Journal of Insurance Regulation

Abstract

Extended warranties are common in the U.S. marketplace and are frequently sold as add-on products at the point of sale for an underlying asset whose performance serves as the basis of the contract. While the industry is highly profitable, it has traditionally suffered from significant negative attention in the headlines related to allegations of unfair practices. This paper addresses those issues and provides three key recommendations designed to simplify the contracts and create a more consistent regulatory structure. Those suggestions include: 1) the elimination of the situational monopoly by banning the sale of extended warranties by retailers at the point of sale; 2) the simplification and standardization of extended warranties contractual language; and 3) the enforcement of extended warranties regulation by a central authority. If implemented, those strategies would eliminate the current situational monopolies while preserving the principle of consumer sovereignty when contemplating the purchase of extended warranties. Journal of Insurance Regulation © 2014 National Association of Insurance Commissioners Introduction For more than four decades, various branches of state governments, industry lobbyists, consumer protection groups and others have wrestled with the regulation of the extended warranty (EW) industry. Despite such regulatory attention, allegations of unfair business practices and traditionally high profit margins have persisted (see, e.g., Warranty Week, 2005; Consumer Reports, 2011; Better Business Bureau, 2011). These allegations suggest that the current regulatory standards governing the EW industry are insufficient and/or inadequate in protecting the interests of the consumer. Whether by accident or possibly even by design, the EW industry exists as something of a “regulatory orphan.” While possessing several insurance-like characteristics (and generally perceived as such by consumers), EWs and their traditional system of distribution also possess some salient characteristics that inhibit regulatory and judicial authorities from recognizing them as insurance. Despite this lack of formal recognition as insurance, the regulation of the EW industry has curiously fallen to the state insurance departments. This allocation of responsibility has contributed to an environment that represents something of a regulatory quagmire. For example, insurance is regulated at the state level, and thus, lacking strong central (federal) oversight, insurance regulation varies across the states. Additionally, given the significantly differing characteristics of the various industries that sell EWs as “add-on” products (e.g., auto, electrical appliance, homes, etc.), a consistent and functional “one-size-fits-all” regulatory structure would prove challenging under the best of circumstance. Last, the regulation of the EW industry has essentially fallen to the state insurance departments by default, and despite what might constitute a “best effort” on the part of state insurance regulators, the existing conditions conspire in creating an insufficient regulatory response. Several recent events may provide some guidance in addressing the concerns related to the EW industry. For example, the experience of the United Kingdom’s foray into the regulation of its electronic appliance industry’s sale of add-on insurance products, including EWs, provides some insight as to potential regulatory solutions. Additionally, the creation of the Bureau of Consumer Financial Protection (CFPB) and its demonstrated interest in the activities of the auto EW industry suggests that the federal government may be willing to encroach into what has traditionally been a state-level regulatory issue. Thus, the responsibility for the regulation of the EW industry in the U.S. would once again seem to be in question. 1. Sponsored by major warranty and service contract companies, Warranty Week (www.warrantyweek.com) is an online newsletter and website intended for warranty professionals. 2. An “add-on” sale is the sale of additional goods or services to a buyer. Its purchase is often suggested by the retailer once the customer has made a decision to buy an underlying asset or service. 2 Extended Warranties in the U.S. Marketplace © 2014 National Association of Insurance Commissioners In light of these recent events and the general state of regulatory affairs in the U.S. EW marketplace, we revisit the issue and develop three specific recommendations that have the potential to mitigate a number of the current negative externalities. This current research differentiates itself from earlier related research on the subject by assuming a distinctly comparative approach that assesses EW regulation in light of existing insurance regulation. Additionally, this research updates and brings into focus the current state of affairs with respect to the regulation of EWs. These findings will be of interest to a broad audience, including: regulators, legislators, consumer protection agencies, public media, EW industry associations, providers of EWs and consumers. In the next section of the paper, we provide a brief overview of the scope and operations of the EW marketplace in the U.S. Subsequently, we turn our attention to the regulation of the industry and identify aspects of market operations that have been found to be particularly vexing. Our focus then shifts to what regulation might accomplish in light of recent related endeavors and shifts in the U.S. regulatory environment; that is, what kind of regulation might actually be feasible and functional in the current environment? We close the paper with a summary of the general findings and their implications. Extended Warranties Background EWs, also sometimes referred to as extended service plans or contracts, are different from other kinds of warranties. An EW is a contract or agreement for a separately stated consideration and/or for a specific duration that obligates one party (the obligor) to perform/provide specific remedies. Such remedies may include the: repair, replacement or maintenance of property or indemnification for repair, replacement or maintenance, for the operational or structural failure due to a defect in materials, workmanship or normal wear and tear, with or without additional provision for incidental payment of indemnity under limited circumstances. EWs are most commonly sold as add-on products in conjunction with the purchase of an underlying asset that serves as the subject of the warranty agreement. By far, most EW sales are conducted at the point of sale of the 3. For example, manufacturer warranties are considered part and parcel of the initial asset purchase itself, whereas EWs are viewed as distinctly separate transactions. EWs are also to be differentiated from “service maintenance contracts.” The latter are contracts where, for a fixed fee, the obligor of the contract agrees to provide regularly scheduled maintenance/service on the asset that is the subject of the EW. 3 Journal of Insurance Regulation © 2014 National Association of Insurance Commissioners underlying asset within the context of a situational monopoly. 4 In situational monopolies, a seller renders its competition irrelevant. The sale of EWs is most commonly associated with a number of industries, including: auto original equipment manufacturers (OEM), auto parts, aerospace, computers, telecom equipment, semiconductors and PCB, consumer electronics, medical and science equipment, data storage, peripherals, appliance and HVAC, homebuilders, building materials, and power generators (Warranty Week, 2013). Of those industries, auto OEM and computer manufacturers represent more than half of the market EWs (based on claims paid in 2012). Thus, while the general character of the EW contract shares many features across a number of industries, the character of the underlying asset that serves as the basis for the contract and the distribution system employed to actually sell the product may differ significantly. As a result, creating a fully functional “one-size-fits-all” regulatory model stands as a unique challenge. The consumer demand for EWs is significant, and the business is highly profitable. According to Warranty Week, the appliance industry alone sold more than 250 million EWs in 2010, and automotive EWs generated almost as much revenue for auto dealers, administrators and insurance companies as factory warranties consumed. Warranty Week (2012) estimates the 2010 revenue of some 109 EW administrators (distributors) to be $11.2 billion at the contract sales level and the revenues of their 32 underwriters (insurers) to be close to $2.9 billion. Warranty Week (2005) reports that although EWs typically represent approximately 3% to 4% of total sales in the electronic appliance industry, those contracts might simultaneously represent as much as 30% to 40% of total retailer profits. Given the significant profit margins typically associated with the sale of EWs, the motive for retailers to promote the purchase of EWs is obvious. Less obvious is the true value of EWs to unsophisticated consumers who represent targets for those selling EWs. Of particular interest are the findings that those least capable of managing their finances and those most financially disadvantaged are most likely to purchase EWs (Huysentruyt and Read [2010] and Chen, Kalra, and Sun [2009], respectively). More broadly, consumers in general demonstrate a poor understanding as to the coverages provided in a typical EW and often confuse those coverages with what might be provided in more familiar homeowner and 4 . Although less common, other scenarios are also possible. For example, some EW offerings will subsequently arrive via direct mail soon after the purchase of an asset is made. Alternatively, other marketing contacts may be made at some distant point in the future; e.g., when the manufacturer warranty of the asset is soon to expire. 5 . For a deeper