May 21, 2009

Warranty Insurance:

Properly insured and administered, an extended warranty can survive the bankruptcy of a retailer, dealer, or manufacturer. And in cases where customers doubt the survivability of a manufacturer's product warranties, insurance can reduce uncertainty and build confidence. Could this also work in Detroit?

If there's any lesson to be learned from the past eight months, it's to expect the unthinkable. At the end of March, the U.S. government announced its Warranty Commitment Program, which would back up the warranties of any domestic auto manufacturer that couldn't pay claims.

Since then, Chrysler LLC has declared bankruptcy and executives at General Motors Corp. are no longer saying a Chapter 11 reorganization is unthinkable. Potential customers are worried that the automakers won't be able to pay warranty claims. And we're beginning to worry that the federal government won't know how to.

On a vastly smaller scale, this has happened before. Manufacturers have gone out of business and taken their product warranties with them to the bottom. It's happened in the UK with computer companies. It's happening now in Australia with an appliance company. And it's happening now in the U.S. with some of the bankrupt RV companies.

Guaranteeing the Guarantee

But in at least one industry, customers have learned the value of insurance underwriting, and have come to insist that all product warranties be fully insured. That way, if the manufacturer goes out of business, they don't need the government to step in and pay claims. All they need is the phone number of the insurance company.

Back in the February 10, 2004 issue of Warranty Week, we wrote about an up-and-coming artificial turf company called FieldTurf, which was then mopping up the mess left behind by bankrupt and defunct competitors that had left cities, schools and sports teams with deteriorating artificial surfaces and no warranty coverage.

Remember how dangerous and dilapidated the artificial grass looked at some fields 15 or 20 years ago? That's because the makers of AstroTurf, and later AstroPlay, went out of business and took their warranties with them to the bottom. Careers were ended as players tripped and slipped on the seams and gaps.

Then FieldTurf came in with a superior product, an eight-year product warranty, and a third party insurance policy to back it up, just in case something happened to the company. But customers were still a bit skeptical, having been burned both literally and figuratively in the past.

Darren Gill, director of marketing at FieldTurf, said that because some notorious former competitors didn't live long enough to outlast their warranties, customers began to doubt whether making a long-term investment in an artificial surface was such a good idea. So FieldTurf began paying for a third party insurance policy, which would kick in if the company ever went out of business and could no longer pay claims.

Gill said that at first, FieldTurf was the only player in the industry that insured its warranties. But now, after absorbing the cautionary lessons of the AstroTurf collapse, savvy customers are beginning to insist on fully-insured warranties as a requirement in their initial requests for proposals. "It has become the rule rather than the exception," he said.

"But it's expensive," he added, "and I think that's one of the main issues. We have not had product failures. We have not made any claims on our warranty. So we could certainly be putting the financial resources we're putting behind the insured warranty somewhere else. We could put it straight to the bottom line. But that's not our interest. It is a significant investment, but it's one that we feel is needed. And we continue to offer it today because we believe there are significant benefits to having it, and our customers are demanding it."

Can't Name the Company

Gill said he's been with FieldTurf for eight years, and the company's practice of insuring its warranties was already two or three years old at that time. He said he's not at liberty to name the insurance carrier, but he did say that they're based in the U.S. FieldTurf is itself based in Montreal, though many of its highest-profile installations are in the U.S. The company was acquired in 2004 by the French flooring company Tarkett SAS.

FieldTurf installations are expected to last at least ten years, the first eight of which are under warranty. Gill said having a fully-insured warranty helps build customer confidence that should something happen to FieldTurf during that time, nothing will happen to their warranties.

"This is just an answer to a lot of the customer demands," he said. "We do plan on being here for the long haul, but should something happen to our company, our customers will still have that peace of mind."

Peace of mind is a term one usually hears mentioned in relation to extended warranties. Because some customers think the product warranty is too short or because they're told it's too limited in scope, some customers typically buy extended warranties to get either longer or better coverage.

Because of manufacturer bankruptcies, however, extended warranties are taking on a new role in distressed industries. For instance, numerous recreational vehicle dealers are now giving away extended warranties as a deal sweetener for nervous buyers. Several RV manufacturers are in bankruptcy, and it's doubtful if the product warranties on unsold units will ever be honored. So the dealers pay the premium on an extended warranty policy, and the customers get the peace of mind they crave.

Could such a model ever work in the passenger car industry? Could dealers ever bring themselves to spend $20 billion on a giveaway of perhaps 10 million vehicle service contracts per year? That would never work for at least two reasons. First, each dealer has grown accustomed to performing upwards of half a million dollars worth of warranty work each year, for which they're paid by the manufacturers directly. Second, the dealers have grown accustomed to selling five million service contracts per year and using some of that income to compensate for lower margins on the actual vehicles. Take away warranty work and service contract revenue and you have a money-losing dealership.

Preserving Dealer Relationships

It would be much less disruptive to keep the existing relationships intact, between the dealer and the manufacturer, and between the dealer and its customers. Manufacturers can continue to give away their product guarantees, and dealers can continue to sell better policies. What's needed is someone to guarantee the guarantee. And that's where insurance again comes into play.

What FieldTurf has done to negate the warranty worries left behind by AstroTurf is something that any specialty insurance company can help Chrysler and General Motors do for their product guarantees. The automakers are always going to be the best choice to administer the warranties, pay the claims, crunch the data, and manage the dealer relationships. But a specialty insurance company can stand behind them, making sure they have adequate reserves and are managing the risk correctly.

In the simplest terms, product warranties are like free extended warranties. They're service contracts without premiums paid by customers. As the RV dealers are now proving, one can be substituted for the other as long as someone besides the beneficiary is willing to pay the premium.

And as sad as it is to say, the extended warranty industry has lately had its own share of failures. On the automotive side, it always seems to be poorly capitalized dot-com buccaneers who take their paper with them to the bottom. But in the appliance and electronics industries, there has been a regime in place for decades that ensures that customers never lose their coverage.

In those industries, most of the service contracts are sold by retailers who work with third party administrators, who in turn are either part of or partnered with an established specialty insurance company (such as one of the four profiled in last week's newsletter).

Each of the four has had its share of failures, but Assurant Inc. has recently had the misfortune of being associated with two of the biggest: Circuit City and CompUSA. But guess what? The system works. The phone numbers may change and the method of service delivery may also change, but the customers are still getting their computers and televisions repaired under (extended) warranty.

The Value of Insurance

One never reads stories about customers avoiding a certain retailer because of fears that either warranties or service contracts will be worthless. It's just not an issue. Savvy customers understand that there are administrators and insurance companies standing behind the retailers. If anything, they're beginning to realize that an extended warranty may be even more solid than a manufacturer's product warranty, because the latter is typically uninsured.

Joe Erdeman, executive vice president of Assurant Solutions and president of the company's Extended Protection Solutions Division, said that before CompUSA decided to cease operations, the retailer acted as its own administrator. CompUSA handled most of the phone calls themselves, and provided most of the service delivery. Assurant held the reserves and provided the risk management. So when CompUSA decided to cease operations, Assurant had to start answering the phones and arranging for the repairs.

Circuit City is a similar story, Erdeman noted. "We're going to end up doing the same types of things we have done for the CompUSA customers," he said. Instead of going back to their local Circuit City locations, service contract holders will call an Assurant phone number (1-800-878-1167 for TVs and 1-800-555-4615 for everything else), and Assurant will then arrange for an alternate drop-off location or shipping instructions to return items to an authorized service center.

"We hope, from a consumer's standpoint, that they'll realize that someone was there to take care of the service contract needs, and the money they used to purchase the service contract was not wasted," Erdeman said. And that will benefit the entire industry. "We hope that also reflects well on Assurant, although most of the customers don't really know the Assurant name," he added.

The Wild West Era

In the distant past, some retailers operated their extended warranty units like most manufacturers now do with their product warranties. Any premiums paid were quickly mixed with other sales revenue, and any repair or replacement expenses came out of cash on hand. There was no separate reserve fund, no insurance, and no accruals or estimates of future costs. And that system worked as long as sales continued to soar.

Then a recession would hit, and the service contracts would vaporize as soon as the retailer was liquidated. But you don't hear about that in the electronics or appliance industries too often any more because they've cleaned up their acts, and have begun working with administrators and insurance companies that know how to price the contracts properly and how to reserve enough to pay future costs.

In recent years, when one of those retailers has gone out of business, there has always been an administrator and/or an administrator/underwriter that steps in and does the right thing, taking customer calls and making sure they get the repairs they deserve, as Assurant is now doing with CompUSA and Circuit City. Because some multi-year service contracts may have been sold right before their going-out-of-business sales began, this process is likely to continue for three, four or even five years after the retailer's liquidation.

"We think we've been able to do that pretty successfully -- to maintain customer service levels for the consumer so they continue to be confident about buying service contracts," Erdeman said. "We do the administration. We do service delivery. And we also insure the risk. So we have everything under one roof that when those types of things happen, it gives us the control over all the pieces, to be able to take care of the consumer."

Could this kind of system also work for manufacturers and their product warranties? Already, there are companies such as Service Net Solutions that work with electronics manufacturers on claims administration and direct marketing. NEW Customer Service Companies works with manufacturers that need its call center services and ability to run help lines 24 x 7. And Assurant works with a handful of manufacturers that need its assistance with risk management and handling reserves. One recent client, Erdeman said, was a manufacturer of both commercial and residential ovens.

No Driving Lessons Offered

But automotive? That's something entirely different. Assurant Solutions, The Warranty Group, Cross Country and Warrantech are among the handful of do work in both the brown and white goods industries and the automotive industries. They have a lot in common, but there are also some important differences. First of all, in the case of a malfunctioning automobile, the owner typically drives it back to the dealer to have it looked at.

In the case of a major appliance, the customer will phone in to arrange a housecall. ServiceBench, now part of NEW Customer Service Companies, has an extensive network that is used to coordinate these appointments on behalf of both manufacturers and retailers. In some cases, ServiceBench also handles the paperwork and the resulting payments to repair organizations. They even perform follow-up research such as customer satisfaction surveys.

In the case of a computer, service delivery typically begins with the owner making a phone call, asking for technical support. And in some cases, it means the administrator could ship some parts to the customer and teach them over the phone how to perform a self-repair. Imagine an automotive company trying to instruct a customer over the phone how to fix their car.

The point is, the way customers are assisted and the way products are repaired varies tremendously from one industry to another. The expertise built up around dispatch, scheduling, and technical support may not translate from one industry to the next. So would the warranty and insurance professionals now working with brown and white goods be able to make the transition into automotive?

Erdeman suspects it's possible. "We feel that the way we provide service contracts, with the backing of our A-rated insurance company, we can provide the confidence for that consumer to buy a service contract. And when they look at the buying of the car and the manufacturer's warranty they get with the car, they're looking at where that promise is coming from," he said. "Long term, there has to be a private sector solution that provides that confidence for those OEM warranties."

Unemployment Insurance for New Cars?

Interestingly, Assurant is already working with the only Detroit-based automaker that isn't under an imminent threat of bankruptcy. During an April 30 earnings call, Assurant president and CEO Craig Lemasters said that the company recently began a new partnership with Ford to underwrite and administer their Payment Protection Plan. Under terms of that promotional program, Ford will make up to 12 monthly loan payments for anyone who finances a vehicle purchased between March 31 and June 1 and who loses their job later this year through no fault of their own.

There are other programs that help workers impacted by their employer's demise. In the event of a manufacturer's bankruptcy, the Pension Benefit Guaranty Corporation stands ready to take over the administration of workers' pension plans. According to an article in today's New York Times, in the last six months, 93 companies whose pension plans are covered by the agency have filed for bankruptcy, including Chrysler, whose failure alone could cost the agency $2 billion. A GM bankruptcy would cost the agency an added $6 billion.

In the event of an insurance company's collapse, various state insurance guaranty funds have been set up to step in and take over the claims administration. Extended warranties and service contracts have always been regulated at the state level as well, typically with regulatory frameworks developed with the assistance of the Service Contract Industry Council, an industry group launched decades ago by top retailers, administrators and underwriters.

The System Works

In recent months, the SCIC has issued several press releases designed to reassure vehicle service contract buyers that their purchases are not going to become worthless because of bankruptcies. On February 19, the SCIC issued a press release entitled, "Extended warranties from bankrupt auto dealerships remain viable." And then on May 19, the SCIC issued another release entitled "Extended warranty coverage not impacted by dealership closings."

Last year, right before Circuit City went under, the SCIC fought back against some of the fear, uncertainty and doubt in the consumer electronics industry with a news release entitled "Consumers are protected when purchasing service contracts." That release pointed out that a majority of service contracts purchased from retailers that were going out of business were protected by insurance, so they would outlive the retailer that sold them.

SCIC executive director Tim Meenan said he must have talked to at least 50 reporters about those releases, explaining to them why service contracts would continue to be honored even in the event of the collapse of a manufacturer, dealership, or a retailer. In plain words, because of insurance, the system works.

"The system works because over the last 15 years, state legislatures have required financial security, registration and licensure of providers," Meenan said. "And the most popular selected method for backing a service contract is contractual liability insurance." That way, if something happens to the seller or to the administrator, there's always an insurance company ready to step in.

Insane Business Practices

"Contrast that with Crazy Eddie," Meenan said, referring to an infamous and notorious New York-area electronics retailer that was liquidated in 1989 after its founder fled the country. "When they went under, they took hundreds of thousands of service contracts down with them." Crazy Eddie sold the service contracts, administered them itself, and did not bother to secure them with insurance. And they used a pay-as-you-go system to finance repairs, if they couldn't find a plausible reason to deny a claim outright. So when they were closed, there were no reserves and therefore no money to pay claims or refund customers.

More recently, some of the smaller vehicle service contract administrators have also gone out of business, and despite their having insurance, they also took their contracts down with them. But Meenan pointed out that they usually were depending upon captive insurance companies and/or risk retention groups that turned out to be as poorly run and thinly capitalized as the administrators themselves. The answer, he suggests, is for the states to require a minimum level of capitalization from now on.

Until recently, the automakers said that bankruptcy was unthinkable because warranties would then be worthless and nobody would buy a car without a warranty. But then bankruptcy became thinkable, and the U.S. Treasury Department said it would back the warranties of any domestic manufacturer who couldn't do it themselves.

Essentially, the message now is "We're from the government, and we're here to help you with your claims administration." And rather than reassuring buyers, the new message worries them that if they buy American they might one day have to deal with a Medicaid-like federal warranty agency.

Can the government do it? Can it be done through some kind of quasi-governmental structure like Amtrak or the Postal Service? Or will the Treasury Department merely make a multi-billion dollar loan to each manufacturer, to finance a few year's worth of claims?

Collapsing Insurance Companies

Meenan said he thinks that if the worst-case scenario comes to pass, the Treasury Department would have to step in and hire an administrator and an insurance company to operate both the automaker's service contracts and product warranties. It would be a run-off process similar to what happens now at the state level when an insurance company goes under, such as when the Reliance Insurance Co. collapsed in Pennsylvania in 2001.

Possibly, he suggested, the government might even turn to a rival manufacturer for assistance with claims administration and service delivery, asking a still-solvent automaker to make its dealer service bays available for warranty work on the bankrupt rival's vehicles. But this would quickly become very complicated, potentially happening at an international level, and involving thousands of dealers/repair shops and millions of claims for perhaps as long as five years, until the very last service contract expires.

"If an auto manufacturer collapses in this country, we believe the federal government will honor both manufacturer warranties and extended warranties through expiration," Meenan said. "We honestly believe that there's just too much at risk if hundreds of thousands or even millions of Americans can't use their car to get to work because it breaks down and they can't get it repaired. So we do believe the federal government would step in with TARP-type funding in such a case. Is that the best long-term answer? No. But is it an answer? I think it is."

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