Changing Warranty Terms: Impact on Service Contracts

In the last five years, manufacturers have generally increased warranty terms on vehicles sold, even though a few have recently scaled back or reverted to the former terms.

If you sell new or extended eligibility coverage, this change will impact your business in several different ways.

First, and most obviously, it will lower the costs for the same service contract for the same vehicle. Some claims that were previously covered by the service contract will now be covered under the manufacturer’s warranty. However, increases in repair costs and repair frequency might reduce or eliminate any gains from the longer warranty.

Second, while the claims would be projected to be lower in total, the claims that do occur will, on average, occur later in the contract period. Therefore, the revenue should be recognized, or premium earned, more slowly than in the past.

What changed?

As the table below shows, manufacturers have not been shy about changing the components of the warranty. At mid-decade, most of the major manufacturers (with the notable exception of Toyota) began to increase the terms of the warranty. In most cases, the powertrain component was increased with the basic warranty remaining the same. Most of the changes occurred between 2005 and 2007.

In the last year, some of the manufacturers have changed course and reduced the coverage. For example, Chrysler has eliminated the lifetime powertrain warranty and replaced it with a more traditional 5-year/100,000-mile warranty.

What Is the Impact?

For an administrator, the additional claims covered by the manufacturers are welcome news. Whether this will actually translate into lower costs is debatable – increases in labor rates, electrical components and other factors may more than eliminate any savings from increasing manufacturers’ warranties.

In addition, the increase in warranty terms reduces the "value perception" of a service contract. For administrators, this may mean seeking ways of adding additional coverage and value during the period when the contract is under warranty. Having features of the product that can be used immediately can increase the value perception to the consumer.

Unfortunately, there are no easy answers in addressing the impact of the additional coverage without a detailed analysis of actual claims.

The increase in powertrain coverage will not eliminate claims equally by make – since some makes will have proportionally more claims in the powertrain portion than other makes.

For example, Honda increased the manufacturer’s warranty from a 3/36 "bumper-to-bumper" warranty to a 3/36 "bumper-to-bumper" and a 4/50 "powertrain."

To calculate the impact of this change, we made assumptions that are general in nature and may not be appropriate for a specific book of business. The assumptions are that powertrain costs are 50 percent of total service contract costs and “extra services” during the full manufacturer’s warranty cover about 5 percent of the total cost.

In addition, we assumed claims would increase by 10 percent a year as the car ages. Finally, we assumed the contract holder would drive on average 15,000 miles per year, with some driving as few as 8,400 miles per year and others driving 21,000 miles per year at most.

Note that the reduction in costs is only a rough estimate due to the increase in warranty terms; it would be offset by any increases due to new technologies or more expensive repairs.

Mazda is an interesting case. In 2007, warranty terms changed from a 4/50 "bumper-to-bumper" warranty to a 3/36 "bumper-to-bumper" and a 5/60 "powertrain." Is this an increase or a decrease in coverage? Using the assumptions above, we calculate that the cost of a service contract under the new plan is actually 18% higher.

Earnings are also included under a "Reverse Rule-of-78s" method. This method is often used for earning new car vehicles. It uses a sum-of-the-digits method and the earnings are in proportion to the month. For example, for a 12-month contract in month 3, the earnings would be (1+2+3)/ (1+2+3+4+5+6+7+8+9+10+11+12) or 6/78 or 7.7%. So in month 3, a total of 7.7 percent would be earned.

While this method is easy to implement, it only does a fair job of approximating earnings. It tends to earn too fast early in the contract when there is very little exposure due the manufacturer’s warranty.

At the end of the contract, it earns too slow because many vehicles will "mile out" and expire the coverage before the end of the term. For example, if a contract holder with a 6-year/72,000-mile contract reaches 72,000 miles in year 5, the contract is completely earned at this point.

More interesting are the hypothetical earned experience curves. While the examples above are hypothetical, it does show that earnings will slow to some degree under increasing manufacturers’ warranties.

Of course, a detailed analysis of the specific factors in your book would be necessary to quantify the impact of a change in the manufacturer’s warranty.

Extended eligibility is another concern for a couple of reasons. First, these vehicles will show significantly different earnings patterns because the expiration of the manufacturer’s warranty will occur sooner. Also, the manufacturer may extend the warranty on these vehicles.

Conclusion

It is important for administrators to know both the underlying cost and the correct earnings rate of their book of business.

Since it is much cheaper to "spice up" a manufacturer’s warranty than redesign a vehicle, we will likely see even more changes to manufacturers’ warranties in the future.

Administrators need to be prepared to understand the impact of these changes on their service contract offerings. In addition, the most successful administrators will likely add new features to the service contract to continue to make it attractive for consumers.

We would like to thank Bill Daley with CareGard Warranty for his assistance on this article.