March 22, 2005

Warranty Conference,
Part Three:

Extended warranties may look like easy money to some, but beneath the surface there are lots of moving parts. Here's one expert's how-to guide:

Just after lunch on the opening day of the recent Warranty Chain Management conference in San Francisco, the topic turned to extended warranties and their potential impact upon both retailers and manufacturers.

During a panel discussion entitled "Extended Warranties 101," which included top executives from three of the top companies administering and underwriting service plans, Anthony Nader, president and chief operating officer of NEW Customer Service Companies Inc., outlined the 12 steps involved in the design of an effective extended warranty program. Follow them, he said, and you're likely to produce a terrific extended warranty plan. Skip a few, and your plan could lead to disaster.

Many of the manufacturers in attendance were looking for information about how they could possibly get into a new line of business that was churning out profits for brands such as Dell, Kodak, and Ford. But they also were mindful of the risks, which in the recent past have cost a few of the big players upwards of a half billion dollars each in losses, not to mention the public flogging of their good names.

Extended warranties are a complex business, Nader told the room to nobody's surprise. They involve both financial and legal risks. Managed correctly, they can boost profits and increase customer loyalty. Managed incorrectly, they can trash a company's brand, wipe out all profits, and conceivably lead to fines and even jail time for some executives. More than anything, he cautioned WCM attendees to secure the advice of experienced professionals before jumping into the business.

Getting Started

"First of all, you need to understand your customer's perceptions and expectations before you design a program," Nader said. "What exactly is the customer looking for from your product?" Is it strictly a question of peace of mind, or are they looking for installation advice as well? Do they want deeper warranty coverage than the manufacturer provides? Or are they merely looking to lengthen its duration?

Once you've figured that out, you move onto product development, where you'll answer questions such as when coverage begins, how long coverage lasts, and what is covered. It sounds like a simple question, Nader said, but it's really not.

Some plans are positioned as enhanced warranties, which begin their coverage on day one and which feature coverages above and beyond what the manufacturer's product warranty offers. For instance, they might cover spoiled food in a broken refrigerator. Other plans are positioned as merely lengthened warranties, extending the same coverage for additional months or years after the manufacturer's warranty expires.

Other parameters to be defined include whether the program will promise to repair or replace defective products, and what types of failures or problems will be excluded from coverage. The typical length of extended warranties varies from product to product, and it also changes over time for the same type of product, Nader said. For instance, years ago the extended warranties issued for computers typically lasted five years, because people were keeping them that long. "Today, I don't know if that works," he said. Two, three, or four year plans are more typical today for PCs. In contrast, almost everybody buying a big screen TV today expects to keep it at least five years, so perhaps lengthy service plan offerings still make sense in that product category.

Replace or Repair?

At the same time, with inexpensive products it might not make sense for either the owner or the administrator to attempt to make a repair, either in or out of warranty. For instance, Nader said, it might always be better to replace a $99 printer rather than try to repair it, even once. "You might decide you want to sell a replacement plan on it," he said. If you do decide to go with a repair plan, you need to decide whether it will feature service at home or if the consumer will need to drop it off or perhaps even mail it in. If it's the latter, you need to decide whether you or the customer will pay the shipping costs.

The third step concerns legal and tax aspects, which Nader said is the "messy side of the business." Depending upon what's covered under the program, in some states it may be considered insurance. That, in turn, may dictate how it can be sold and who can sell it, or a state may require licensing, registration, or detailed filings. Individual states may also have laws specific to service contracts, and then of course there's also the federal Magnuson-Moss Warranty Act, which covers warranties offered to consumers at the retail level.

Nader noted that the terms of the service contract itself may determine whether it will be treated as insurance in any states. "Depending on what's included in your plan, you might be subject to some insurance laws," he said. "Depending on how you sell the plan, you might submit yourself to that." It's a tricky task to balance the need for product consistency across the 50 states (plus DC) when all the states regulate differently, he said.

For instance, let's say the screen on a laptop computer cracks. If it cracked because it was dropped, it might be covered by an accidental damage protection clause on the service contract. In some states, that might be considered to be insurance, while in other states it would not. In some states where it's considered to be insurance, the sale of such policies might be regulated in some way, while in other states it might not be. Meanwhile, if the screen cracked because of a manufacturing defect, the contract that provides for its free repair would not be considered as insurance anywhere.

Those who get it wrong risk the suspension of their programs in some states, fines in others, and possibly jail time in a few of the strictest. Nader alluded to, and next week we'll delve deeper into, a presentation given later in the day by attorney Timothy Meenan, which detailed this legal tangle on a state by state basis. We'll also get around to covering the presentations of the other extended warranty panelists, which included Paul Swenson, president and chief executive officer of Aon Innovative Solutions, and John Estrada, chief operating officer of ServiceBench Inc.

Marketing 101

Then there are the marketing questions. Will you sell your service plan in the box? Will it be sold on the Web? Will you use direct mail or email? Or will it be sold by a retailer at the time a product is purchased? This question matters a great deal to manufacturers, because few of them actually sell their products directly to the end user.

Many times, there's an intermediary -- usually a dealer or retailer -- and in most cases those dealers and retailer are already selling extended warranties. Some say those extended warranties bring in more profits than the actual products they protect. So it's not always possible for a manufacturer to either compete or partner with the retailer/dealer when it comes time to offer extended warranties.

Step five, Nader said, is to define the sales operation. "You need to make sure you have a mechanism to receive data from the customer: the consumer that actually bought the plan," he said. "If you're dealing with something that's in a box or over a Web site, you have to figure out how to get it into your system. If it's from a retail perspective, you need to figure out how your point of sale system might interact. But getting that data is critical to actually fulfilling what you said you were going to do throughout the chain."

The technology involved can be extensive. "The infrastructure must integrate with multiple external systems," Nader said. There are numerous parties involved in the warranty chain, including service providers, insurance companies, consumers, and clients (manufacturers, retailers, utilities, etc.). "Everything from the sale, to the customer care experience, the service delivery, producing those actuarial numbers, and financial reporting to the states (or to yourself, or to your clients) becomes critical."

Data Mining & Analysis

This leads directly to the next step Nader outlined, which is database management. Once you've successfully moved all that data into your system, what are you going to do with it? "Can you mine it? Can you figure out how to match up the customer information with demographic information? Can you learn anything about your product as a result of having everything in your database? Do you know as a manufacturer when it's being fixed within that period? Can you count the number of times it's been fixed, and for what? Getting that data and figuring out what to do with it is a critical part of developing a successful program," he said.

Step seven is deciding what to do about underwriting and reserving. Nader said the key points here are to make sure that the program's underwriter is financially stable, and to make sure the premiums paid by customers are large enough to cover both claims and operating expenses. "A well-priced program can have a lot of stability," Nader said. "An incorrectly priced program can be disastrous."

Years ago, Nader said, nobody talked much about underwriting because most service plans were self-insured (or more precisely, uninsured). If the seller of a service plan went out of business, they usually took their extended warranties with them to the bottom. So the buyer had to guess whether the seller would outlive the contract. Today, for the most part, that risk has disappeared as most plans have become fully-insured by an underwriter. Now it's up to the administrator of a plan to pick an underwriter that will outlive its contracts, or at least one that has a good reinsurance company behind them. That way, it's highly likely that funds will be available to pay claims.

"From a financial perspective, have you looked around and seen what the underwriter is rated?" Nader asked. "What does A.M. Best, which does the insurance ratings, have to say about the underwriter? What's their rating? What does [Standard & Poors] or Moody's [Investor Service] have to say about it?"

Predicting Costs and Producing Prices

The process of pricing the plan seems so simple, Nader said. Basically, the formula is:

Insurance Premium + Administration Cost + Profit = Price

"The reality is, it's not that simple," he said. "There are a lot of moving parts." The premium is going to be determined by the multiplication of two factors: the frequency of claims, and their severity. Let's say the frequency of claims for a given type of product is one out of ten units, or 10%, and the severity of each claim is $200. The multiplication of the two, called the loss cost, would be $20.

The insurance company could reasonably expect the cost of underwriting such a contract to be $20. However, they're also going to want to make a profit. So the price they charge the administrator is going to include a "risk fee" at some negotiated rate.

The administration cost is comprised of factors such as the level of customer care and service management, the techniques and costs involved in marketing, and the technology infrastructure used. It has some relationship to the frequency and severity of claims, but not as much as it might appear. Marketing costs, for instance, arise independently of claims. And even if there were no claims at all, there would still need to be an infrastructure to support and salaries to be paid.

So there are lots of moving parts. And they move in ways that aren't always predictable. "If you forecast any of these incorrectly, it can cause the program to not do as you had expected," Nader said.

For instance, let's say that the frequency was really 12%, not 10%. And let's say the average claim turned out to be $205, not $200. Now the actual loss cost is $24.60 -- a deviation of 23% above what was expected. To put it another way, Nader said, a program built around these expectations could end up being underpriced by 23%.

In terms of administration costs, let's say that the company determines that customer contacts cost $1.00 per minute. Let's say they predict that 15% of customers will make contact (note that this rate is substantially higher than the 10% or 12% who need a repair), and that the average customer contact will take three minutes. If each call costs $3.00 and 15% of customers require one, the cost per contract would be 45 cents.

Let's say it turns out that the $1.00 per minute figure is accurate. However, in actuality the calls average three and a half minutes each, because the customers ask difficult questions that the call center agents can't quickly answer. And the contact rate -- the percentage of customers actually calling in -- turns out to be 17%, not 15%. Therefore, the cost per contract would turn out to be nearly 60 cents. Administration costs, therefore, could be underestimated by a third.

The next step is customer communication. "You need to interact with the customer how the customer chooses to interact with you," Nader said. "So you can have a call center. You can have a Web site. How are you going to let the customer speak to you?" Nader also noted that how this step is accomplished at the outset has an impact on customer loyalty in the future. The call center agent who answers the phone is the one who makes that first impression.

Last week, NEW became the first company in the service plan industry to be certified by the J.D. Power and Associates Certified Call Center Program as being within the top 20% of all call centers. J.D. Power, which is soon to be acquired by McGraw-Hill, conducted a random survey of people who had recently contacted NEW's call center. They were polled about the courtesy of the customer service representative, their knowledge, their concern for the customer's questions and/or problems, the usefulness of the information provided, the convenience of their operating hours, the ease of getting through to a live representative, and the timely resolution of the customer's questions and/or problems.

Self-Help Training

Once the call center is in place, it has to do more than simply answer the phone. "On the troubleshooting side of things, have you trained your call center people to actually solve the customer's problem before they have to have a truck show up at their home, or they have to send their product back in?" Nader asked.

What's required is a training program that teaches call center staff to help customers diagnose some problems themselves. "Customer satisfaction is highest when a customer can sit in their home and have their product fixed by simply calling you on the phone," he said. "The Web can also be a pretty effective tool for this."

Nader also noted that effective customer self-help procedures also can help to reduce warranty costs. When trucks don't roll and technicians aren't dispatched, the cost of adjusting a claim is reduced by the amount of time and labor not expended. It can come down to a matter of parts and postage. And when combined with the tendency of customer satisfaction to rise highest after a successful break-fix episode, Nader said this is the best combination of all: happier customers and lower warranty costs.

Step ten is the delivery of service. This includes everything from the making of service appointments over the phone to the eventual capture of data by the administrator from the customer visit. "Have you figured out a way to interact with your service provider properly to make sure the service delivery was meeting customer expectations?" Nader asked.

Delivering exceptional customer care, Nader said, is essential. "It protects your brand," he said. "It builds customer loyalty. It increases customer value." Nader said that every point of customer contact, be it the Web site or the call center, has to reinforce that mission.

"We have data that shows us that when you fix the product right the first time, not only customer loyalty but also overall customer satisfaction goes up exponentially," he noted. Customers who purchase extended warranties are 23% more satisfied with retailer than those who don't make the additional purchase. And customers who purchase extended warranties are 20% more likely to recommend a given retailer, Nader said.

On the flip side, after a negative claim experience, customer loyalty falls by 50% or more, he said, and 91% of unhappy customers will never purchase from that company again. On average, they'll each tell nine people about their unhappiness, thus magnifying the damage. "Do the math," he said. "Your franchise gets destroyed pretty quickly if you don't do a great job."

Final Steps

The final two steps are accounting and customer feedback, Nader said. In terms of accounting, the administrator needs to know how to recognize revenue from service contracts, either in stages over the life of the contract or all at once at the outset.

Customer feedback, Nader said, echoes some of the earlier steps such as customer communication, where data gathered from the interaction with and the satisfaction level of the customer are used to improve and possibly redesign the product offered.

Nader asked the audience to consider how they would gather and use this data. "Do you survey your customers? Do you ask them about how the warranty provision met their expectations? Do you have a way to figure out whether the service providers in the field actually did what they said they were going to do, before the customer blows up and gets upset?"

Go to Part One: Opening Keynote Speeches
Go to Part Two: AIAG Early Warning Standard
This is Part Three: Extended Warranties 101
Go to Part Four: Customer Loyalty
Go to Part Five: National Regulatory Trends
Go to Part Six: Auto Warranty Fraud
Go to Part Seven: PC & Appliance Warranty Fraud
Go to Part Eight: Warranty Metrics

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