When an administrator develops a new product, the actuary must simultaneously find a price that will be competitive in the marketplace, incentivize production and provide enough funds to settle all the claims.
While all these concerns are critical, it is paramount to ensure that a product generates enough revenue to settle all expected claims. In analyzing a new program, an administrator or actuary may look to similar claims data from other programs to develop an indication of the overall claims costs.
Unfortunately, past experience may not be indicative of future costs if the distribution or marketing of the product changes significantly. In general, we have found that there are two critical elements that are generally outside the realm of historical data that can influence claims:
- How is the product sold and how much did the consumer pay for it?
- What information does the consumer know about the product?
Before we answer these questions, it may be worthwhile to note a simple (if not widely reported) fact: the failure rate on most products is much higher than the claims rate on an associated service contract.
Many potential claims go unreported because either the consumer does not know he or she has a service contract or forgets about it. Additionally, the benefit of fixing or replacing an item may surpass the difficulty of obtaining service.
There is no reliable way to measure these phenomena, as these potential claims remain invisible in our databases. However, we do know that engineering studies of products will indicate higher failure rates than actual service contract claim rates.
How Is the Product Sold and How Is the Consumer Paying for It?
The cost of a service contract to the consumer can range from free to several thousand dollars. Some examples of a free service contract are an extended warranty for a product purchased with a credit card and a road hazard program that is automatically included in the cost of a new tire. A free product will typically have a low awareness rate among consumers. For example, a typical credit card program will not notify you of coverage when you make an eligible purchase.
When a consumer pays for a service contract, there is increased awareness, as he or she made an intentional decision to purchase additional coverage. All else equal, a higher price will create more awareness, which, in turn, will lead to more claims.
A variable with a greater impact on the claims rate than price is self selection, or in insurance lingo, “adverse selection.” For example, recent discussions of health insurance have focused on adverse selection as a continuing issue in the insurance market – the sickest consumers will seek insurance while healthy people may choose to go uninsured.
For service contracts, the price of the product will impact the sales or penetration rate. As the price of the contract moves higher, reasonable consumers will make the trade-off between risking a breakdown and purchasing a service contract.
For example, consider a customer who drives over rough terrain or off-road and who has had tire punctures in the past. This consumer will likely have a higher price point for purchasing a tire and wheel product. So as the price of the product increases, the consumers who purchase the product will be the ones most likely to have claims.
Another example is “refund programs,” which may refund all or part of the service contract price after expiration if there are no claims. One may look at historical data on other programs and find that few consumers held contracts to expiration with no claims, leading to a belief that these types of refunds will be rare. However, with a refund program, consumers will change their behavior and avoid submitting low cost claims in order to qualify for a refund. Historical data on the number of contracts without claims on a non-refund program is of virtually no help in pricing a refund program.
How Much Does the Consumer Know?
A related concept to the impact of price is how much the consumer knows about the product. This is an especially acute problem in the sale of vehicle service contracts long after the purchase date of the vehicle, known as extended eligibility contracts. The consumer is in the best position to know the mechanical condition of the vehicle and will be more likely to purchase a contract if the vehicle has exhibited a history of problems.
Additionally, some consumer will seek to utilize an extended eligibility service contract for existing problems. Even though most vehicle service contracts will have waiting limits and other exclusions, it can clearly be seen that there is a “claims surge” on some extended eligibility products at the beginning of the coverage period.
Claim behavior is an important driver of service contract losses. Even though past experience should be representative of emerging experience on an existing program, when you develop a new program that is similar to an existing program, but differs in an important way – such as a significant change in price or marketing approach – the rate of losses may vary substantially from the original program.