Financial Benefits for Consumer Goods Retailers
The financial benefits of premium reduction and tax reduction are sufficiently motivating in the captive formation stage. These owner-centric benefits have been well-documented. But, certain types of captives offer so much more than profit preservation for the owner. Many of the less obvious benefits are underemphasized and under-celebrated.
This article is focused on extended warranty captives formed by consumer goods retailers. It is intended to highlight three of the less tangible yet positive and powerful forces that go to work when a retailer takes ownership and control of its program.
Because we are referring to a program offered through the retail channel rather than the warranty of the product manufacturer, the more legally accurate name is an “extended service contract”. This term distinguishes it from the product warranty that is inseparable from the product purchase. The common theme of these three benefits fits the spirit underlying the key captive concept. That concept is control.
What are extended service contracts?
An extended service contract is a contract between a goods purchaser and an “obligor”. The obligor is a company required to satisfy the duties of repair, maintenance or replacement of the purchased product. Satisfaction of this duty is often arranged through an in-house service team or outsourced to local companies. The terms and conditions of the service obligation are set forth in the extended service agreement.
Unlike a manufacturer’s product warranty which attaches to the physical item at the time of purchase and without a separate price, an extended service contract is optional. It is separately priced and sold as a distinct line item on the customer’s receipt. In many cases, it is the goods retailer who offers this add-on at the point of sale. In other cases, the extended service is offered by a third-party warranty administrator not affiliated with the retailer through common ownership.
These contracts are in demand for higher value consumer goods such as large appliances, consumer electronics, and vehicles. They are also in high demand for items such as expensive medical diagnostic equipment such as MRI and CT scans as well as other types of commercial and industrial machinery.
Each of these physical items typically comes with a manufacturer’s warranty limited in time and scope with no added cost. The extended service plan extends the term of coverage and often expands the scope of coverage. Consumer arrangements are frequently consummated at the checkout counters of hardware and appliance stores as well as car dealerships. Home builders also offer these products which cover a number of items and systems included with the home sale.
A common example of an extended service contract may be the purchase of a 3-year extended service plan sold for $129.99 on a $1,200 LED television set. The 3-year plan here may cover certain costs and expenses in the first year that are not covered by the manufacturer’s warranty.
For example, first-year coverage for this plan may give free in-home service calls or free shipping costs on repairs so that its scope of coverage is larger than the basic manufacturer coverage. It’s this expanded coverage that makes the deal attractive even to those who believe the duration of the manufacturer’s warranty is sufficient.
Home and kitchen appliances along with heating and cooling equipment are almost always sold with an offer of an extended service plan. These plans also include additional coverages during the manufacturer’s term so that the first year of coverage does not duplicate the manufacturer’s warranty.
Benefit #1 – Enhanced Customer Relationships
Owning the warranty insurer is better for customer relationship building. When the retailer is seen by the customer as the product seller and the quality guarantor, the relationship is strengthened. The ideal place for a retailer to occupy is the inside of the customer’s advisory circle with something to lose if things go wrong.
Selling an ongoing relationship is usually preferred to selling a transaction when one considers the true cost of gaining a customer. The extended service program can certainly be funded through a commercial carrier, but this takes away the key benefit of control. The ability to make the final decision on whether your customer gets a fourth repair visit or a new replacement product is powerful.
With ownership, the retailer can protect the relationship and set policies that serve long term goals. With this alignment between insurer and retailer, the brand becomes more valuable as goodwill increases. Not to mention, few things validate a consumer’s choice like a retailer that stands behind its sale.
Benefit #2 – Negotiating Power with Manufacturers
Knowledge is power. When a retailer owns and controls its own scorecard on the types of defects incurred, the timing of the defects and the relative failure rates by model and manufacturer, real knowledge translates to negotiating power.
Take a retailer that carries six brands of refrigerators. With its self-insured, self-administered service program, the retailer is armed with years of clean, reliable and robust information. Metrics on every aspect of model failures including frequency, severity, and timing are available in real-time. The predictive value alone is useful. But leveraging that information during supplier price negotiations can boost margins and the bottom line.
Imagine that same retailer walks into the negotiation with a spreadsheet comparing defect rates and average costs by the manufacturer. The manufacturer has been shown that its burden on the warranty program is significantly higher than other suppliers even adjusting for sales variations. That failure rate directly impacts the servicing costs assumed by the retailer’s warranty obligor. Would you suppose a ten million account could obtain a purchase discount when this is revealed with actual data?
To illustrate this point, we provide the graphic below that shows a manufacturer with a defect rate on washing machines that is clearly an outlier (Manufacturer E). This manufacturer’s warranty loss costs far exceed its share of warranty sales as a percent of the total warranty costs. Ownership of the warranty program means the information necessary to present this argument is under the control of the retailer.
An additional negotiating strategy is to protect your business with a guarantee agreement that requires your suppliers’ products to “not exceed” a pre-determined defect experience. If a certain make or model does not perform up to the standard during long term use, the manufacturer is required to fund all or some of the excess loss incurred by the captive. With this type of agreement, the manufacturer becomes a de facto reinsurer and gains valuable information about design and defect issues evident only with information about the long-term use of its products.
Without the participation of the retailer in the extended service program, the manufacturer may not have a strong monetary interest in long term design defects. Product guarantee agreements are one way to get the finance team and the design engineers on the same page as the end-user.
Benefit #3 – Diversification with Higher Margins
Consumer goods is a highly competitive space. The volume at stake allows companies to sharpen pricing. But this environment makes retailers less focused on the long-term goal as it races margins to zero and beyond. Thin margin businesses require creative marketing programs, special offers, gimmicks and often times leads to the need to diversify in order to survive.
An extended service program is a creative way to take the sales of your primary business and turn it into capital surplus and margin. Properly run programs generate both short- and long-term profits for the risk owner that are typically in excess of the consumer goods margins.
Additionally, the time value of money offers an extended warranty captive owner the chance to partially fund losses on a mature program with investment income. Would a high volume retailer really want to surrender the most profitable part of the business to a commercial insurer?
Conclusion
Before launching a warranty captive, one of the first questions to ask of course is whether the consumer goods retailer knows whether the existing warranty program managed by a commercial carrier generates an underwriting profit. For many programs, the question may be difficult to answer. The long-term nature of a program that offers three, five- and ten-year promises means that the final score first-year business is not known until half a generation has passed. With the benefits of such a program comes cost and risks. An experienced program advisor and captive manager can make a significant difference.
The extended warranty captive of a retailer is much like other captives with financial benefits. But with retailers, the organizational benefits and control aspect makes the argument compelling. In any event, there will be an organization that will interface with the customer and provides the guarantee and the servicing. That organization is going to be rewarded with profits in exchange for taking the risk. So which organization should handle the program? The customer likely prefers the organization with a long-term relationship in mind.
