March 28, 2006

Extended Warranty Advice:

An industry expert tells retailers and manufacturers how to get more value from their extended warranty data, possibly helping them to decide what to sell and how to price it based on how much it costs to repair.

One of the most notable attributes of the Warranty Chain Management Conference held recently in Las Vegas was how the agenda so nimbly shifted from product warranty to extended warranty and back again. And it's not as if manufacturers are interested only in product warranty issues and retailers care only about extended warranties. Increasingly, one is being seen as an extension of the other.

Paul Swenson, president of the Fulcrum Warranty Solutions unit of Fulcrum Analytics Inc., closed out the first day of the WCM conference with a call for manufacturers to take a long hard look at extended warranties.

"First of all, if you don't have an extended service program, start one," he said. "Second, if you already have an ESP program, then take it to the next level for both customer loyalty and satisfaction."

Swenson, who managed Circuit City Stores' extended warranty program for ten years, followed by three years at the helm of Aon Innovative Solutions, is now in the business of advising and consulting with both retailers and manufacturers about their extended warranty programs. In fact, before joining Fulcrum in late 2005, he said he was a client of Fulcrum for nine years, so he was already well-acquainted with what they have to offer.

Being Good Isn't Good Enough

Overall, his message to retailers and manufacturers is that being good is no longer good enough. Those who offer service plans now must strive for greatness, because everybody else is good. "We all work for companies that have high expectations. We might have had a tremendous year in 2005, but that doesn't matter any more, because we have to find ways to continue to improve revenue, profits, and margins," he said.

"An interesting thing happened to many companies along the way, and that is extended service programs have become a significant contributor to all those goals," Swenson added. "In fact, there are a lot of companies out there in both the retail and manufacturing segments for which this is their profitability. And that's a problem, because now it's in the base.

"So what am I going to do in 2006 to increase my profitability in those areas? Traditional extended service programs are good in many ways, but like dialup Internet services, there has to be a better way."

Swenson said most service plans sold by manufacturers and retailers deliver good service to the customer and substantial profits to the company. However, he said this is something of a problem, because so do the service plans offered by many other competitors. The problem is how to differentiate one good plan from all the others. How can you take profitability and customer satisfaction to the next level? How can you continue to top last year's results?

Boosting Attachment Rates

Traditionally, there have been three ways: increase the attachment rate (the percentage of products sold with extended warranties), increase the number of units sold (with a constant attachment rate), or increase the renewal rate for expiring plans.

"But there are other ways to increase profitability too," Swenson said. For instance, a manufacturer may rely on Web sales in the aftermarket, or may telemarket to customers whose basic product warranties are about to expire. Swenson suggested ways for manufacturers to get more out of the data they already collect.

Swenson suggested that companies offering ESP programs should make sure they know everything their insurance underwriters know about risk. Some programs may have been started eight or ten years ago when not a lot was known about risks or failure rates, so the underwriter may have insisted on an extra safety margin. But now there's a wealth of data on those metrics, with less guesswork, and therefore less of a need for a safety margin. However, if this data is in the hands of just the underwriter, it doesn't benefit the companies selling the ESP programs.

"At Fulcrum, when we go in and take a look at the risk and underwriting opportunities, and the way they're structured, we usually find about ten points of profit that we can drive back into the retailer or manufacturer. And at the same time, the underwriter is satisfied, because they know they have a long-term client and some stability," Swenson said.

Another item worth exploring is what happens to the investment income on unearned premiums. Swenson said that at the very least, retailers and manufacturers should find out how much money is being made off investments while the premiums are sitting in the bank. Potentially, they could also ask for a share of that income. But first they have to know what the underwriter knows.

"That can add stability to the program," he said, "when the underwriter and the retailer or the manufacturer are working hand in hand. They all know what everybody else knows. Then the wealth of information you get from that is incredible."

Swenson illustrated his point with an example of how an underwriter and a retailer can take a deep dive into loss cost data for big screen televisions. By exchanging information about which brands and models fail the least and the most, they can adjust the price of service plans up or down by particular brand or model, rather than simply using some crude scale based on the purchase price of the product alone.

Deciding What to Sell

It also could help a retailer decide which brands to stock, based not only on how likely customers are to buy service plans, but how likely those service plans are to be used. In other words, it's not only how much profit can be derived from the sale of the product, but also from the sale of the extended service plan. And that depends on not only the price paid by the consumer, but also the likelihood of repairs down the road.

"I will tell you as a [former] retailer," Swenson said, "I found significant advantages in having that kind of information, and I used it not only in my ESP program -- optimizing my ESP prices, terms, and tiers -- but also in going back to my merchandising group to help them understand which one of brands were the 'bad boys.' And it's extremely powerful information. It was incredible."

Further up the warranty chain, manufacturers can use that loss cost information in their supplier recovery efforts, demonstrating to parts suppliers how their defects caused claims to rise and therefore profits to fall for a given extended warranty program. Or, at the very least, it can help a manufacturer justify switching to another supplier, even if the cost per part is slightly higher, because in the long run the total cost of service is lower.

Building Shareholder Loyalty

There are at least two types of loyalty, Swenson added. The one most frequently cited is customer loyalty, for obvious reasons. Without customers there is no business. But there's another type of loyalty, namely between a company and its stockholders. And they're the ones who are more likely to demand better and better results every year. So profitability is what drives shareholder loyalty.

Swenson then showed the group a list of 12 different "foundation blocks" that will help a service plan provider deliver value. Most of the items on his list were obvious and well-known such as training and accounting, Swenson said, but a couple are less heavily exploited than others.

"At Fulcrum, we have tool sets for each one of those that do a complete assessment in each of those foundation blocks areas," he said. "And then we look for opportunities inside of each of those areas, and those tool sets will give us a range of additional profitability that can be expected, so then we can work with our partner to prioritize."

Swenson then listed numerous reasons why people traditionally buy extended service contracts: their perception of high failure rates and/or high repair costs, convenience, peace of mind, and trust in the manufacturer and/or the retailer. To that list he added some new and emerging reasons: accidental damage protection, technical assistance, installation advice, and access to discounts and other member-only club benefits.

Accidental Damage Protection

Accidental damage protection, Swenson said, is becoming one of the hottest new add-ons for extended warranty plans. But it's not so simple. Because ADP covers accidents and not just manufacturing flaws, it's less like a warranty and more like insurance. In some states, that means it can be sold only by licensed insurance agents -- not the traditional cashiers, salespeople, and call center staff members.

The best way to get around this is to chop the plan into pieces -- to let the traditional staff sell the traditional extended warranties, and then point the customer to the licensed staff for the ADP. Sometimes, that means the customer has to call a special (800) number to hear about the ADP portion of the plan, because the cashier or the salesperson isn't properly licensed and can't even discuss it.

"Some examples would be laptop computers or camcorders," Swenson said. "There are retailers and manufacturers that are now offering coverage with or without accidental damage protection, which is insurance in a number of states. And so they've found different ways to market it in the non-insurance states and they've also found ways to market it with licensed agents in the insurance states."

The technical assistance and installation advice services are particularly relevant in the computer sector of the extended warranty business, but are increasingly becoming important at the cutting edge of the home entertainment electronics business, Swenson said. Customers installing home theater systems, high-definition television, satellite systems, and digital video recorders may occasionally have questions that have nothing to do with product failures or repairs, but have everything to do with customer satisfaction and loyalty. In fact, knowing that there's somebody who can advise them is an important reason they buy the service plans in the first place.

"Then there is a segment of customers who want value from their extended service plan now," Swenson said. "They don't want to have to wait for something bad to happen. Hence, they want to feel like their loyalty is being recognized now. And so they want to be a member of a kind of club, or to receive discounts."

Rewarding Customer Loyalty

He suggested the creation of a customer contact strategy that recognizes this loyalty in some way. For instance, perhaps there are relevant parts or accessories that can be offered to the customer at a discount. Perhaps there are filters or other consumables or supplies that could be discounted for the most loyal customers of all: those who bought both the product and the service plan.

Swenson said that over the years he must have attended at least 120 different focus groups, during which consumers were probed about their service plan buying habits. The conclusion he sees drawn from these studies again and again is that most consumers will consider the purchase of a service plan if they're asked. Of that group, 8% to 10% will buy a service plan virtually every time, if asked. With certain product types that are heavy on new technologies, attachment rates are extraordinarily high -- up in the 60% to 70% range. And for certain products and brands, renewal rates are also surprisingly high -- sometimes over 80%.

"At Fulcrum, we work with a number of clients in the aftermarket renewal business," Swenson said. "And we have some attachment rates in renewals in the 80s. It's incredible, because these customers want the peace of mind, and they want the convenience."

More than anything, Swenson cautioned, companies thinking about entering the service plan business have to make sure they're setting their prices right, given the size of the expected repair bills. He took the audience through a mathematical exercise, first asking the group how much the bulbs in new LCD and DLP video projectors cost. They guessed correctly, more or less, with a pick of $250. Then Swenson added the cost of rolling a truck to install a new bulb, bringing the cost of such a repair up to a $400 average.

He figured that half the bulbs will make it past three years, and half will not. That's just their normal lifecycle. Therefore, one could predict that the average cost for a service plan that covers bulbs will be around $200 per unit.

"The day that customer walks out the door with that television and that ESP, I've got a $200 loss cost," he said. If these sorts of assumptions aren't built into the price of the service plan, it's likely to become a money-loser in the long run. In fact, he said, some companies offer discount service plans that don't cover bulb replacements, precisely so they can avoid losing money on the offer.

Letter to the Editor

The following letter was received from Donald Easter,
a plaintiff's attorney based in Oklahoma City who took
exception to the opinions expressed in last week's
newsletter by warranty attorney Jonathan Friedman.

I am responding to the article by Jonathan Friedman, published March 21, 2006. I take issue with some of Mr. Friedman�s statements as well as with his suggested ways to cut legal costs for manufacturers. My comments are intended to apply only to breach of warranty litigation, and not to products liability cases.

As a plaintiff�s attorney whose practice is primarily focused on warranty litigation, I have sued manufacturers and dealers of motor vehicles, manufactured homes, recreational vehicles, boats and motors on an almost daily basis for the last 15 years. The litigation in which I am involved deals with both consumer and commercial clients.

I am, I suppose, what Mr. Freidman would term a "warranty mill." In Mr. Friedman�s opinion, I am a lawyer who "preys on disgruntled customers." In my experience, the manufacturers and their dealers invite litigation not only by their own acts and omissions but also by reason of the systems they utilize to process customer complaints.

In 99% of my cases, clients feel that it is necessary to hire a lawyer only as a last resort. I estimate that 80% of my clients have never dealt with a lawyer prior to their car problems, and most had not engaged in litigation other than possibly a divorce. It appears to me that they are as reluctant to contact a lawyer about their warranty problem as they were to hassle with the dealer in the bargaining for a new car!

Cost of Doing Business

Lawsuits and legal expenses are a cost of doing business, just like calculating the anticipated costs of warranty repairs for next year�s model. If you are going to promise to repair your product and you fail to do so within a reasonable number of attempts, then why shouldn�t you be liable to the buyer?

The trick to cutting your legal costs is to be able to spot the problems and deal with them quickly and fairly as often as possible with in-house personnel, thereby avoiding lawsuits and the costs associated with them.

Blaming plaintiff�s lawyers for industry ills and shortcomings is nothing new, especially for the defense bar. In truth, the defense bar sends Christmas cards to plaintiff�s lawyers because it is plaintiff�s lawyers that keep defense lawyers in beans.

Manufacturers, you don�t need to blame plaintiff�s lawyers, Congress or the legislature for your legal defense fees. You need to blame yourselves, because if Mr. Friedman�s information is correct, you�re evidently paying way too much for legal defense of express warranty cases. The truth is that excessive legal defense costs are within your ability to solve.

There is no reason why a simple warranty case involving a $15,000.00 car should ever cost $8,000.00 in defense fees, provided the client has any concept of reality. If you paid $8000.00 to defend a $15,000.00 warranty case for a $15,000.00 car, you need to audit the bills you received from your attorney and get a second opinion next time such a lawsuit presents itself.

In a recent case I tried, defense counsel for one of the Big Three automakers asked the jury if anyone thought they should get a perfect car when they purchased a new car. All 12 jurors raised their hands without hesitation. That response is pretty typical. Faced with that kind of public opinion, just how successful do you expect to be in any case where the plaintiff has a stack of repair orders and an expert witness to demonstrate that the product is defective?

Manufacturers have options. You can replace the product, repurchase the product, or provided a trade assist that would have taken the consumer out of the product. The manufacturer can cut its legal costs and avoid incurring legal fees and the time and effort that its staff is required to spend dealing with lawsuits. Paying defense lawyers to try consumer warranty cases when there is a significant history of repairs or failures is not very smart.

Arbitration of Express Warranty Cases

Mr. Friedman suggests that you consider arbitration as an alternative to traditional litigation in express warranty cases. In my experience the economics of modern arbitration does not lend itself to saving money. Here is why:

  1. There is a cost to you to participate in the arbitration, whereas in the typical lawsuit the plaintiff paid the court costs;

  2. There is the cost of the arbitrator, or worse yet, an arbitration panel. Basically, you are paying one to three attorneys $200.00 an hour to hear your case, whereas in a traditional system the judge is paid by the state and the jury, who doesn�t get paid at all, provide the same services as those highly paid arbitrators;

  3. In arbitration you�ll pay additional sums for most every motion, every letter, and the decision if you want to have a decision you can appeal;

  4. Most of the dealer alternative dispute resolution clauses that I encounter require use of the federal rules of evidence and civil procedure in arbitration. Where is the savings?

  5. Discovery will be required in arbitration just as in the traditional setting.

Arbitration is no longer a simpler and less expensive alternative to litigation. It has become a more expensive forum for litigation dedicated to providing income for those who are employed by it. It may or may not be any quicker to complete a case in arbitration. The decision you receive in arbitration will be made by an arbitrator(s) chosen from a list of lawyers who may or may not be qualified to make the decision and who may be motivated by the thought of being rehired for the next arbitration.

The only time I suggest that the manufacturer use arbitration is when the possibility of punitive damages is present. I find arbitrators less likely than juries to give large punitive damage awards, so that the additional expense of arbitration is justified.

In cases where a binding arbitration agreement is present, I have suggested to defense counsel that instead of arbitrating, let�s agree to try the case non-jury. It eliminates the costs of arbitration. It provides a low-cost, well-educated, and experienced trier of fact. It gets the case tried in a much more timely manner. Everyone is assured that discovery will complete. Appeal, if necessary, has a better record to work from.

Shortening the Warranty and/or Trickery

Last but not least, Mr. Friedman�s suggestions about how to avoid your warranty obligations by making warranty registration a race to the post office is exactly the kind of approach that will increase his income and your litigation expenses.

The only sure way to cut your litigation costs is to get the defense lawyer out of your system by making sound economic decisions before a lawsuit becomes a reality. Cap the cost of attorney fees to a defense counsel for preparation and trial of an express warranty case. Allow for exceptions where a case requires more effort and time.

Before Daimler arrived at Chrysler, the carmaker's warranty litigation division was staffed with courteous and experienced in-house attorneys. They knew how to value a case and I respected their opinions. I settled about 90% of the cases I presented to them. My clients were pleased, and Chrysler saved money.

I do not mean to imply that defense lawyers are not necessary or worth what they charge. There will always be those cases that need to be tried and a good experienced defense counsel is required.

I do mean to imply that manufacturers and their dealers are their own worst enemies. Take care of the customer by timely repairing or replacing the defective product and he won�t be hiring a lawyer. You have the ability and the means to cut your litigation costs by making sound business decisions and without resorting to trickery or deception. Spend the money you are now spending on defense counsels to satisfy your customers. Your customer satisfaction and sales might just increase!

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