February 14, 2006

Manufacturer's Extended Warranties:

Although retailers dominate the business, a handful of manufacturers do very well for themselves in the extended warranty business. Now a major bank's insurance unit wants to help more of them to launch service plan sales efforts.

In the extended warranty business, word gets around fast. In the past four or five months, numerous articles have detailed how retailers can expect 40% or even 50% sales commissions for the sale of an extended warranty, and how manufacturers such as Dell Inc. are bringing in literally billions of dollars in additional revenue through their sales of service plans.

The insurance industry hears about it too: how they can expect to pay out perhaps 20% of the premiums collected from consumers to honor their warranty claims. In a business where even a 70% or 60% loss ratio is impressive (especially in our disaster-prone world), the potential of a 20% loss ratio gets lots of attention.

While it's barely an exaggeration to say that everybody in retail now sells extended warranties, thanks to Wal-Mart's entrance into the market in late 2005, it's not so common among manufacturers. And while the lucrative economics of extended warranties are becoming widely-known within the insurance industry, the truth is that only four insurance carriers utterly dominate the industry.

New Service Plan Underwriter

Along comes the General Fidelity Insurance Company, a unit of the Bank of America Corp. According to Jim Mann, a senior vice president with General Fidelity, the company is a property and casualty insurance subsidiary of the Bank of America that's largely in what's called "runoff mode" in the insurance industry. That means they aren't selling too many new policies, but they still have a large number of current policies that need to be run off. And in the mean time, they have at least $650 million in surplus capital that needs to be put to good use.

Jerome Breslin, another senior vice president with GFIC, said that while there continues to be many good opportunities to invest that surplus in property and casualty reinsurance activities, the extended warranty underwriting opportunity looks even more promising. Specifically, there are lots of opportunities to underwrite service plans for smaller and mid-size manufacturers who may now be self-insuring, if they're in the business at all. There's also an opportunity to possibly underwrite the basic product warranty too, so that at least initially, the risk of failure is spread over 100% of the installed base.

Most of the extended warranty underwriting business is now handled by one of four insurance companies: Aon Corp., Assurant Inc., the American International Group Inc. (AIG), and the Great American Insurance Group, part of the American Financial Group Inc. Essentially, GFIC is making a bid to become the fifth.

Rather than simply jump into the business, however, GFIC has formed an alliance with the extended warranty experts behind the company known as Service, Administration & Financial Enterprises LLC, or SAFE LLC for short. Jim Sebastian and Randy Moudry, the partners behind SAFE, actually met while they both worked at AIG years ago, where they learned in great detail the mechanics and economics of the extended warranty business. In early 2002, the pair decided to go off on their own and form their own consultancy, dispensing extended warranty advice and insight to retailers and manufacturers.

Chance Meeting in Arizona

This alliance came together under somewhat serendipitous circumstances towards the end of 2004, when all the principals were in Scottsdale, Arizona. Moudry is based in nearby Phoenix. Sebastian, based in a suburb of Atlanta, was also in town. "[Jim Mann and] I went out to the AAMGA: the American Association of Managing General Agents annual meeting in Scottsdale two years ago," Breslin recalled. He also took a meeting with the folks from W3 Solutions Inc., to talk about an administration-underwriting deal they were working on.

"Randy and Jim weren't involved in the transaction, but they happened to be at the meeting anyway," he said. So, they got to talking, and one thing led to another, and two years later, here we are.

"It was kind of a chance meeting," Moudry remembers, "but we realized after we spoke a few times that we had a lot more in common with our approach to business. It's turned out to be a pretty good symbiotic relationship."

It's also an informal relationship, in part because of the complex negotiations that would likely be required for the B of A to make it official, and in part because Moudry and Sebastian said they prefer the autonomy that they can maintain under the current structure.

Together, GFIC and SAFE plan to help manufacturers set up extended warranty offerings that the manufacturers themselves sell and administer. GFIC does the underwriting and SAFE applies its expertise to questions such as pricing. SAFE handles all the communications between the clients and the insurance company. SAFE also handles all the legal and compliance issues, making sure the plans are legal in all 50 states.

The client usually performs the claims administration. But if the client is unable to continue administering claims for some reason, SAFE will step in and take that role over as well. Moudry said SAFE usually warehouses all the data and performs periodic audits too, so it would be able to take over administration rather quickly, if required.

Target Market: Manufacturers

"Manufacturers are our primary target, but we are also looking for prime retailers -- not necessarily the big box guys, but good solid partners. I guess a better definition [of the target market] would be people who are interested in truly partnering in all aspects of the program," he said.

When a new account presents itself, Sebastian does most of the pricing and actuarial work. "Typically, we do a full analysis of an account, which would include looking at historic data," he said. "We may even help them with the design of the terms and conditions if what they currently have is not adequate. For instance, a couple of the retail clients that we've dealt with have been extremely unhappy with what they had with other vendors. So they were looking at alternatives. One was to actually do it themselves. So when we got involved, we ended up helping them design and craft terms and conditions that better met their needs and their desires for their clients and customers. So we helped them by bringing in our knowledge base of what we'd seen that worked and what did not work."

"We go in and do a really thorough analysis of the account," Moudry added. "Unlike some other people that both Jim and I have worked with, who go in with a program first and then work backwards, we go in and try to find out what their actual wants and needs are and what their capabilities are, and then start to work up from there to build the program to their specifications."

Breslin said the big four underwriters that currently dominate the market are all known entities, for better or worst. "They carry a lot of baggage," he said. "We represent a different value proposition to the warranty administrators and the OEMs out there, in that we're never going to try to take their business from them or compete with them. We're not interested in being an administrator. We don't want to buy them."

He also suggested that manufacturers might feel more comfortable doing business with an arm of the Bank of America than they would with any of the other four potential underwriters. "They trust the name, and it would be a harder sell to get them to trust one of the others," he said.

Barriers to Entry

Historically, manufacturers have stayed out of the extended warranty business for two big reasons. First, they didn't want it to seem as if they're trying to profit by selling insurance on their own products. Imagine if surgeons sold life insurance or if weathermen sold flood insurance. While they'd probably have an unmatchable perspective on the risks, it just wouldn't seem right.

The second reason is more structural. Most manufacturers depend upon dealers, distributors, and retailers to connect them to their ultimate customers. Unfortunately for these manufacturers, their distribution channels long ago overcame their distaste for extended warranties, so these manufacturers will have to compete with their own salesmen.

Moudry pointed out that a few manufacturers continue to believe that having their own brand of extended warranties reflects badly on the company. "We just finished working with a manufacturer," he said, "and their people back in Japan caught wind of them doing an extended warranty. And their viewpoint of that was that if they offer an extended warranty, that would indicate in some way, shape, or form that they feel their product is inferior.

"Years ago that [viewpoint] was a lot more prevalent in the marketplace, especially with high-end audio people -- both dealers and manufacturers. They said their stuff was too good, and if they put an extended warranty on it, that means it isn't any good," he said. "That perception has been steadily changing to a consumer-friendly model, where you look at it like auto insurance: If your car smashes up, we're going to fix it for you. Something can happen to almost anything.

"I think the perception of the industry in general is also changing, because of folks like B of A and many other reputable companies. Like N.E.W., for example," Moudry said. "They've been around for a long time. Many of the other people in the business now are established, and unlike what you wrote about last week, there are not so many people going by the wayside. I think the auto [extended warranty] industry is almost shaken out."

Competing With Retailers

Still in the way, however, are the dealers and retailers who likely already sell their own extended warranty plans. And they not only sell them. Some utterly depend on the income they receive from extended warranty sales commissions to keep them profitable. Whether it's a passenger car or a plasma screen, it's highly possible that the seller makes more off the service plan than they do off the product. So they are unlikely to welcome new competition from their own manufacturers.

Moudry sees two good strategies for manufacturers to follow if they want to overcome this significant barrier to their entrance into the market. First, manufacturers can somehow partner with their dealers and retailers, especially in cases where those dealers and retailers don't stock that many brands of products. He said it's reassuring to customers to hear that the backers of the service plan they're offered for a well-known brand of products are the people who manufactured the product. For instance, that works very well for the auto manufacturers, who sell extended warranties through subsidiaries that partner with the franchised dealers of their brands. It also works well with outdoor power equipment, lawn & garden, and power sports equipment, he said.

Second, Moudry suggests that manufacturers look into developing some kind of "in the box" service plan that allows the consumer to sign up at any point between the time of sale and the expiration of the basic product warranty. The theory here is that after the consumer takes the product home and opens the box, away from the pressure of the selling floor, they might respond more favorably to an extended warranty offer, especially if it carries the name brand of the product they just bought.

One Year at a Time

A lot of the consumer electronics manufacturers, Moudry said, are either already doing this or will be doing it soon. Some make the offer more palatable by selling the service contracts in renewable one-year increments, for which they get surprisingly high renewal rates. While he said he couldn't be specific about attach rates or brand names, he suggested that some of the European consumer electronics manufacturers he's worked with have been very successful with this "in the box" approach. It's also worked for a Midwestern bicycle manufacturer and for a Northeastern furniture manufacturer, he added.

"I really think it's the brand name offering," Moudry said, that helps the manufacturer to make the sale. Plus, it's the ultimate in soft sell -- putting a card in the box -- in contrast to the hard sell the consumer has likely turned down at the point of sale. "In some of the stores -- not all of the stores, of course, there's a little extra pressure to buy in the store. And a lot of people react quite negatively to that."

Sebastian suggested that either approach would at the very least allow the manufacturer to keep in touch with their customers after their basic product warranty expires. "They don't have a clue," he said, about product failure rates a year or two after the warranty expires. Extended warranties and service plans would provide them with that information, not to mention the opportunity to continue having a relationship with their customers.

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