make a subsequent failure likely. These are both forms of so-called 'adverse selection'. Third, there is so-called 'moral hazard', where consumers might take less care than usual in operating their DEG as they anticipate that they can claim for any damage sustained under their EW; indeed there is a risk that some policy-holders might induce a failure on older equipment in order to get a replacement, although policies will exclude wilful damage. 2.46 To the extent that these factors operate, historical claims data will reflect them. The second of these effects will be reduced, however, because purchase of the EW at the point of sale precludes consumers deciding later to purchase an EW in the light of experience with the product. Consequently the overall risk of claims, and so prices, would be lower. Where EWs are offered on 12-month old DEGs, prices are typically higher than for new DEGs, which may support this analysis. 2.47 It is possible that, rather than being constrained by those of competitors, consumer prices are limited by the amount that consumers are willing to pay. Consumers always have the option not to purchase an EW and to accept the risk of having to pay for future repairs or a replacement. Therefore pricing may tend to reflect 'preparedness to pay' rather than underlying risks and costs. 2.48 In a competitive market, we would expect price dispersion for broadly similar EW products from different providers to be limited. The Commission is examining whether there is considerable variation in the prices charged for EWs by different providers, although we note that there are variations in the terms and conditions of different EWs. 2.49 In a competitive market, it would be expected that EW providers would set prices with regard to a range of factors, including competitors' prices, rather than just pricing according to costs and margins. There will also be a strong pressure, in such a market , for prices to be driven down towards a level where an efficient operator is achieving so-called 'normal' profits, ie sufficient to cover all costs, sustain the business and provide investors and other providers of finance with a return sufficient to maintain funding. Where such pressures are intense, some providers may fall back on cost plus a 'normal' margin as being an easy way of identifying and maintaining competitive prices. Irrespective of the specific pricing techniques used, profitability can be a useful indicator of whether pricing is subject to effective competitive constraints. The Commission is therefore assessing the profitability of EW providers. We are considering the appropriate level of disaggregation to do this, whether to assess profitability of EWs on particular DEG product groups, by type of EW, or for a provider's overall EW business, or for all of the provider's activities. 2.50 It should be noted that the total profitability of an EW business could include some or all of: agents' commission; profits from the provision of repair and replacement services; profits from administration services; from underwriting; and from reinsurance services to the insurer (if an insured scheme). Profits need to be assessed with regard to all areas where they could arise; some EW providers realise some of their profits off-shore. In broad terms this should make little difference to the Commission's analysis of competition, provided any resulting tax advantages are not immune from the competitive pressures emanating from the market. 2.51 It is possible that market prices are largely determined by the major retailers, with other retailers, and other EW providers, largely setting prices with reference to those set by the major retailers. Some leading provider(s) could then be seen as broadly signalling market prices. This may lead to 'umbrella' pricing, where other market suppliers follow a broad pattern and level of prices set by one, or several, market leaders. Competition might then be limited to innovation on EW features. 2.52 Alternatively, there may be no clear market leaders in relation to pricing levels, but nonetheless there could be limited incentives for any individual supplier to undercut existing prices, even if they were high in relation to costs. This would arise if it were anticipated that a price cut would either have only a limited effect on sales of EWs; or, if it were anticipated that there would be a matching and offsetting price cut from competitors if it did start to cause significant numbers of customers to switch suppliers. The Commission is examining prices and sales data to see what light they throw on price competition. 2.53 Evidence received from retailers indicates that there are a wide variety of gross margins on EWs for different DEG product categories. This could arise for a number of reasons: it may be that costs are varying and unpredictable between product categories and so gross margins vary; in some cases, for example PCs, this may in part reflect higher indirect costs; and EW providers may be price averaging, where the pricing policy may be to set EW prices as a percentage of the DEG product price and accept differences in gross margin, provided the overall average margin is acceptable. However, the last of these possibilities still raises the question as to why margins on some DEG products are not pushed down by competitive pressure. We are examining whether different providers show a similar distribution of gross margins across their products; this might indicate that prices are accepted and copied industry wide, that is, suppliers follow industry price levels rather than competing on a category-by-category basis. Product bundling 2.54 As noted above, many EW contracts include benefits over and above repair of mechanical and electrical faults. These include replacement of 'beyond economic repair' items on a new-for-old basis, accidental damage protection, and insurance against frozen food loss and against theft. Terms and conditions vary between providers. 2.55 The Commission is considering whether consumers value this choice or whether it complicates their ability to make comparisons and provides unwanted features. In our consumer survey, of those who had purchased retailer EWs, only 3% stated that aspects such as theft and accidental damage protection were important to them. It is rare for an EW provider to offer the consumer a choice for the package of benefits that they buy; rather it tends to be an all- inclusive package. There are a few variants on this - for example it is possible to purchase theft and accidental damage cover for mobile phones without conventional EW cover against breakdown. 2.56 In the recent past, some retailers have introduced a variety of packages: Dixons has been test-marketing multicare (a multi-appliance policy) and PC Care (a multi-appliance policy for PC users). It also has a repair and protect policy for consumers who contact Dixons for a repair, which provides EW cover on a product up to 8 years old after the repair has been completed. PC World offers PC Healthcheck plus, which provides future breakdown protection where a PC has received one of their 'healthchecks', which may be favoured by consumers with older or heavily used PCs, or ones with a wide variety of software or upgrades. All these packages are available on products purchased from other retailers. The Commission will consider to what extent these types of product have had an impact in the EW market(s). 2.57 In many cases, additional cover for events such as accidental damage extends from the date of purchase of the EW, not from the expiry of the manufacturer guarantee as is the case for repair and replacement cover. However, it is not possible to purchase such additional cover without the simultaneous contracting in advance for the purchase of repair and replacement cover, which might, after the cooling-off period, lock consumers into a contract of up to 5 years, either because any refunds available may be less than pro-rata (this may be due, at least in part, to up-front administration costs) or because of any perceived or actual difficulties that consumers may face in obtaining a refund. Barriers to entry and exit 2.58 There have been a number of new entrants to the provision of EWs in recent years, such as utility providers, and insurers supplying consumers directly. Some have offered differentiated policies (such as multi-appliance policies). These entrants have been able to contract with pre-existing repair networks (or create networks from other repairers) to undertake their servicing. However, it has been suggested to us that there may be limited availability of trained repair engineers who could be recruited if new entrants wished to establish their own repair network. It has also been suggested that the number of independent repair organisations has fallen rapidly in recent years, although whether this reflects an overall reduction in supply, or consolidation of suppliers in the industry, is not yet clear. 2.59 Assessing risk and setting premiums and prices would be difficult without prior experience, but there are insurers able to undertake this task either for themselves or for others as new entrants to the market. A new entrant could match competitor pricing (on the assumption that costs will be similar) and adjust premiums as a claims history is built up. Where an agreement is made with a repair network, there appear to be no large-scale sunk costs to serve as a barrier to exit, but where an entrant has developed its own repair network, there would be a substantial sunk investment. The same may apply if a provider has established support services such as helplines for PC users. Providers have a liability to customers over the life of the contract, although there have been cases where other providers have taken over obligations where an EW provider has failed. 2.60 Overall, however, the market penetration of new entrants remains low; none appears to have managed to make significant inroads against EWs supplied by, or on behalf of retailers. This suggests that there may be a significant barrier to entry or expansion into existing retailer's point-of-sale activity. This could be thought of as a barrier to entry if point of sale EWs are viewed as a separate market; or as a so-called 'barrier to mobility' into point of sale selling of EWs in the context of a wider EW market . Strength in DEG retailing might create a point of sale related customer base that others cannot easily access. As DEG purchasers will often have already been offered and may have bought an EW at point of sale, the number of prospective EW customers remaining for alternative providers after the DEG purchase will tend to be small. One possible exception is where existing retailers, such as supermarkets, diversify into the supply of DEGs and EWs. Such entrants can develop their own point of sale advantage. Other entrants, such as insurers and utility companies, have their own customer lists. These, however, give the provider no information about whether the consumer is purchasing a DEG or otherwise would have a particular interest in an EW at any given time. Differing profit contributions and effects on the market for DEGs 2.61 As noted earlier, we have found that consumers are not active in shopping around and comparing prices for EWs, whereas retailers have indicated that many consumers are active in shopping around for DEGs. There may therefore be a lower degree of price sensitivity for EWs than for DEGs. It is possible that many retailers experience ongoing pressures to set DEG retail prices at or below competitor levels so as to attract consumers. However, if consumers are not so price sensitive when buying EWs (and possibly other accessories and add-ons) then retailers could generate a significantly bigger profit contribution from EWs relative to their scale of activity than from DEGs. We are therefore investigating the profit contribution of EWs in relation to that of DEGs. In addition, we are considering whether the rate of return on EWs is higher than the rate of return on DEGs, as well as any indicative evidence based on margins. 2.62 If evidence indicated that the profit contribution on DEGs were low in relation to the cost of capital, but with the gap covered by a significantly larger profit contribution from EWs, then it would follow that EW sales are partly funding DEG sales. Such cross-funding may enable DEG retailing to operate on lower margins than would otherwise be sustainable in the long-term. Although the retailer business model may in some cases be based on selling both products in the same stores, only a minority of consumers of DEGs purchase EWs and there is no obligation to purchase them together. EW customers would thus to some extent be financing distortions in the DEG market in a way which was unfair both for EW purchasers and for suppliers of DEGs who do not supply EWs. 2.63 More specifically, a comparatively large profit contribution from EWs could permit lower margins on DEGs, increasing DEG sales, and thereby offering scope to sell more EWs, and so on. Competitors with limited or no EW business would then find it increasingly difficult to compete on DEG sales. In the longer term this might lead to reduced choice of products and/or outlets, and less competition in the DEG retailing market. The market share of the largest DEG retailers has increased in recent years and there is already a significant degree of concentration in the structure of DEG retailing. Based on data in Mintel Retail Intelligence review of electrical retailers 2001, including mobile phone and PC retailers, the industry Herfindahl7 exceeded 1700 in that year. Retailer relations with manufacturers 2.64 Retailers control access to their final consumers, and may have market power over manufacturers, arising from their capacity to influence or control the extent to which each manufacturer's products are offered in store, their positioning in the store, and the promotional policies they run. Although many manufacturers offer EWs, there has been little evidence received to suggest that they actively advertise the existence of their EWs prior to sale. We also note that whereas it might be expected that DEG manufacturers would have an incentive to promote above average reliability through longer inclusive guarantee periods or cheap EWs, this is comparatively rare (although there are some instances such as Miele's 5-year guarantees and Dyson's 2-year guarantees, and a few white goods suppliers - including Ariston, Candy, Hoover and some Hotpoint products - which have a guarantee of 1 year parts and labour plus the following 4 years of parts only). In certain other industries, such as cars, manufacturers make a merit of the reliability of their products and provide warranties or guarantees for 3 or 5 years or more - these form an important part of the promotion of their products. 2.65 We have seen some evidence that for most DEG categories product reliability continues to improve. However, there is also some evidence that repair costs have increased due to the greater technical complexity of some products. We are investigating the overall impact of these factors on repair costs. 2.66 It is possible that, in the face of potential retailer power, some DEG suppliers are reluctant to market EWs, and hence become competitors to the DEG retailers; and, in the face of the retailer point of sale advantage, the returns from promoting EWs may in any case be limited. It may then be mutually beneficial for retailers and manufacturers largely to keep to their own sphere of operation, with EWs seen by both groups as largely for retailers. We are comparing experience in the UK with that in other countries where retail structures may differ. 2.67 There have been suggestions that retailers have in some instances sought to limit the ability of manufacturers to compete for EW business, by, for example, removing manufacturer EW details from packaging, or removing publicity about manufacturer EWs from display models. None of the major retailers has indicated that this is their current practice, although it has been acknowledged that there have been examples of such behaviour in the past. It has also been indicated that retailers may be unwilling to allow retail pricing to reflect longer inclusive manufacturer guarantee periods (by refusing to accept increases in manufacturer's prices necessary to meet the extra cost of the longer guarantees). Evidence on such behaviour is anecdotal at present; however it would be an issue if it becomes apparent that there have been more than a few isolated cases. PART 3 - POSSIBLE MONOPOLY SITUATIONS Introduction 3.1 Against the market and economic background presented in Part 2 above, Part 3 of this letter considers possible monopoly situations that may exist within the meaning of the Fair Trading Act 1973 (FTA - see Annex 4). Both the scale and complex monopoly provisions relate to the share of supply of reference services, and this is considered first. In determining shares of supply for jurisdictional purposes, we are concerned only with the amount of the reference services supplied, not with the definition of the market or markets in which they are supplied. Market definition can be important, however, in determining whether relevant conduct creates a monopoly, and this is considered in paragraphs 3.8-3.12 below. The reference services 3.2 Under section 10 of FTA, and to the extent that the supply of EWs occurs through different forms of supply, the Commission may disaggregate the reference services when it considers that such differences constitute a material difference for the purposes of the identification of a complex monopoly situation. In the light of the issues discussed in Part 2, we currently propose to treat the supply of reference services for the purpose of the identification of a complex monopoly situation as the supply of EWs by retailers, insurers, manufacturers, utilities and credit card companies, where the EW extends the original guarantee to repair or replace faulty brown and white DEGs, PCs and mobile phones, and renewals of those EWs. It also includes EWs supplied at no additional charge. It does not include agreements concerned primarily with planned maintenance on fixed installations such as central heating or alarm systems, nor home insurance. It does not include EWs supplied to businesses. 3.3 On this basis, according to information provided to us to date, the total supply of the reference services in 20018 was in the region of £800 million in terms of sales net of tax (VAT and Insurance Premium Tax (IPT)), and 15 million in terms of the number of EWs sold. We are still awaiting information, and a provisional estimate of the supply by companies from whom we do not yet have information has been included in these figures. Scale monopoly 3.4 Information supplied by Dixons Group plc (the Dixons Group) currently indicates that it sold [ ] million EWs to consumers in 2001, at a total sales value net of tax of £[ ] million. This indicates that the Dixons Group may provide more than one-quarter of the supply of the reference services. The Dixons Group may therefore be a scale monopolist under the provisions of section 7(1)(a) of the FTA. Any finding of the existence of a scale monopoly depends only on the share of supply and does not imply any adverse findings relating to the conduct of the Dixons Group. Complex monopoly 3.5 A complex monopoly exists, under the FTA, where at least one-quarter of the relevant goods or services is supplied by members of a group who, whether voluntarily or not, and whether by agreement or not, so conduct their respective affairs as in any way to prevent, restrict or distort competition in connection with the supply of the relevant goods or services (See Annex 4). Complex monopoly - shares of supply 3.6 Information supplied by the companies listed in the table in Annex 1 Table 2 shows the sales value (net of tax) and number of EWs sold by them to consumers in 2001. It will be seen that taken together, these companies provide more than one-quarter of the supply of the reference services. They are all companies involved in the sale of EWs at the point of sale of the relevant DEGs. We are considering whether the way in which these companies conduct their respective affairs may amount to conduct which prevents, restricts or distorts competition in connection with the supply of the reference services. This would make them a group in the terms of section 7(2) of the FTA (see Annex 4). The relevant conduct is set out in the annotated list in paragraph 3.16 below; further explanation is given in Annex 3. It is not necessarily suggested that all the companies concerned conduct themselves in all of the ways listed. Nor does membership of a complex monopoly of itself imply any adverse findings relating to the conduct of any of these companies. Other companies are also involved in selling EW at the point of sale of the relevant DEG and it is possible that the Commission may conclude that some or all of those other companies are also complex monopolists. 3.7 The table in Annex 1 Table 2 includes both retailers and other companies that are associated with them in the provision of EWs. As explained in paragraph 2.10 above, business models vary, and the consumer may contract with an insurance company or another party rather than with the retailer. Nevertheless these companies are all parties that may be involved in the supply of the EWs concerned, linked to the sale of the DEGs that are covered by the EWs. Where, for example, an insurance company sells EWs through a high street retailer, both are included as parties who may be involved in the complex monopoly and who may benefit from it. Values and numbers of EWs sold are attributed to them jointly in Annex 1 Table 2. Market definition 3.8 Whether any specific course of conduct, or courses of conduct taken together prevent, restrict or distort competition may depend on the economic circumstances involved, including the economic market or markets involved. In Part 2 of this letter above we set out a number of issues on the extent of the market or markets. In summary these were: i) whether there are separate markets for EWs on each different type of DEG. Alternatively, whether there is a single market for EWs on most or all white and brown goods, but separate markets for EWs on either or both of PCs and mobile phones; ii) whether EWs with a wide range of cover, such as both repair and/or replacement and additional cover (eg accidental damage, theft, frozen food damage) are in the same market as EWs with more limited cover, such as only repair or only repair and/or replacement; iii) whether single appliance EWs are in the same market as multi-appliance ones; iv) whether point of sale EWs are in the same market as others, but with sufficiently distinctive characteristics as to allow significant price discrimination as between point of sale EWs and others; or whether there is such a point of sale advantage for retailers that point of sale EWs form a separate market v) whether renewals of EWs are in the same market. 3.9 The issue was also raised whether EWs are in a separate market from the DEGs to which they relate, or whether they are just one amongst a number of attributes of DEGs which influence customer choice of DEGs, such that EWs are an integral part of the DEG market, rather than in a separate EW market; or are at least so interdependent that they cannot be considered separately. 3.10 Determining the boundaries of the market or markets involved in the light of the above may or many not turn out to be critical to our inquiry. While competition pressures will normally arise within an appropriately defined market, important competitive pressures may arise from outside a market, particularly if it is more narrowly delineated. Conversely, competition concerns may arise in relation to part of a more broadly defined market. 3.11 Based on our work to date, we currently consider that: i) the principal market comprises all EWs in the UK, as described in paragraph 3.2 above, supplied by retailers, manufacturers, insurers and credit card companies; whether single or multi-appliance, whether paid for or free, and including renewals; ii) this market is distinct from the market or markets for DEGs: iii) within this principal market, separate markets may exist for EWs on white and brown goods, EWs on PCs, and EWs on mobile phones. iv) retailers (and companies involved with them) enjoy a substantial point of sale advantage which, at the least, significantly affects the extent of competition between point of sale EWs and others and which might justify regarding point of sale EWs as a separate market. 3.12 It is on this basis that we are considering whether one or more complex monopolies might exist. We do not currently believe that the issues for discussion on complex monopoly would be greatly affected by alternative market definitions, but this point may itself be an issue to be pursued. Point of sale advantage 3.13 As we currently regard point of sale advantage as an important factor in the market, with a potentially powerful bearing on the scope for various courses of conduct to restrict, prevent or distort competition, this issue is briefly addressed next, before listing practices that may amount to courses of conduct in a monopoly. 3.14 In Part 2 above it was suggested that the sale of EWs at the point at which the DEGs covered by the EWs are also sold provides 'point of sale advantage'. The OFT drew particular attention to this factor in its report when making the reference. This may provide the opportunity for companies to act in ways that prevent, restrict or distort competition. Moreover, some conduct that might be commonplace in other markets, with no detrimental effects on competition, may prevent, restrict or distort competition if it occurs in the context of a point of sale advantage. In addition, such conduct may exploit or maintain a monopoly, or be detrimental to the public interest in such a context even though it might not have such an effect in the absence of a point of sale advantage. In such circumstances, companies involved in a complex monopoly would consist of those whose courses of conduct are linked to point of sale advantage. In addressing this issue, we are considering whether companies selling EWs but without a point of sale advantage have other advantages which partly or totally offset the point of sale advantage. 3.15 It may be that others apart from those directly involved in point of sale EW transactions also engage in or benefit from uncompetitive conduct associated with point of sale advantage. For example, other providers may also be in a position to benefit from uncompetitive conduct by following the market if retailers with a point of sale advantage overprice EWs. Possible uncompetitive practices 3.16 Under the terms of FTA, forms of conduct, which prevent, restrict or distort competition constitute uncompetitive practices. We list below possible uncompetitive practices in relation to the supply of EWs, which may constitute the basis of a complex monopoly. Not all the relevant evidence has yet been received; further analysis is still to be carried out, and all such propositions will only be decided upon after hearings designed to give the main parties full opportunity to express their views and after the proposed public hearing. However, relevant material so far available is summarised in Annex 3. Possible uncompetitive practices include the following: A. Restricting choice At the point of sale, consumers may generally be offered a restricted choice of EW products and a specific combination of cover and related terms, typically: (i) only EWs provided by the retailer; (ii) EWs covering repair or replacement of faulty DEG, together with specific additional services dependent on the retailer and relating to the DEG involved (eg accidental damage, theft, frozen food loss, PC help line); (iii) EWs providing cover for either 1 plus 2 years or 1 plus 4 years. This may restrict or distort competition in that it may: (i) restrict consumers' ability to acquire an alternative provider's EW; (ii) restrict consumers' ability to acquire cover for the separate elements of risks. For example, a consumer may be confident of the reliability of a product and may not want protection against breakdown other than as provided under the manufacturer's guarantee which comes free, but may wish to obtain cover for accidental damage or theft; (iii) restrict or prevent consumers acquiring alternative periods of cover, for example an option of one additional year on a one year manufacturer's guarantee in a case where the consumer may intend to replace the product within a relatively short period; (iv) as a result require consumers purchasing at the point of sale to acquire some elements of cover that they do not need (because they are already duplicated by statutory rights, other insurance or the manufacturer's guarantee) or would not otherwise buy, in order to acquire other elements they do want to purchase at the point of sale; (v) effectively prevent competition for the service for the 3 or 5-year period of the EW, in the absence of cancellation, (which may be costly and appears to be rare). This contrasts with the situation that would exist if, as in many other areas of insurance, contracts were annually renewable, providing annual opportunities for others to compete on terms or price. If consumers regard themselves in practice as committed for the 3 or 5-year period, then effective competition may have to focus on the point of sale, but to the extent that there is a point of sale advantage for the seller of the DEG, this may prove difficult. In assessing these issues we are taking into account the extent to which consumers find it advantageous, primarily in terms of convenience, to purchase EWs at the same time as DEGs. We are also considering to what extent any of the possible restrictions listed above are a necessary consequence of providing EWs at the point of sale. B. Contracting in advance At the point of sale, consumers may be required to contract in advance for services, provision of some or all of which will not start for some time, in that repair services (and in some cases other elements of the EW) are already provided for the first year (and occasionally longer) by the manufacturer's initial guarantee. (i) Contracting in advance for a service frequently occurs and is not inherently likely to constitute uncompetitive conduct. However, in the case of EWs, this may restrict or distort competition, in so far as EWs provided by or for the manufacturer are not recognised by consumers as ready substitutes, although they may be significant potential alternatives. Detailed information about them may not be readily available until after a purchase has been made. At that stage, switching to an alternative provider would require cancellation of the original EW. If any 'cooling-off' period has expired, this may mean only partial reimbursement. Such reimbursement may or may not reflect the split between those services already provided (eg accidental damage since purchase) and those yet to be received , either in terms of their cost or of their value to the consumer. To this extent there may be a deterrent against searching for alternatives. (ii) In many cases contracting in advance is associated with payment in advance; once such payment has been made consumers are unlikely to search actively for EWs that better meet their needs or do so at a lower cost. Although purchase on credit terms delays most or all of the payment made, this may make little difference, given that the consumer is committed to the full credit arrangement (which, in any event, will often be for less than a year, and usually entails the payment of interest). C Setting prices above competitive levels. This may arise from point of sale advantage or any other element or feature of the market. (i)Evidence supplied to us suggests that retailers, to varying degrees, take into account a range of cost, demand and competitive factors when setting or modifying prices for EWs, with the cost factors including both the likelihood of repair or replacement, as well as repair or replacement costs themselves. This general approach is likely to mirror pricing methods in numerous other markets. However, one additional, and therefore distinguishing factor may be the relationship between the price of the EW and the price of the DEG to which the EW is attached. Most EW pricing appears to be carried out in terms of price 'banding' where the price bands relate to the price of the DEG, and evidence has been submitted that a significant element of customers' evaluation of the price of an EW is the price as a percentage of the price of the DEG, though the acceptable percentage may well vary with the product. (ii) However prices are set, we would in broad terms expect that, in a competitive market, prices would tend over time to come intoline with underlying costs plus the margin necessary to ensure continuation of the business, including sufficient returns to shareholders and other investors. If there is insufficient competitive pressure to achieve this, such that most or all prices are above this level, then those price levels may distort competition and may tend to result in too limited a demand for such services in relation to the optimal level which fully competitive conditions would generate. (iii) In this connection we are considering at what level of disaggregation a comparison of prices and costs, or assessment of profitability of EWs, should be made. The most disaggregated level would be at the individual DEG product level, eg specific models of a particular manufacturer's range of washing machines. The next level up would aggregate all models of a particular manufacturer's washing machines in specified price bands. Still higher levels of aggregation would put together all models of a particular manufacturer's washing machine; or all manufacturers' washing machines in separate price bands. Either might be aggregated further to include all white goods. (iv) In practice, few if any, point of sale providers appear to price extended warranties at a more disaggregated level than product type and price band, primarily because more disaggregated data on reliability or repair cost are not available when new models are launched. It has also been put to us that past data on the reliability of particular manufacturers can be a poor guide to the reliability of their latest models. This suggests that it is not sensible to examine price-cost relationships at any more disaggregated a level than the product categories and price bands that such providers themselves use. Even here there are likely to be issues of cost allocation that could make such an assessment difficult. (v) We also note, however, that some insurers providing EW services to a number of different manufacturers do have data on the different reliability and repair costs associated with different manufacturers; that the variations appear sizeable and sustained; and that this does lead to differential pricing of different manufacturers' EWs in the light of these differences in anticipated costs. We may therefore wish to utilise data available at the level of individual manufacturers' DEGs. (vi) The alternative to disaggregated analysis is for us to assume a substantial amount of averaging, across different products, manufacturers and price bands, and look at the price-cost relationship across all EWs supplied by each provider. Whichever level is adopted, however, the issue is essentially the same; whether prices are excessive in the sense that they are, over a period, significantly above the level necessary to cover costs and adequately reward investors. If so, they would be above the level which full competition would generate, and would themselves distort the competitive process. (vii) The Commission's usual approach to profitability is to consider return on capital employed and we will therefore seek to calculate return on capital employed in the EW business for those parties that represent a substantial share of the supply of EWs. The return on capital employed will be compared with the firms' cost of capital. The Commission's preferred approach to cost of capital is currently the Capital Asset Pricing Model. (viii) In this connection, it should be noted that an individual manufacturer's EW should, in competitive conditions, tend to reflect any superior or inferior reliability and/or cost of repair, which its products exhibit. This in turn could provide useful information to consumers as to the likely reliability of different manufacturers' products and so enhance competition. Provision of such information could be restricted if, as a result of point of sale advantage, EWs were predominantly sold by retailers who did not distinguish between different manufacturers in any particular product category. D. Restricting information Information available to consumers at the point of sale about alternative EW offerings may be restricted. (i) Information is generally available at the point of sale about the main specifications of the DEGs available and their price. It appears that, in contrast there is very little, if any, information provided to consumers at the point of sale to enable them to evaluate EWs offered by the manufacturer or their related insurer prior to purchase of the DEG. This reflects the fact that in relation to the specific purchase, any information on those alternative providers of EWs is typically either inside the packaging of the DEG or only supplied if a registration card is sent off. In either case, the information is not readily available at the point of sale prior to purchase. This may therefore restrict or distort competition. (ii) We are therefore examining the extent of such in-store information, and whether it is adequate for consumers to make properly informed decisions. It is, of course, quite understandable that a retailer may not wish to, or be expected to, offer full information on a product which is in direct competition with its own EW (though this does to some extent happen in relation to DEGs themselves, given that manufacturers' products compete with some retailers' own brands; and we may wish to explore this difference). But competition may still be restricted or distorted if the failure to sell, or to inform customers about alternative EWs mean that retailers have to some degree foreclosed access to customers of EWs for other providers. (iii) These restrictions or distortions of competition may occur as the result of failure by retailers to provide relevant information. Further such effects could occur if manufacturers take steps to promote their EWs, for example through adding stickers to their packaging with information about their EWs and providing fuller information inside the package, but retailers offset this by removing such information or seeking to ensure that manufacturers with whom they deal do not include such material. The existence and, if so, the extent of any such practice is therefore an additional issue for investigation. (iv) This in turn raises the possibility that competition will be restricted if manufacturers are either dissuaded from seeking to promote their EWs at the point of sale, or at all, as a result of either indications, or a concern that such activity may have some bearing on their efforts to obtain retailers' shelf space. E. Selling practices Retailers may engage in selling practices such as providing misleading information or excessive selling pressure designed to increase the sales of EWs sold at point of sale of the DEGs. (i) Unless a consumer has decided in advance to buy a particular DEG product, and has broadly decided the price, and has then taken the opportunity to research alternative providers of EWs, their terms and prices, then at the point of sale the consumer will have little, if any, directly useful information on alternatives to the retailer's EWs offered. (ii) If consumers generally purchase EWs at the point of sale, but do not have full information at that point on alternatives, the question of whether the retailer's EW, typically the sole EW being offered at that point, is "good value" in itself (ie leaving aside whether a lower priced equivalent or a preferable EW specification might be available later) may become more important than otherwise. (iii) However, information on likely reliability, potential repair costs, probability of theft or accidental damage, and so on, may not be available. If so, consumers may be more susceptible than otherwise to any statements made by sales staff at the point of sale. This may be limited to the provision of only such information as is known to be accurate, or more generally information in line with best practice codes of conduct; however, in some cases it may consist of over-enthusiastic selling of EWs, unintentional exaggeration of their benefits, attempts to exaggerate the potential risks, dangers and costs of failing to purchase an EW, or other types of pressure selling. In practice, the borderline between some of these practices may be very imprecise. However, if substantiated, the latter categories of conduct could distort or restrict competition. Benefits of any monopoly identified 3.17 Following section 49 (2) of FTA, the terms of reference require us to investigate in favour of what person or persons any monopoly situation exists. The companies engaging in the conduct listed above, who may thus be monopolists, may also benefit from that monopoly in so far as it enables them to increase revenues from EWs through either higher sales volumes or higher prices, or a combination of these. They may be in a position to take steps to exploit the monopoly as listed below. They may not be the only companies that benefit from the monopoly. For example, others who sell EWs may follow the prices set by the monopolists. Steps, acts and omissions to exploit or maintain a monopoly situation 3.18 Following section 49 (2) of FTA, the terms of reference also require us to investigate: whether any steps (by way of uncompetitive practices or otherwise) are being taken by that person or persons for the purpose of exploiting or maintaining the monopoly situation and, if so, by what uncompetitive practices or in what other way; whether any action or omission on the part of that person or persons is attributable to the existence of that monopoly situation and, if so, what action or omission and in what way it is so attributable. 3.19 In the event that some or all of the courses of conduct described above are found to constitute one or more monopolies, a number of them may also have the effect of exploiting or maintaining the monopoly. 3.20 Of the possible uncompetitive practices listed above, A, B and D may, individually or together, make it difficult for manufacturers or others without access to point of sale advantage to offer alternative combinations of cover and time period which may in principle be attractive to consumers. In addition, it may be more difficult as a result for manufacturers to offer two-year guarantees, which might impinge on the attractiveness of a paid-for EW, if information on this is difficult or impossible to obtain at the point of sale. There also appears to be little, if any, scope for such provision to be reflected in the price of DEGs, given the absence of information on such aspects of a DEG at the point of sale; but with no adjustment of the price of the DEG to reflect the greater cost to the manufacturer of a two year guarantee, there is potentially a significant disincentive to offer longer guarantees. In addition, E above could serve to maintain a monopoly by reducing the scope for manufacturers and others to obtain some element of point of sale advantage. 3.21 Furthermore, it may be that if consumers had more information at the point of sale about relevant statutory rights; alternative providers of EWs; reliability, durability and repair costs of products, as well as the incidence of accidental damage or theft; then this might to some extent reduce any point of sale advantage available to retailers and hence lessen the scope for the various courses of conduct described to restrict, prevent or distort competition. If so, to the extent that retailers do not provide such information this may constitute an omission, which helps to maintain a monopoly. In examining this we will also wish to consider whether any such omission may reflect the cost and/or practicality of such information being made available at the point of sale. Whether any such omission serves to maintain a monopoly is also likely to depend on the extent to which such information is available elsewhere and, if so, whether consumers have ready access to it. 3.22 C above may act to exploit a monopoly created by one or more of the courses of conduct, in that it would generate profits above the level obtainable from EWs in fully competitive conditions; this might then enable price competition for DEG business to continue at a consequent level of profit contribution which would by itself be too low to be sustainable. 3.23 It may also be that firms, if members of a monopoly resulting from the courses of conduct described, may exploit the monopoly in other ways. Possibilities include: F. Unfair terms Terms or conditions may be specified that are not fair to consumers and would not be sustainable in fully competitive conditions. Possible examples are: the termination of EW cover following a claim; disproportionately small repayment on cancellation in relation to the cost of EWs; applying depreciation rates, or using reconditioned products for replacement in a way which was not sufficiently highlighted and therefore expected by some consumers. A further practice, which we understand may have been largely discontinued, has been offering cash back to consumers for making no claim during the life of the EW, but with conditions that mean many consumers in practice fail to meet the terms. We will consider evidence for such conduct, whether any such conduct persists and, if so, on what scale. G Uninsured cover EWs may be offered in the form of uninsured service agreements rather than via insurance contracts in order to obtain the advantage of preferential tax treatment. Such agreements may provide consumers with a lower level of protection in the event of insolvency. Many EW providers have established ring- fenced trust funds to mitigate this risk. We will consider the extent to which, if at all, these arrangements fall short of providing in practice the degree of protection afforded by insurance schemes. The Public Interest 3.24 Following section 49 (2) of FTA, the terms of reference of the inquiry ask "Do any facts found by the Commission in pursuance of this investigation operate, or may they be expected to operate, against the public interest?" In considering the competition issues, it appears to us that it could be against the public interest if the following facts were found to be the case. 1) there may be lack of choice for consumers; (see practices A and B) If there is lack of choice between EWs from different providers, or lack of flexibility in the packages offered at point of sale, consumers may not be able to obtain the specific cover that meets their needs. They may not, for example be able to take alternative bundles of cover, or for alternative time periods, or to take a 'pay-each-year' option at the point of sale. Consumers may also be effectively locked in by having contracted and paid for the EW in circumstances in which they were not in a position adequately to consider alternatives. They may find it difficult to cancel in order to switch provider. In assessing this, account needs to be taken of the extent to which flexibility is in fact provided, and the advantages of a relatively standard EW product, as well as the extent to which it requires consumers to take more than they want. 2) there may be excessive prices; (see practice C) Whether or not consumers perceive that what they are buying is good value for money, it is a matter of public interest if lack of effective competition means that they are paying more than they would otherwise. In assessing this, account needs to be taken of costs, how they relate to different elements of EW provision, and how prices are set. 3) there may be distortion to competition to sell DEGs ; (see practice C) If there is scope to make profits in excess of competitive levels on EWs, the issue arises as to the broader impact. Shareholders may gain but, if so, this does not appear to raise any additional competition issues. If, however, the result is lower prices than otherwise in other competitive areas of business such as DEG retailing, then this may cause further distortions or restrictions on competition in these other areas. An excessive profit contribution from EWs could permit a level of profit contribution on DEGs that would otherwise be unsustainably low. This could mean that retailers with significant EW business could successfully seek to undercut other DEG retailers who did not have this advantage. This could progressively reduce the latter's market share, even if their DEG offering at a competitive price were as good as, or perhaps even better than the alternative; or it could force price-matching on DEGs from those retailers who lack the benefit of the greater profit contribution from EWs, thereby threatening their longer term viability. In either case competition in the wider DEG retailing market could be distorted or restricted. This could be against the public interest if it tended to reduce consumer choice between retailers. It might keep down prices of DEGs, although account would need to be taken of whether this was at the expense of those buying EWs, and whether those buying EWs tended to be concentrated in particular socio-economic groups. 4) information may be insufficient or not readily available; (see practice D) (a) on alternative EWs available, their terms and conditions; (b) on the relevant risk factors, primarily likelihood of a fault, accidental damage or theft, and likely costs of repair or replacement in the absence of an EW; (c) on statutory rights; It could be against the public interest if consumers are effectively prevented or hindered from knowing whether or not it is in their best interest to buy the EW on offer, or to buy one at all, through lack of information at the point of sale of the related DEG. In assessing this, account needs to be taken of the type of information that might be reasonably made available, and its likely accuracy and relevance. 5) there may be insufficient competition in the provision of EWs at point of sale; (see practices A and D) There may be very limited scope for alternative providers to obtain or challenge a point of sale advantage. It could be against the public interest if, for example, consumers are hindered or prevented from making a reasoned and informed choice about which EW to buy because alternative EWs are not made available, particularly at point of sale. The point of sale is likely to be the time when it is natural and most convenient for a consumer to consider an EW, and when, as a result, most consumers do in fact purchase EWs. If manufacturers' (or others') EWs were presented as clear alternatives at the point of sale, this could provide a real choice for consumers. For example, manufacturers might be in a position to offer EWs on terms that reflected actual risks related to the reliability of different manufacturers' DEGs. In assessing this account needs to be taken of commercial relationships between retailers and manufacturers, and of what is reasonable and practicable in the retail environment. 6) there may be excessive pressures on consumers to buy EWs; (see practice E) Clearly it is a matter of public interest if there are found to be unreasonable sales pressures. The point of sale context, with the potential for bargaining over credit and DEG prices, may affect sales behaviour in relation to EWs. Sales targets and commissions to staff may be a factor. 7) consumers may be subject to unfair terms; (see practice F) If terms such as those indicated under practice F above persist, this could be against the public interest, depending on factors such as the precise effects of such terms, the extent to which consumers are aware of the terms at the time of purchase, and what scope they have to purchase EWs without such terms. 8) there may be inadequate protection under non-insured schemes (see practice G) Many (though not all) EW providers have moved from insured to non-insured schemes in response to tax changes. This has had the effect of removing the cover that consumers would have had in the event of insolvency of the EW provider. In assessing whether this is against the public interest, factors to consider include the extent of risk, given that some EW providers have become insolvent, any benefits to the consumer under the new arrangements, and the extent to which trust funds provide adequate protection to consumers with non- insured EWs. TABLE 1 - SUPPLIERS OF REFERENCE SERVICES 9 ANNEX 1 RETAILERS MANUFACTURERS INSURERS Apollo 2000 Limited Apple Computer (UK)Limited AXA Insurance UK plc Argos Limited Beko (UK) Limited AON Warranty Group Limited Bennetts (Retail) Limited Belling Appliances Limited Cassidy Davis Insurance Services Ltd Box Clever Technology Limited BSH Home Appliances Limited Cornhill Insurance plc British Sky Broadcasting Limited Crosslee plc Domestic & General Group plc Carphone Warehouse Group plc Dell Computer Corporation Limited Hitachi Credit Insurance Corp Ltd Comet Group plc Dyson Limited Landmark Insurance Company Limited Co-operative Group Limited Electrolux plc Norwich Union Insurance Limited Dabs.com plc Fisher & Paykel Appliances Limited Pinnacle Insurance plc Dixons Group plc Fujitsu Siemens Computers Limited Royal & Sun Alliance Insurance plc Grattan plc & Freemans plc General Domestic Appliances Limited Warranty Direct Ltd Jessops Limited Hewlett-Packard Limited John Lewis plc Hoover Limited UTILITIES Littlewoods Retail Limited IBM United Kingdom Limited Centrica plc MFI UK Limited JVC (U.K.)Limited Npower Gas Limited Miller Brothers Group Limited Kenwood Appliances plc South Staffordshire Group plc N Brown Group plc LEC Refrigeration plc Southern & Scottish Energy plc Orange Retail Limited LG Electronics U.K. Ltd Phones 4u Limited Miele Company Limited BANKS & CREDIT CARDS Powerhouse Retail Limited NEC (UK) Ltd Barclaycard (Barclays Bankplc) Redcats (UK) plc Panasonic U.K. Limited Royal Bank of Scotland Group plc Richer Sounds plc Philips Electronics UK Limited Thomson Multimedia Sales UK Limited Samsung Electronics (UK) Limited Vodafone Limited Sanyo Industries (U.K.) Limited Sharp Electronics (U.K.) Limited Smeg (UK) Limited Sony (U.K.) Limited Time Technology Group Limited Toshiba Information Systems UK Ltd Whirlpool (UK) Limited ANNEX 1 TABLE 2 This table lists the companies currently identified as providing EWs at the point of sale of the relevant DEGs, and having more than 1% of the supply of the reference services. These, together with others who provide EWs at the point of sale and are listed in Table 1, may be involved in a monopoly situation. (See notes on next page) Company Value of EWs sold 10 (£'000) No of EWs sold11 ('000) Dixons Group plc Appliance Serviceplan Ltd Cornhill Insurance plc Comet Group plc Landmark Insurance Company Ltd Powerhouse Retail Ltd Pinnacle Insurance plc Argos Limited First Home Services Ltd (Pinnacle Insurance plc) Cornhill Insurance plc Littlewoods Retail Ltd ESP Limited (Pinnacle Insurance plc) MFI UK Ltd London General Insurance Company Ltd Total for those listed above (in respect of EWs provided at point of sale) £415,000 6,100 Total supply of EWs at point of sale Not yet calculated Not yet calculated Total supply of EWs12 £800,000 15,000 1. The companies listed in Table 2 are providers of EWs at the point of sale of the relevant DEG (including mail order and telephone sales). The groups of companies listed have currently been identified as providing more than 1% of the total supply of EWs in each case, through the relevant retailer's point of sale. (See paragraphs 3.7 for an explanation of the way in which the providers of EWs are grouped). 2. Other companies also provide EWs at the point of sale of the relevant DEGs, and it is possible that the Commission may conclude that some or all of them are also complex monopolists. These include the other retailers listed in Table 1 of this Annex, and retailers with small shares of the supply of EWs. Some of these are members of the Radio, Electrical and Television Retailers' Association (Retra) and provide EWs supplied by Retra Insurance Services Ltd, a subsidiary company of Retra. Many smaller retailers provide EWs which are supplied by insurance companies; in particular Domestic and General and Cornhill. If some or all of these are included in the "point of sale" complex monopoly group the total share of supply of this group will be greater than the amounts currently given in Table 2. This letter is being addressed to all the companies which the Commission has so far individually identified as those which may fall into this category and to other interested parties. It is also being published. Comments are invited from any company that may be affected. Inclusion in a complex monopoly does not imply any adverse findings relating to any of the companies concerned. 3. The remaining part of the total supply of EWs is made up of renewals, and provision of EWs other than at the point of sale of the relevant DEG; eg manufacturers' EWs and direct sales to consumers by insurers and credit card companies. 4. Confidential figures in columns 2 and 3 have been excised. Sales to businesses are excluded. ANNEX 2 INFORMATION ON MARKET AND ECONOMIC ISSUES 1. This Annex contains further material and evidence relevant to the market and economic issues described in part 2 of the issues letter, and where applicable paragraphs are cross-referenced to part 2. Some of the material is also relevant to part 3 of the issues letter, the possible monopoly situations. Where EWs are sold - rates of purchase 2. Paragraph 2.12 - The NOP survey showed one in three of those who had bought an electrical product for over £50 from a shop in the past twelve months had purchased at least one of the items with EW cover. 82% of those with an EW had obtained it from the same retailer that sold them the electrical appliance. 4% had obtained it from the manufacturer and 4% from an insurer. 2 % had credit card cover and 1% had cover from the bank. Although retailers are not always able to quantify separately the proportion of their EW sales which are related to DEGs purchased from a different DEG retailer, they all believe this to account for a very small proportion of their total EW sales. 3. Paragraph 2.13 - For some categories of DEG, the rate of sale of EWs is higher than in others, particularly for higher priced DEGs. Evidence provided by retailers shows that the rate of sale of EWs in retail stores can be over 30% for product categories such as camcorders, washing machines and washer dryers, whereas EW sales on microwaves and video cassette recorders may be 10% or lower. The NOP survey found that a greater proportion of those who had purchased a DEG in the last 12 months had taken an EW where the DEG was more expensive, the rate of take up being over 40% for products over £300, compared to 25% for products under £100, and 27% for those between £100 and £200. 4. Paragraph 2.13 - Evidence from retailers also shows that within a particular product category, consumers are more likely to purchase an EW if they are purchasing a higher priced model. Retailers have also suggested that consumers purchase EWs for higher priced DEGs because the proportionate cost of the EW tends to be lower and the cost of replacing such an item may be prohibitive, whereas some cheap models may be regarded as 'disposable'. Also, if a consumer greatly values a particular DEG (eg their lifestyle means a washing machine or TV is an essential item), they will be more likely both to go for an expensive model (with more features, quality and perhaps greater perceived reliability) and purchase an EW to assure its continuing availability. Market definition 5. Paragraph 2.17 - Evidence to date suggests that it is fairly easy for suppliers to move between offering different types of EW policy (such as the usual single appliance policies, multi-appliance policies, and replacement only policies), ie there is close supply-side substitutability. Parties have indicated that supply-side substitution between these different products is easy as they are essentially the same product, can be sold in the same way and can be sourced from the insurance market or other suppliers in the same way. Multi- appliance policies, at the simplest level, can be created by bundling together single-appliance EWs. Survey evidence suggests that consumers are unaware of the difference between insurance-backed and service-contract schemes. The terms and features offered by insurance-backed and service-contract EWs are usually very similar. All suppliers who expressed a view stated that there would be very close substitutability between these products in the eyes of consumers. The OFT Report on the Consumer Survey about Extended Warranties (July 2002) reported only 14 % of consumers considered there was a difference between the two types of extended warranty after they had been prompted that there were two different types. Of these, only a very small proportion correctly understood what these differences were. 6. Paragraph 2.19 - In the case of PCs and similar high-technology digital equipment, most problems experienced by consumers will not arise from mechanical and electrical failure, but will result from software problems, the effects of combining different DEGs that are required to interact (such as a PC and its peripherals, or a TV, satellite or digital TV receiver, home cinema system, DVD and video and camcorder), or the customer's inability to follow complex or incomplete instructions. Distinguishing between hardware faults and other problems may be difficult. For consumers, it is irrelevant whether a problem arises from hardware, software or connectivity problems; they merely require the problem to be fixed. Therefore, in order to provide a satisfactory service, EW providers may need to offer an advice service, such as a helpline staffed by trained engineers. One retailer told us it managed to fix 86% of reported PC faults either over the phone or by e-mailing software fixes rather than having to arrange a physical repair. However, such a helpline service can represent a significant investment in facilities and staff training that would not be required for EWs without such a service. 7. Paragraph 2.24 - The major retailers have told us that their business strategies are based on attracting customers by offering both DEGs and add-on products such as finance and EWs. The retailers said that when shopping for DEGs, consumers weigh up their options carefully and this can take several weeks. During this period they investigate products and brands, undertake price comparisons and select the retailer from whom they wish to make the purchase. However, once the product is selected, price becomes the most important factor. Thus pricing in the DEG market is intensely competitive. Retailers argue that consumers will evaluate all aspects of a retailer's offer before deciding on where to make their purchase, including aspects of after-sales service and the competitiveness of the EW offering. However, retailers note that the major factor is pricing on the DEG. They say the interaction of EWs and DEGs with consumer purchasing behaviour provides a constraint on their business conduct and the relative margins that can be achieved on differing aspects of their business. 8. Paragraph 2.26 - The NOP survey broadly indicated that consumers rarely perceived EWs and DEGs as a package. Regarding sales practices, only 9% of respondents to whom an EW was mentioned reported that they were offered a 'package' price of EW and DEG together. 9% of respondents said they were offered a discount or some other advantageous financial arrangement subject to the take-up of an EW (17% among EW users). Overall, 93% of consumers who obtained an EW from the retailer said it was clear how much the EW would cost on top of the price of the DEG, in which case there is scope to consider and buy them separately. Point of sale advantage 9. Paragraph 2.28 - The major retailers have accepted that they have, to some extent, a point of sale advantage. One acknowledged that the price sensitivity of consumers to EW prices is less than for DEG prices. EWs are harder to compare (because terms differ) and tend to be seen as a complementary add-on to the DEG by many customers, therefore it acknowledged that a point of sale advantage exists for DEG retailers. However, another argued it could not seek to exploit any such advantage as, in common with other reputable retailers, it had no incentive to 'entrap' customers into contracts that they would subsequently wish to cancel. It also argued that many consumers were aware of alternative EW offers and of those customers who purchased EWs, many had actively considered the purchase of an EW before entering the store. However, it is possible that this could amount to no more than an intention to buy an EW at the point of sale. 10. Paragraph 2.29 - The boundaries of the relevant market (or markets) for EWs can be determined through the use of the 'small but significant non-transitory increase in prices' or SSNIP test. The test defines the economic market as the minimum number of products or services and the minimum geographical area in which a hypothetical profit-maximising firm that was the only seller of these products and services (ie a hypothetical monopolist) could profitably impose at least a small but significant and permanent increase in price from the competitive level. The test is applied by taking the smallest possible market, and asking whether the monopolist could profitably impose a small (say 5%) price increase. If enough consumers would switch to another product to make the price rise unprofitable, then those products should be considered as part of the relevant market. The test would then be repeated. The point of reference needs to be competitive price levels. If prices were greater than this level, they may have already been raised to the point where further increases would not be profitable. Then alternative products would appear relatively cheaper and so more attractive as substitutes, and the true market would be drawn too broadly. 11. In order to apply the SSNIP test precisely one needs observations of how consumers' demand for, and suppliers' supply of the product or service responds to changes in prices from the competitive level. In practice, these are rarely available. Therefore we rely on evidence which allows these effects to be inferred, such as surveys of consumer awareness of substitutes, their willingness to search for information on alternative offers, how consumers say they might react to price changes from current levels, their observed switching behaviour, evidence of competitive interaction in pricing between different suppliers, whether supplier behaviour indicates they regard other products as substitutes, and so on. 12. Paragraph 2.31 - Evidence received from different EW providers suggests that there are few if any significant advertising campaigns aimed at consumers. It has been put to us that when advertising campaigns have been undertaken, these have had very little success in increasing sales. We have been told by one of the parties that several attempts at advertising EWs have generated a poor level of consumer interest. Price Setting 13. Paragraph 2.40 - Retailers' evidence on their EW price setting processes suggests that some are wholly or primarily influenced by competitor pricing levels. They price at market levels or try to match or beat their key competitors. However, any price matching promises tend not to apply to EWs as terms and conditions often differ between different providers. One retailer has told us it would price match on a DEG, or DEG and EW together, but not an EW on its own. Those suppliers who tracked and responded to competitor pricing acknowledged that sometimes they could end up selling some EWs at a loss, but they sought to avoid such situations. Where EW providers match market prices, it leaves open the question as to how market prices are determined. Other retailers base their pricing on sales rates achieved, forecast claims and repair costs, and they will also respond to changes in the prices of the DEGs to which they relate. In some product categories, EWs may be priced according to the price of the DEGs to which they relate; for example EW prices will be higher for a DEG between £200 and £300 than for a DEG below £200, and there may be a higher priced EW for DEGs over £300, and so on. We were told this policy may arise to allow for the higher cost of replacing more expensive DEGs, because there may be more features in the product that could fail, or they are more complex and so more expensive to repair, and also so that the price of the EW relative to the DEG does not deviate too far from usual levels (see paragraph 15). 14. Retailers do not usually break down their pricing analysis by model or manufacturer. They have said that there are no forward-looking data available on reliability, claim rates and repair costs for particular models and manufacturers which would allow them to do this, and it would be too confusing for staff and consumers to have a variety of EW prices for similar DEGs. Where there are significant differences in the claims ratios according to the type of technology in a product, different prices may be charged. For example, frost- free fridge-freezers may have different EW prices from standard fridge-freezers, and EW prices of digital camcorders may be different from those of analogue camcorders. Where a new category of DEGs is introduced, there will be no claims history available and no market price to match. In such cases EW providers may base EW pricing on the best available forecasts of product reliability from technical sources, or experience in other countries where the products may already have been launched. 15. Paragraph 2.41 - Some retailers said that the ratio of DEG and EW prices could have a significant impact on sales-rates. Some retailers have approximate targets for the ratio of EW to DEG prices. One insurer told us that consumers are highly sensitive to the EW:DEG price ratio, and they will dispense with EWs once the ratio is excessive - it gave the example of VCRs where EW sales have reduced dramatically as the product price has declined. It said that new technology, highly complex or household critical products may have higher sustainable EW:DEG price ratios as customers have a greater propensity to protect their investment . 16. Paragraph 2.43 - Insurance companies have told us that, in setting the prices of EWs that they sell direct, they would be aware of pricing in the market and seek to remain competitive. However, they appear in general to attach more weight than retailers to the need for all product categories to cover forecast claims costs and to ensure an adequate return. Where EWs are distributed through retailers acting as sales agents, a target margin may also be added for the retailer to retain. Pricing of multi-appliance policies is more difficult, as claim costs will depend on the mix of products that consumers choose to cover. Costs are therefore calculated based on experience; pricing may be guided by a target margin over costs for the insurer. Insurers have also noted that administration costs tend to be lower for renewals and so a lower mark up is required, although because the product is older and there is potentially an element of adverse selection in which consumers choose to renew, forecast costs will be higher. Insurers do not generally break down costs by model type or manufacturer, as they, or their retail agents, would find it difficult to reflect these in pricing lists; they say it would create too many options and confuse consumers. Where insurers are providing EWs to one or more manufacturers, they can base forecast costs, and therefore charges, on the claims history of each individual manufacturer alone. 17. Paragraph 2.47 - It is possible, therefore, that rather than being constrained by those of competitors, retail prices are limited by the amount that consumers are willing to pay. Consumers always have the option not to purchase an EW. As noted above, EW providers may perceive that demand is sensitive to price increases from current levels. As noted in part 2 of this letter, a major reason for the fact that the great majority of DEG sales are not covered by EWs is because consumers perceive prices as too high. The Commission is investigating whether prices have profitably been increased from a competitive level already. 18. Paragraph 2.52 - Evidence received from retailers and insurers indicates that there are a wide variety of gross margins on EWs for different DEG product categories. These seem to have become accepted in the EW industry as normal pricing. We asked some retailers to provide EW gross margins on each of their DEG categories, calculated as retail price minus risk premium, tax and administration charges (no allowance was made for any other variable costs or allocated overheads). Typically, such gross margins varied from around zero (and were occasionally negative for EWs covering particular price bands for certain DEGs) to over 80%, although the number of product categories towards the extremes of the distribution were low. It appears that different retailers have a similar pattern of distribution of margins. One major retailer acknowledged that there was wide variation in the gross margin by product, and stated that this resulted from the fact that it largely set prices by reference to its competitors' pricing. Barriers to entry and exit 19. Paragraph 2.58 - There is limited evidence that the number of independent repair organisations has fallen rapidly in recent years. One manufacturer estimated that the number of authorised service centres had fallen from around 800 three or four years ago, to around 450 operating now. We will consider whether this may impede the ability of a new entrant to the supply of EWs to establish a repair network. 20. Paragraph 2.60 - We have found that consumers are not usually active in shopping around and comparing prices for EWs, whereas retailers have indicated that many consumers are active in shopping around for DEGs. One retailer's response summarises the typical views expressed: "A consumer buys an electrical product only once every eight months on average. For major purchases the frequency is, on average, every fifteen months. It is usually a highly important purchase and is both planned and considered, since few other purchases, other than cars, houses and holidays, have such large ticket values. Consumers typically seek to educate themselves on the different products on offer, search for the lowest price available, and, for some, gain added reassurance through the proposition of strong after-sales support and service... Price comparison is made easier by the fact that most electrical products are directly comparable between retail chains, and on the internet. This leads to especially price-sensitive behaviour by consumers looking to make an electrical purchase." Retailer relations with manufacturers 21. Paragraph 2.64 - Although many manufacturers offer EWs, there has been little evidence received to suggest that they actively advertise the existence of their EWs prior to sale. Some manufacturers have indicated they are passive in their approach to the market, they do not see EWs as their core business, and one said it made no efforts to monitor competitors' behaviour in this area. Manufacturers told the OFT that there were difficulties in competing with retailers, as they did not want to compete against their own customers who might see EWs as their domain; the same views have been expressed to us. One manufacturer argued that sales targets and incentivisation distorts the sales of DEGs as it encourages retailer sales staff to sell low-cost, less-reliable DEGs with an EW rather than a higher-priced, more-reliable DEG without an EW or with a free or cheaper manufacturer's EW. ANNEX 3 INFORMATION ON COMPETITION AND PUBLIC INTEREST ISSUES 1. This Annex contains further material and evidence relevant to the competition and public interest issues listed in Part 3 of the issues letter: A Restricting choice B Contracting in advance C Setting prices above competitive levels D Restricting information E Selling practices F Unfair terms G Uninsured cover 2. The material and evidence is also relevant to the market and economic issues described in part 2 of the issues letter. A. Restricting choice Choice and coverage of EWs and reasons for buying them 3. The Commission has received very little evidence to date that any retailers sell EWs other than those they provide themselves. 4. Most retailers' EWs, as well as those of some insurers and manufacturers, offer cover beyond mechanical breakdown, for accidental damage and frozen food loss. Some EW policies provide cover against theft. When offered, these benefits cannot be taken out separately from the mechanical breakdown cover. 5. When asked whether they were aware of these benefits that might be included in their own EWs, only 33% of consumers spontaneously said that they were covered for accidental damage, and 12% for theft (however, only 52% said they were covered against mechanical breakdown, and 20% for parts and labour costs). Most consumers (92%) have home contents insurance policies. Of those with home insurance, 85% thought this covered their electrical appliance for theft, while 72% said their appliance was covered for accidental damage. 6.Commission analysis of the NOP survey results found that 3% of consumers said that a reason why they took out an EW was to obtain accidental damage or theft cover. According to a survey presented by one company, 10% of consumers spontaneously mentioned protection against accidental damage as a reason for purchasing EWs. When consumers in the NOP survey were prompted for their valuation of the different EW benefits, mechanical breakdown was top of the ranking, accidental damage was ranked fifth, theft ninth and frozen food loss appeared at the bottom. 7. The NOP survey also showed that some consumers value the convenience of an EW that covers them for all eventualities. Convenience of arranging repairs and peace of mind were among the main reasons for taking an EW. Peace of mind was also the most important reason for EW take-up in the survey presented by one of the companies. This is likely to be enhanced where an EW covers a wide variety of risks. 8. However, some respondents to the NOP survey would prefer being able to buy extended cover for different risks separately, as this would be better tailored to the DEG that they had purchased, and could be cheaper. Incidence of claims 9. Over all EW claims, for the financial year 2001, data from major EW suppliers indicates that mechanical and electrical failures account for around 75% to 95% of the value of all claims, accidental damage anything from under 2% to around 15%, and frozen food loss 1% to 2%. Where theft cover is included it accounts for approximately 10% of claims. We are investigating the considerable variability in claims profiles for different EW suppliers. We will also consider whether the claims profile is significantly different for products such as PCs and mobile phones, and if so, whether they are sufficiently different that this might indicate that such products could be in different economic markets. 10. Data provided by some of the parties show that there are virtually no claims other than for mechanical failure in some product categories, whilst in others such as mobiles, claims for accidental damage and theft can be much more significant. One EW provider told us that it does not offer these additional benefits together with cover against mechanical failure as it believes they are largely superfluous to the product offering. Periods of cover 11. Retailers typically offer lengths of EW cover of three and five years from the date of purchase. Some retailers may also offer cover for other periods, such as two or four years. However, Commission analysis of the NOP survey results shows that more than half of consumers (56%) who purchased an EW from theretailer that sold them the DEG claim not to have chosen the length of cover themselves but say it was pre-specified. Insurers selling direct to consumers and manufacturers offer EWs for different periods including three and five years, or longer, but also annual renewal policies. 12. The NOP survey showed that although consumers would see benefits from shorter term EWs being available, they also believed that signing up for a three or five year policy was likely to be cheaper than one-year renewable policies, that it represents a fixed/known cost and provided them with the reassurance that the electrical product is covered for the relevant term. Consumer search behaviour 13. Some evidence indicated that many consumers would not actively search for alternative EW providers even in response to an increase in EW prices. The NOP survey asked consumers what would they do if, hypothetically, EW prices increased by around 10%. Out of those who had taken an EW from the same retailer as sold them the electrical appliance, two in three (64%) would still have taken cover from the same retailer if the price of cover at that retailer had gone up by 10%, whilst 23% would not have bought an EW, and only 11% would have 'looked actively for EWs from other providers'. However, of those that would look actively for EWs from other providers, 33% would still have taken an EW from a retailer if the price increase had occurred at all retailers B. Contracting in advance Original guarantees and EWs 14. The manufacturer's guarantee covers consumers for the cost of repair due to mechanical failure, normally during the first year after purchase, although some manufacturers offer a two-year or longer guarantee on some product categories. In the OFT survey, all consumers expected manufacturers of large electrical appliances such as colour TVs or dishwashers to provide a guarantee. 60% expected the manufacturer's guarantee to last for one year, and almost all the rest expected it to last longer than one year. Almost two in five (39%) consumers in the NOP Survey thought they could only take out an EW when they bought an electrical product, or within one month from purchasing the appliance (8%). 15. EWs are usually paid for when the policy is taken out, with the obvious exception of free EWs, and of contracts where there is a credit package with a monthly repayment schedule. (Some insurance company warranties are paid for by monthly direct debit.) During the first year many claims would be covered under the Sale of Goods Act, so the benefits of the warranty are higher thereafter. However, providers have emphasised to us that there are features of their warranties from which a consumer could benefit in the first year. These features may include cover for accidental damage, help-line support, faster call-out times for service engineers and loan of appliances. Cancelling and cooling off 16. Cooling off periods vary considerably.EWs sold by retailers offer cooling off periods that vary between 14 and 30 days, and we have been told that these are in line with the cooling off periods for insurance contracts in other markets. However it has also been pointed out that the retailer's cancellation period may have expired by the time the consumer is aware of the manufacturer's offer. One party has put it to us that if retailers' limited cancellation periods were to be extended then more customers would have the ability to shop around for competing offers from either the manufacturer or a direct insurance provider. Some non-retail competitors can make consumers aware of their EW offers through their regular customer contacts, e.g. utility companies through their monthly bills. 17. In practice few consumers seem to search for alternatives during the cooling-off period (even if they are aware that such alternatives exist). According to the NOP survey, 18% of respondents regretted having purchased their EW, but less than 2% considered cancelling it. 18. It appears that there could be a number of psychological barriers that mean a consumer will find it difficult or be reluctant to cancel an EW contract and take out a new one elsewhere. First, they must be aware that they have a right to cancel the contract. Second, they must know of, and be able to identify a suitable alternative provider. Third, they must contact the point of sale provider to cancel their existing cover. Fourth, they must admit to themselves that they had made a mistake in their first choice of EW provider. Fifth, there may be a financial cost in seeking a refund (see paragraph 19). 19. Our current understanding is that for most EWs, if a consumer were to cancel the policy after the cooling-off period, then there would be no refund due for the unexpired period, except by special dispensation in unusual circumstances. However, at least one non-point of sale provider said it would refund the entire fee if the consumer wishes to cancel the policy before expiry of the manufacturer's guarantee provided no claims have been made; in its annual plans (i.e. plans taken after expiry of the manufacturer's guarantee) this provider would offer a pro-rata refund for the unexpired period of the policy as long as there have been no claims on it. C. Setting prices above competitive levels Cost reflective pricing 20. The OFT maintained that EW pricing appeared not to be cost reflective, after examining data available to it on average repair costs and noting that a standard fee is charged for EWs for goods of the same general type within the same broad price banding despite differing failure rates of electrical goods. 21. Several retailers have told us that pricing at the level of brand or model would not be feasible due to variations in the reliability of a manufacturer's models, the fact that reliability varies over time and the need for large sample sizes to project claims. They also argue that price banding is easier for consumers and ensures that EW prices are attractive, given consumers' sensitivity to the EW price in relation to the DEG price. A retailer has told us that EW penetration rates seem lower for product categories where the EW:DEG ratio is higher. At the same time, we have been told that although the level of EW prices is strongly influenced by market conditions, prices must be above the cost of the insurance premiums associated with each EW to avoid negative margins. 22. From some information received, it nevertheless appears that the amount payable by retailers to insurers to cover risks relates to whole appliance categories or subdivisions that do not necessarily match the retail pricing structure. Also, it has been put to us by an insurer that when underwriting an agent's scheme, the amounts payable to cover insured risks are set on overall appliance performance. In this way, risks may be more than covered by the amounts payable on higher performing appliances but not on the lower performing ones within a product category. This may allows an EW to be offered on higher risk products. Comparability 23. Within each appliance category, there are wide variations between EW prices charged by different providers. Some retailers have told us that they would not necessarily wish to match a competitor's EW price, given the fact that the benefits attached to some EWs may not be the same, which makes them not directly comparable with others. 24. It seems that there is a wide variation in retailers' mark up of EWs between different types of appliance. Our preliminary analysis of information from retailers shows that the five year EW gross margin across different appliance categories can vary from 0% to over 80% (or can even be negative). On the other hand, a retailer has put to us that variations in margins are a result of its market driven approach to setting EW prices. It argued that it does not set EW prices on a cost-plus basis but to ensure competitiveness against other EWs and that a correspondence is maintained between EW prices and the prices of the DEGs to which they relate. It has also been put to us that differences in retailer's margins may partly be due to the fact that the 'risk groups' (the categorisations of DEGs used to assess the costs of covering risks) and the retail pricing structure for EWs (based on particular types of DEG and price bands for the DEG) are not identical. 25. We also note that there are price differentials between EWs offered by different providers. We have been told that price differentials may be due to different levels of cover, or variations in the product ranges stocked across retailers. On the other hand, it appears from a preliminary analysis that claims under certain elements of EW cover within particular product categories represent a low proportion of total claims (see Annex 3 paragraph 9). Pricing factors 26. Our preliminary analysis confirms that EW pricing is not based uniquely on costs. Factors that often appear to be more important in price setting than costs include: comparisons with competitors (including non-retail competitors and manufacturers), the price of the related DEG, the need for margins on EWs to be positive, sales targets, and tracking of the number of EWs sold compared to the number of DEGs sold in each category. 27. Our analysis to date suggests that for policies sold directly to consumers, competitors' prices are the main criteria in setting price. 28. For policies sold via an agent, the price charged by the insurer to the retailer appears to be a function of the risk of product failure and the expected cost of repair. The final retail price charged by large retailers (ie the retail margin added as well as the premium paid to the insurer) appears largely to be based on what competitors are doing. Some small retailers may more closely follow insurers' recommendation by charging prices that add a standard margin on the risk premium. Profitability 29. Our preliminary analysis of the questionnaire responses suggests that electrical retailers do make considerable profits on the sale of EWs. Profitability in terms of returns on sales after allocation of indirect costs ranges around the 20% to 50% level, or assuming no allocation of indirect costs, around the 40% to 75% level. 30. In the case of at least one insurance company, it appears that profitability of the EW business may be lower than for its other insurance activities. 31. Information analysed to date suggests that retailers may be using the profits from the sale of EWs to lower the price of DEGs below what they would otherwise have been. At least one retailer has stated in its response that the best strategy is to offer the lowest possible DEG price along with a high quality service, to maximise overall profitability levels. D. Restricting information Awareness of alternatives 32. Consumers appear to give less thought to planning the purchase of an EW than a DEG, and we have found that many consumers seem to have little or no awareness of where EWs could be purchased other than at DEG retailers. The NOP survey showed that three in five purchasers of major DEGs (i.e. priced at £50 or more) recall salespersons mentioning EWs but only 4% of these consumers recalled salespersons mentioning alternative EW providers. NOP reported that the preliminary shopping around for a DEG does not include information gathering about EWs, either because information is not available or because it is not a priority at this stage. Consumers in the NOP focus groups believed that if they could not buy EWs at point of sale, then they would forget unless they were reminded of them. Some respondents thought sourcing alternative providers would be 'time consuming and inconvenient'. 33. Three in five EW purchasers had not planned to buy EWs before entering the shop (compared with 41% in the OFT consumer survey) and we found based on the NOP data that very few (about 3%) of these had considered suppliers other than the retailer where they bought the DEGs. Half of EW purchasers who considered alternative providers had considered another retailer. Less than 4% of all EW purchasers were able to make comparisons of price and EW features. A survey submitted by one of the parties showed that 8% of EW purchasers considered alternatives for their EW before purchasing it in store. 34. Consumer surveys indicate that the levels of awareness of different types of EW provider are different at the spontaneous and prompted levels13. In our consumer survey, only one in two respondents were spontaneously able to identify any type of supplier. Those most often associated with EWs were retailers (30% of respondents) and insurers (22%). Manufacturers were only identified by 7% of respondents, and credit card companies, banks etc by 2%. Note that some respondents identified more than one type of provider. At the prompted level awareness was much higher. 92% identified retailers as providers of EWs, 81% insurance companies and 79% manufacturers. 54% were aware of credit card companies and 35% of banks' extended cover . 35. It is possible that consumers did not understand, or were led by, the prompted questions - many EW holders could not spontaneously name any type of EW provider, and the prompted figure for awareness of banks' EWs seems very high given the very limited availability of such cover. Also 50% of respondents agreed that finance companies were a source of EWs when this is not normally the case. As a comparison, the OFT Consumer Survey found,before prompting, 7 out of 10 respondents mentioned retailers as a source of EWs, and only 1 in 4 mentioned manufacturers and 1 in 7 mentioned insurers. After prompting, 9 in 10 mentioned retailers,two-thirds manufacturers, and half insurers. 36. Retailers do not generally accept that consumers were unaware of alternative EW providers. They have argued that consumers have access to information about the different providers of EWs, as well as their cost and terms. Sources of such information include DEG retailers, providers of EWs who market directly to customers, consumer bodies and the media; information is provided to consumers by various methods including advertising, direct mail, the internet, material provided at points of sale or at other points of contact with the customer. They have also stated that most consumers will have had experience in the market, and many will have purchased EWs from other sources. They have also argued that the cooling-off period allows consumers the chance to shop around. They also said that while some consumers may not be aware of alternatives, provided sufficient numbers were aware of and could compare alternative providers then this would exert competitive pressure on pricing. Information at point of sale 37. Information on EWs from other providers such as insurers or manufacturers is not available at point of sale. The NOP survey found that information about other providers of EWs was offered in only 4% of cases where the sales person mentioned EWs. Retailers have told us that they do not train their staff on the terms and prices of manufacturers' EWs. 38. Manufacturers do not place information on their EWs on the appliance for retail display. Any documentation would either be available in the appliance box (which consumers will only see when they open the package at home) or through mail shots upon return of the guarantee card contained within the appliance package. Some manufacturers have told us that they cannot compete directly with retailers as they do not have access to the consumer at point of sale. 39. We have been told that it is not common for manufacturers to place material about their warranties on packaging or display equipment, but where they do place material such as stickers on equipment, we understand that the retailer may decide to remove these from display stock. This is apparently not limited to extended warranty publicity; the retailer wishes to control the appearance of the shop floor. Historically, there may have been some instances where appliance registration cards may have been removed from packaging but manufacturers and retailers have told us that this is not a common occurrence today. 40. It has also been indicated that some retailers may be unwilling to allow retail pricing to reflect longer inclusive manufacturer guarantee periods (by refusing to accept increases in manufacturers' prices necessary to meet the extra cost of the longer guarantees). 41. Some manufacturers have told us that they are not more active in the sale of EWs as they do not wish to compete with their customers' EWs. For example, a PC manufacturer told us that a retailer had indicated to it that it regarded information about the manufacturer's own EW in the packaging of its appliances as unhelpful to consumers. Similarly, retailers have argued that they do not offer other providers' EWs as they regard EWs as an integral part of their service rather than as a separate product. But we note that some retailers have started to sell EWs not associated with the sale of a DEG through direct mail, telephone and their repair services. 42. Different parties including retailers and insurers have expressed their belief that most consumers prefer to buy EWs when they purchase the DEG. Some have also argued that this is because consumers' primary focus is the choice of the DEG, not the EW. The NOP survey showed that most consumers believe that if they could not buy EWs at point of sale, then they would forget unless they were reminded of them. It also showed that, according to some consumers, finding alternative providers would be 'time consuming and inconvenient'. Take-up of alternatives 43. From the information gathered so far, it appears that the rate of return of manufacturers' registration cards is low, varying from 1.8% to 20%. Also, the consequential take-up rates for insurer or manufacturer EWs out of total mailings are low. A retailer who also mails customers who do not purchase EWs in store has said that it selects the products for its mailing programme where historic take-up rates show that this is economically viable when compared with more general marketing costs. E. Selling practices The BRC Code 44. Retailers told us that sales staff are trained to follow the British Retail Consortium (BRC) guidelines on sales practices14, and that written information on EW prices and conditions is available. In its July 2002 report, the OFT stated that the mystery shopper exercise which it commissioned demonstrated poor compliance with the BRC Code of Conduct. For example, three quarters of stores did not display signs referring to the price of EWs and more than half of stores did not display clearly visible leaflets or signs about EWs. The larger retailers have indicated to us that they are taking measures to ensure all their branches fully comply with the Code. However, the BRC is not seeking approval for the Code under the OFT's codes regime, and the BRC says it has no powers to discipline its members or force compliance with the Code. Statutory rights 45. Consumers appear to be widely unaware of their statutory rights under the Sale of Goods Act. According to the NOP survey, 65% of consumers thought they could only be compensated for a failure with their product for a period of one year after purchase or less. 13% mentioned a period longer than a year and 22% did not know. A separate DTI consumer survey has shown that there is relatively low awareness of what is a "reasonable time" in which to return goods, with over half being ill-informed or simply not knowing. 43% correctly stated they could return a faulty television 18 months after purchase, while 34% did not think this was correct and one in four (28%) did not know. The DTI survey showed that availability of warranties and guarantees added to consumers' confusion over what was a reasonable length of time - they assumed they were not entitled to anything once the guarantee period had expired. The availability of guarantees also appeared to contribute to consumer confusion, with many assuming that they had no rights once a guarantee had expired. Two in three consumers (62%) in the NOP survey would still take out an EW despite the protection available under their legal rights, given the need to show inherent fault at the time of purchase. 46.Although some retailers have told us that they train their sales staff on the Sale of Goods Act, there seem to be no leaflets on it available in store. Some retailers believe there is substantial confusion over consumers' statutory rights due to what they see as the general and imprecise nature of the Act. Information in store 47. It seems that written information is not always available when EWs are mentioned to consumers in store. According to the NOP survey, less than half (45%) of those consumers to whom the salesperson mentioned an EW had been given any written information available about the EW, or noticed that it was available, before they had to decide about it. Of those, 59% said after reading the information it was clear what they would be covered for and 11% said it was not clear. 28% did not read the information. Of those consumers who recall EWs being mentioned to them at point of sale, four out of five were either completely clear (39%) about the terms of the EW or clear to some extent (41%) whilst one in ten were not clear at all. 48. The NOP survey showed that over one third of purchasers of major DEGs were advised by sales persons to take out an EW. Of those who were so advised, one in ten were also advised that the EW was good value for money. Over half were not completely clear about the terms of the EW cover based on what the salesperson had told them, and similarly three in five were not completely convinced by what had been said. Information on repair costs 49. Evidence received indicates that there is great variability in the reliability, and also in average repair costs, of different brands and models of DEG. However, the patterns of average levels of reliability for different manufacturers can change over time. Information on historic levels of reliability and average repair costs by brand and model is not generally made available to consumers by retailers and manufacturers. Some retailers claim to advertise their standard repair charges in store, and one insurer's website provides details of approximate costs of repair. 50. The OFT found that sales staff may emphasise problems of reliability and repair costs when seeking to sell an EW. According to the NOP survey, consumers recalled that in 10% of cases where the salesperson mentioned EWs they indicated how likely the product was to break down, but in only 2% of cases they said that the product was very or quite likely to break down (compared to 6% where it was described as very unlikely or quite unlikely to break down). Retailers pointed out that it would be impossible to give reliability data for particular models as this would not be established for a couple of years after launch, by which time the model is likely to have been replaced or updated. Reliability data based on a manufacturer's overall record could also be misleading as relative reliability changes over time and there is great variability between models. 51. The Consumers Association has surveyed its members to determine their experience of average DEG failure rates and the average costs of repairs. The OFT undertook a similar study. Some companies have provided evidence which suggests the incidence and cost of repairs have been understated in such surveys. Evidence provided by both retailers and insurers of actual claim rates under EW schemes (and based on much greater numbers of consumers), show claim rates for EW holders to be much higher than the failure rates found in these surveys would suggest. The companies also provided details of the cost of repairs. Despite purchasing repair services in bulk and providing guaranteed work flows to repair organisations, the cost per job tends to be in excess of what the surveys report to be the average cost of a repair for an individual consumer. 52. Some parties have suggested that past reliability is not a good indicator of future breakdown due to changes in product design, the constant introduction of new models and the variability in manufacturers' reliability over time. Also, manufacturers regard reliability as highly sensitive information. 53. Providers of EWs have told us that no information is generally provided at point of sale on product reliability and repair costs. Providing such information was not practicable as the risk of breakdown depended on a number of factors, many of which were specific to the individual consumer. In addition, it has been suggested that historic product reliability is no guide to future reliability. One retailer told us that it was mindful that if such information were provided, it could be criticised for using scare tactics to sell EWs. 54. We found one retailer which advertises its standard repair charge in store and through call centers, and of one insurer which provides information about approximate costs of repair on its website. In neither case is this information widely advertised. 55. Retailers have told us that consumers largely draw on their own experience to assess product reliability and cost of repair and that consumers are generally well informed about the risks and possible costs of repairs, partly based on experience of owning other DEGs, and partly from information that is available in the public domain such as newspaper and magazine articles. In the NOP Survey consumers expected 19% of products on average to break down in the first five years (note however that responses varied widely below and above the average). The average perceived cost of repair was £76. Selling practices 56. According to the NOP survey one in three consumers (36%) were advised by the salesperson to take out an EW. In the survey, NOP also found that some retailers (namely Currys, Comet, Powerhouse, Dixons and PC World15) were significantly more likely to have advised the consumer to take an EW than the average (54%, 52%, 44%, 55% and 50% of cases respectively as compared to an average of 36%). However, only 1% of those consumers who did not take an EW said they decided not to do so due to sales staff pressure. In the OFT mystery shopping exercise 7.4% of consumers felt retail staff put them under pressure to take out an EW. According to the OFT consumer survey, 9% of consumers claimed staff put them under pressure to take out an EW. These figures rose to 24% for Dixons and 21% for Comet. 57. The Consumers' Association has suggested that retail sales staff have been pressured to promote warranty products, and are being given incentives to give inaccurate information to ensure this happens. The Association also thought there was some evidence that pressure selling of EWs had declined since summer 2002, although it had not disappeared altogether. 58. We currently understand that different retailers pay varying rates of commission to their sales staff for EW sales. One has told us it pays no commission; other major DEG retailers report that commissions on EW sales could account, for an average salesperson, for between 1% and 11% of their total remuneration depending on the retailer, rising to between 3.5% and 14.6% respectively for a top performing sales person at the same retailers. One retailer told us that it believed commission payments do not give disproportionate incentives to its staff to pressure sell extended warranties. We were told that although sales staff are given incentives to make sales, the rate of incentives is usually no greater for EWs than for any other product or service. 59. We have seen examples of sales training material used by retailers. Staff are encouraged to seek to make sales, for example by focusing discussion of an EW on areas where a consumer may be concerned: for example where a customer has young children, sales staff may be trained to stress access to rapid repairs for an essential item such as a washing machine, or may stress the risk of accidental damage for a video recorder or television. 60. Some large retailers told us that they do not believe their sales staff use undue pressure in the sales process. Their staff training, store management processes, and complaints handling procedures are intended to ensure that selling techniques follow good practice. One retailer told us that in its experience, undue pressure upon customers to purchase an extended warranty simply had the counter-productive effect that the customer would change to another retailer for the next purchase. Bundling and discounting 61. Discounts appear to be available on combined purchases of a DEG and an EW. Although relating to the EW they may be applied to the DEG. Retailers' offers may be framed in some cases as to encourage the take up of an EW with the related DEG. According to the NOP survey, in 9% of cases where the sales person had mentioned EWs, the EW was described as part of the product price (11% of cases where the consumer actually took an EW). In 4% of cases it was presented as part of the finance costs. 9% of consumers to whom an EW was mentioned were offered discounts or financial arrangements such as store credit conditional upon the take-up of an EW with the appliance. We found from the NOP data that among the reasons given by consumers for taking up EWs, 2% mentioned the discount dependent on the take up of an EW and 2% the availability of a credit deal. 10% of consumers in the OFT survey claimed to have taken an EW because it was part of a package/special deal. Take up of EWs was higher when the EW and DEG were purchased on credit. Discounts seem to be higher on packages that contain an EW than those without it. According to some suppliers, free credit periods may be extended if an EW is taken. 62. Evidence provided by retailers suggests that average discounts granted on purchase prices are greater where a consumer purchases an EW and a DEG compared to where they purchase a DEG alone. One retailer indicated the average rate of discount was 2% higher where an EW was purchased. However, it noted that part of this was because discounts were offered on discontinued or soiled stock and customers might be more inclined to take an EW for such goods. Another retailer recorded a difference of over 3.5% in average discount. As in this case discounts were given on only a quarter of all sales, where a discount is negotiated, the absolute difference in the rate of discount is proportionately greater. We were also told that discount rates are higher on average where the purchase is on credit. The retailers told us that while offering discounts conditional on EW sales was not their policy, there would be an incentive on staff to secure sales, and one said in its case this would be greater where the sale included higher margin products such as EWs. F. Unfair terms 63. For some policies, if an item is replaced then cover is then terminated. We understand that in this situation some providers would pay the warranty-holder a refund of part of the EW cost proportionate to the time remaining on the policy, whilst other providers would not pay any refund. However, at least one supplier offers continuous cover, where the remaining period of cover under the EW is transferred to cover the replacement product. It has been put to us that the policy period being advertised should reflect the period of cover, irrespective of the claims experience on the policy. 64. In Autumn 2000, the Financial Ombudsman Service ruled on a complaint received about a Comet extended warranty refund offer, described as 'Make a claim or your money back'. The warranty holder had not complied with the terms for claiming the refund, and the Ombudsman considered that 'small print' procedural requirements such as these terms were inappropriate and might well be considered unfair contract terms. Comet subsequently rescinded its cashback scheme. So far as we know, very few retailers still operate similar schemes. 65. The OFT suggested that policies that assumed depreciation in the value of goods, so that after a certain period of time the electrical appliance is assumed to be worth significantly less than its original cost, might be considered to be unfair. Some policies limit overall liability of the provider to the original purchase price or the current value, whichever is lower. Where a depreciation rule is applied, then the overall liability is subsequently reduced. 66. In practice, we understand that for most EWs, if a consumer's product needed to be replaced, the warranty provider would provide a voucher for a monetary amount that would allow the consumer to buy a comparable new product. In many cases, customers would receive an enhanced specification of the product compared with that of the item being replaced because the original specification might no longer be available. In some cases, particularly for older products, this may mean that the value of the replacement product is below that the original purchase value, but it may nonetheless be a superior product. G. Uninsured cover 67. There have been examples of company failures that have led to purchasers of EWs losing their cover. Our preliminary review of the questionnaire responses suggests that a high percentage of retailers are now operating uninsured service agreements. While most of the larger retailers have told us that their agreements are backed by independent trust funds, some smaller operators may be offering less financial security. 68. Where an EW is backed by an insurance company, the insurer will be FSA regulated and so required to maintain reserves likely to ensure solvency, but should it fail the consumer will have the benefit of an FSA compensation scheme. Uninsured service contracts are not subject to the same regulation. However many providers of such schemes have arranged ring-fenced reserves to protect the interests of their EW customers in the event of insolvency. There have been cases where other providers have taken over obligations where an EW provider has failed. During early 2002 Dixons Group provided EWs to 400,000 former Tempo customers through arrangements entered into with the Administrators of the failed business and various of its credit providers. ANNEX 4 RELEVANT STATUTORY PROVISIONS AND TERMS OF REFERENCE Fair Trading Act 1973 Section 7: Monopoly situation in relation to supply of services (1) For the purposes of this Act a monopoly situation shall be taken to exist in relation to the supply of services of any description in the following cases, that is to say, if - (a) the supply of services of that description in the United Kingdom is, to the extent of at least one-quarter, supply by one and the same person, or supply for one and the same person, or (b) the supply of services of that description in the United Kingdom is, to the extent of at least one-quarter, supply by members of one and the same group of interconnected bodies corporate, or supply for members of one and the same group of interconnected bodies corporate, or (c) the supply of services of that description in the United Kingdom is, to the extent of at least one-quarter, supply by members of one and the same group consisting of two or more such persons as are mentioned in sub-section (2) of this section, or supply for members of one and the same group consisting of two or more such persons, or (d) one or more agreements are in operation, the result or collective result of which is that services of that description are not supplied in the United Kingdom at all. (2) The two or more persons referred to in sub-section (c) of thissection, in relation to services of any description, are any two or more persons (not being a group of interconnected bodies corporate) who whether voluntarily or not, and whether by agreement or not, so conduct their respective affairs as in any way to prevent, restrict or distort competition in connection with the supply of services of that description, whether or not they themselves are affected by the competition, and whether the competition is between persons interested as persons by whom, or as persons for whom, services are supplied. (3) In the application of this section for the purposes of a monopoly reference, the Commission, or the person or persons making the reference, may, to such extent as the Commission, or that person or those persons, think appropriate in the circumstances, treat services as supplied in the United Kingdom if the person supplying the services -has a place of business in the United Kingdom, or -controls the relevant activities from the United Kingdom, or -being a body corporate, is incorporated under the law of Great Britain or of Northern Ireland, and may do so whether or not those services would otherwise be regarded as supplied in the United Kingdom. Inquiry Terms of Reference Extended Warranties The Director General of Fair Trading in exercise of his powers under sections 47(1), 49(1) and 50 (1) of the Fair Trading Act 1973 (the Act) hereby refers to the Competition Commission the matter of the existence or possible existence of a monopoly situation in relation to the supply of extended warranties for domestic electrical goods within the United Kingdom. The Commission shall investigate and report on the questions whether a monopoly situation exists and, if so: (a) by virtue of which of the provisions of sections 6 to 8 of the said Act that monopoly situation is to be taken to exist; (b) in favour of what person or persons that monopoly situation exists; (c)whether any steps (by way of uncompetitive practices or otherwise) are being taken by that person or persons for the purpose of exploiting or maintaining the monopoly situation and, if so, by what uncompetitive practices or in what other way; (d) whether any action or omission on the part of that person or persons is attributable to the existence of that monopoly situation and, if so, what action or omission and in what way it is so attributable; and, (e) whether any facts found by the Commission in pursuance of their investigations under the preceding provisions of this paragraph operate or may be expected to operate against the public interest. For the purposes of this reference: 'extended warranty' means a contract, whether backed by insurance or otherwise, which covers consumers within the meaning of section 137 of the Act for the cost of any repairs or replacements that may become necessary within a specified period beyond that covered by a manufacturer's, retailer's, or importer's guarantee, and includes both contracts that provide cover during the period of the manufacturer's, retailer's, or importer's guarantee, and contracts where cover commences after this period, and 'domestic electrical goods' are products designed to be connected to an electricity supply or powered by batteries, and on which extended warranties are offered to consumers within the meaning of section 137 of the Act. The Commission shall report on this reference within a period of 12 months from the date hereof. Director General of Fair Trading 2 July 2002 ANNEX 5 TAX ARRANGEMENTS Insurance Premium Tax and Value Added Tax 1.Insurance products are exempt from Value Added Tax (VAT). Insurance Premium Tax (IPT) was introduced in October 1994 on certain insurance products, including insured EWs, at a single rate of 2.5%. This was raised to 4%% in 1997. At the same time a higher rate of 17.5% was introduced (the same rate as for VAT) for EWs sold by retailers as well as certain other products. The lower IPT rate remained for EWs sold directly to consumers (and all EWs on mobile phones); the rate was increased to 5% in 1999. Unlike most VAT, IPT is not recoverable. VAT is not recoverable on costs associated with insured EWs (such as repair costs). 2. Uninsured EWs (or service contracts) are not insurance products and therefore attract output VAT at 17.5%. No IPT is levied. Companies that supply these contracts can recover the input VAT incurred on their business costs by offset against output VAT levied and a net figure paid to/recovered from HM Customs & Excise. 3. Before the IPT rate increase to 17.5% it was advantageous to retailers to supply insurance backed rather than service contracts. This advantage disappeared when IPT was raised to 17.5% and was replaced by the disadvantage that no input VAT could be reclaimed. 4. Some "hybrid" EWs include elements of insured and uninsured cover, for example with cover against the need for repair provided through a service contract and cover against theft through insurance. Controlled Foreign Companies 5. A Controlled Foreign Company (CFC) is a company that is; * resident outside the UK * controlled by persons resident in the UK * subject to a lower level of tax in the jurisdiction in which it is resident (lower than the rate at which it would be taxed in the UK - (2002/03: small company rate 19%, and large company rate 30%). Current legislation 6. Under Corporation Tax Self Assessment (CTSA), all UK companies must, in their annual Corporation Tax return, list all CFCs in which they have an interest and self assess the Corporation Tax due on any eligible profits arising within them. 7. A company is deemed to have an interest in a CFC if * it holds a 25% interest in the company and * the company has a minimum profit before tax of £50,000. 8. Where a UK resident company has an interest in a CFC, the profits of the CFC are taxed in the UK to the extent that they would have been assessable to UK tax if the CFC had been a UK resident company (subject to any eligible double tax relief). That is, the profits which would have been assessable to tax are included within the Corporation Tax computation for the UK parent and the amount already paid in tax in the territory in which the CFC is resident is deducted from the balance due to avoid any double taxation on the same profits. For example, if a CFC pays tax on its chargeable profits at 10% in a foreign jurisdiction then, assuming the parent company pays tax at 30%, a further 20% would be due to the UK Revenue. 9. Under current legislation certain activities of CFCs are deemed to be "exempt activities" and any profits arising on these fall outside the scope of UK Corporation Tax, despite the fact that had the company been a UK resident it would have been assessable to Corporation Tax. Some DEG retailers have been able to avoid paying UK tax on the extended warranty activities of their CFCs by ensuring that less than 50% of the premium income of these CFCs derives from connected or associated parties, thus qualifying for the exempt activities provision. This is achieved in one of two ways. Either the consumer contracts for the EW with the retailer which insures the transaction with an unconnected insurer, which in turn reinsures with a captive insurance company in the same group as the retailer; or the consumer contracts with the captive insurer rather than with the retailer. Changes in legislation 10. In his pre-budget report on 27 November 2002 the Chancellor announced certain changes in legislation. These are aimed at taxing those profits arising from the EW business of retailers in the UK which have previously structured their operations to take advantage of the exemptions described above, such that in future profits arising from such EW business will be chargeable to UK Corporation Tax provided that more than 50% of the profits on such activities arise from UK residents (ie UK resident companies or individuals). This change in the legislation ensures that both primary insurance and reinsurance through captive insurance companies is now within the charge to UK Corporation Tax. These changes are not retrospective and apply only to accounting periods beginning on or after 27 November 2002. 11. The additional Corporation Tax due as a result of this change will become payable in the UK by the parent company of the CFC and will be the difference between the amount which would have been payable in the UK had the captive insurance company been a UK resident company and the amount which has already been paid in the jurisdiction in which it is currently resident (thus avoiding any double taxation on the same profits). 1 In some cases an importer or local subsidiary may represent a manufacturer in the UK. Where we use the term 'manufacturer' this should be taken to include cases where the DEG or EW under consideration is actually supplied by an importer or another company acting on behalf of the manufacturer. 2 Existing statutory protection currently provides only for compensation and not for a right to repair. However, the EC Directive on Consumer Goods and Associated Guarantees is likely to establish a right to repair or replacement when it is implemented in the UK; it will also shift the burden of proof from the consumer in establishing that a fault existed at the time of purchase, to the retailer who will have to establish that there was no pre-existing fault. This is likely to be in March 2003. 3 The term 'service contract' does not imply that there is any programme of regular servicing included in the EW - very few EWs of any type include such terms. 4 However, there may also be advantages to the consumer from paying for an EW in advance. Advance payment may reduce the size of risk premium an insurer will charge to a retailer, or may lower the expected costs of claims the supplier of a service contract EW may face, and hence the retail price to the consumer might be lower (see paragraph 2.45 for the reasons for this). Payment in advance will also preclude inflationary increases in premiums, and will protect the consumer from being penalised for claims as may happen under annually renewable policies. 5 Some EWs have included terms which allow consumers to claim back the cost of the EW when it expires if they have not made a claim. In practice consumers have usually had to meet tight deadlines for registering for the offer when they buy the EW, and for claiming the money at the expiry of the EW. Consequently successful claim rates have usually been low. Most providers have now withdrawn such cash-back policies. 6 When a failed DEG is beyond economic repair, providers may replace it with an equivalent model, or provider a monetary contribution. Some EW providers may pay less than the purchase price of the DEG, to reflect the fact that the product will have depreciated, the consumer will have benefited from part of the useful life of the product, and to guard against any deliberate sabotage of DEGs by policy-holders as the EW nears the end of its term. Whether any such depreciation clauses are applied, and the rates employed, can vary between providers. 7 The Herfindahl-Hirschmann Index is a measure of market concentration, calculated by summing the squares of the percentage market shares of all companies in the market. To put this value in perspective, the US Competition Authorities issues guidelines in 1992 for assessing mergers which suggest that a Herfindahl value of up to 1,000 indicates a market which is unconcentrated and so a merger would be unlikely to cause concern, whereas a figure over 1800 would indicate a concentrated market where a merger would be likely to raise strong concerns. Moderate concentration, between 1000 and 1800, would need to be assessed on a case-by-case basis. 8 As companies' accounting years vary, this is based on information supplied to the Commission in respect of whichever accounting year includes 25 December 2001. 9 Those currently identified. Not included in the above list are small retailers (approximately 3,000) which will account for small shares of supply of EWs. Also not included are some large companies who account for small shares of supply. 10 Figures for those companies listed are for EWs sold at point of sale of the DEGs (ie excluding renewals and other non-point of sale provision of EWs). 11 All EWs sold by the relevant companies at point of sale. Includes free EWs. 12 The sum of the supply of all EWs whether or not at point of sale of the DEGs. This is taken from information supplied to date with an addition of £50m. to cover estimates of information not received. 13 By spontaneous, we mean that respondents were asked whether they could name types of companies that provide EWs. For prompted responses, they were then read a list of types of company and asked which ones supplied EWs. 14 We were told that the BRC Best Practice Code sets out "minimum standards of good practice [to] be observed when promoting and selling EWs", and it explicitly states "those selling extended warranties and warranty providers will take steps and have a policy to prevent undue pressure to purchase being applied at the point of sale." 15 It should be noted that sample sizes for Powerhouse, Dixons and PC World are small so the results should be regarded with caution.