Monday, February 26, 2024

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Manufacturers gravitating towards captives to write extended warranty


  • Extended warranty generally more profitable than traditional P&C lines
  • Bermuda, Cayman, Vermont and Hawaii popular domiciles for extended warranty
  • Less risky that P&C lines but companies must still carefully assess exposures
  • Often fronted as domiciles have different rules on third-party risk

Companies are increasingly leaning towards utilising captives to write extended warranty coverages.

A warranty is an insurance policy which guarantees products will be repaired or replaced if the item is faulty or broken.

Once the warranty has expired, an extended warranty policy will cover the customer for mechanical or electrical breakdown, and for things like accidental damage.

Captives often use fronting carriers to help issue extended warranty programmes as different jurisdictions tend to have disparate regulation around third-party risk.



Extended warranty is usually more profitable than more traditional property and casualty lines, has a lower loss ratio, and can help diversify a captive’s portfolio.

Utilising a captive to (re)insure extended warranty is often a secondary consideration for a captive after beginning with more traditional risks, although some are established primarily for that purpose.

“If I am the risk manager of a large group, I am likely to be in a situation where the first difficulty for me will be to find a good market for property or liability, and this is a main motivation,” Paris-based Etienne De Varax, head of the centre of excellence for risk finance solutions at HDI Global SE, told Captive Intelligence.

“Once we have reached something which is sizable and understood by the chief finance officer, then we may have a chance to open a different dialogue around something like extended warranty.”

Bermuda, Cayman, Vermont, and Hawaii are considered popular domiciles for extended warranty business.

“Hawaii is very comfortable with third-party business reinsured by a captive, and Vermont also allows it,” said Michael Serricchio, Americas consulting leader at Marsh Captive Solutions.

Around 27% of Marsh-managed captive premium provides coverage for third-party risks, according to the broker’s 2023 Captive Landscape Report.

Jimmy Bynum, CEO and founder at Garde Solutions, told Captive Intelligence there are three ways a manufacturer can manage its extended warranty programme.

“A company can leave the risk on its balance sheet, buy insurance from a third-party insurance company, or set up a captive and do it themselves,” he said.

Garde Solutions partners with manufacturers in the commercial heavy equipment industry to create extended protection plans.

Bynum said captives typically make most sense for manufacturers and large dealers.

“In our work, manufacturers and dealers that use a third party warranty provider switch to self-insurance,” he explained.

“They switched when they quantified the frictional costs, customer irritation with denied claims, lack of data transparency, and the significant profits the third party makes.

“Comparing the costs and values of the end customer versus that of the third party is often all it takes to make that decision.”

Bynum said he has worked with one company who has set up a captive just for its service contract risk, “and that’s with a large dealership”.

“It has evolved into enterprise risk and a loss damage waiver programme for their rental operations,” he said.

Adriana Scherzinger, head of alternative risk solutions at Zurich, said manufacturers of cars, mobile phones and appliances are especially likely to “gravitate” towards using their captives for extended warranty.

“Manufacturers know what goes into making their products, and writing extended warranty coverage in their captive is a way of betting on themselves and the quality of the products they make,” she said.

We are now seeing a greater variety of companies utilising their captives to write extended warranty.

“We may have a risk purchasing group, or we may have a large power and utility company that has millions of customers asking how they can use a captive as a profit centre with third party business that helps their customers and the captive,” Serricchio said.

He added that extended warranty used to be purchased at the point of sale, but is now sometimes “more innovative and sophisticated”.

Using captives for extended warranty coverage is a growing trend in part because it is usually profitable and can offset losses from more capricious property and casualty risks.

“If the quality is high, writing extended warranty coverage in the captive can be quite profitable,” Scherzinger said.

“Many companies want to retain as much of this risk as possible for this reason.”

Extended warranty also helps diversify the portfolio within a captive.

“In terms of diversification and capital, it’s very efficient to house affinity business within a captive and it transforms the captive from an optimised cost centre into a profit centre,” Eric Joly-Puttuz, deputy head of HDI’s centre of excellence, told Captive Intelligence.

Bynum said that for those companies that already have a captive for risks such as general liability, workers compensation, auto liability, and property “I think we will see some of those companies move their extended service contract liabilities and add that to their current captive model”.

If a company is well-equipped with the right data, extended warranty should be stable and predictable business for the captive.

“If a client has that, they should have an opportunity to generate income from their customers,” De Varax said.

Serricchio said the general rule is that third-party extended warranty is “good for the customer, it’s good for the captive” and likely has a low loss ratio ranging from 20% to 60%.

“It helps the captive grow their capital base, it helps the captive diversify themselves, and it allows a captive to do more,” he added. “Most of the time it is very, very successful.”

Manufacturing and agricultural equipment giant, John Deere, is a good example of a captive that started by insuring extended warranty products, but has since expanded to provide more corporate lines to the group.

Established in Vermont in 2004, John Deere Indemnity now writes lines including casualty, some of the group’s property deductible, product liability and trade credit as well as accessing the US government’s Terrorism Risk Insurance Program, commonly referred to as TRIA.

“In the past four years I’ve been involved, we have actually doubled our written premium, we’ve grown our extended warranty portfolio, we’ve added some product liability coverage, property deductible, trade credit,” Aileen Krehbiel, manager of captive insurance programs at John Deere, said while speaking on the Global Captive Podcast earlier this year.

Krehbiel said getting the structure correct for extended warranty is key, while pricing is an area that also needs a lot of consideration.

John Deere has a C Corporation (C Corp) warranty company that writes the product as a service contract with the captive then reinsuring a portion of the risk.

“On average I would say our extended warranty contract length is around four to five years,” Krehbiel said.

Pricing is very important because a company does not understand if it is profitable or not until a “way down the road”.

“Making sure you’re analysing data, understanding what your expected claims will be and that you’re pricing appropriately,” she added.

Challenges

Although often more profitable and predictable than other lines, there remains challenges to be considered when writing extended warranty in a captive.

“Extended warranty risks can be challenging to assess accurately, and captive owners need to have a solid understanding of the underlying exposures to manage them effectively,” Scherzinger said.

De Varax said that when it comes to extended warranty or any type of affinity business, it is often more difficult to write than property and casualty because the company needs to “create a product”.

“To create a product, it means that for the sponsor, they need to align people who are going to be on the marketing side with people who are going to be more on the insurance side,” he explained.

He added it has consistently been a challenge to bring these people together and arrive at a “common understanding”.

“It’s already difficult when we want to have an insurance company involved, but when we talk about using a captive it is even more complicated,” he said.

Bynum said the biggest challenge is sometimes getting the risk manager, the chief financial officer, and the leadership team to understand the true structure, value and benefits of a captive.

“So really understanding the business proposition of why taking management of that risk is a good strategy,” he said.

Different countries have different extended warranty rules, regulations and processes, and companies need to make sure they are compliant in each country.

“Captives must comply with insurance regulations, and extended warranty products may have specific regulatory requirements that need to be navigated,” Scherzinger said.

Fronting

It is common for captives writing third party extended warranty to use a fronting carrier to help ensure they do not fall foul of each jurisdiction’s regulations around writing third party business.

“It’s always fronted if it involves an accidental component, so breakage or stolen, for example,” Serricchio said.

He also said there are situations where a manufacturer can offer an extended warranty directly.

“But there’s a lot of different hoops they must jump through and a lot of regulations, so it is best practice to have it fronted.”

Fronting carriers will be on hand offer administrative support, handling policy issuance, claims processing as well as other operational needs.

“They may help at points of sale, with how you handle policy issuance and how it’s processed,” Scherzinger said.

“Captives need carriers’ paper and can benefit from carrier support and flexibility on other needs.”

Scherzinger said the agreement between a captive and a fronting carrier is usually a long-term quota-share agreement, which can be as long as 10 years.

“Each year the carrier may cede more of the risk to the captive,” Scherzinger said.

“What’s driving this trend is a desire for more control, cost efficiency and customisation on the customer side.”