Ask an Expert: Nat Pope, Ph.D., UNT

Thursday, August 12, 2021

Nat Pope, UNTUNT System HR brings you UNT World experts with this periodic and always timely installation called "Ask An Expert." So, let's ask...

EXPERT: Nat Pope Ph.D., a UNT Associate Professor of risk management and insurance, has published works on the topic of extended auto warranties and worked in the extended warranty industry for a period prior to becoming an academic. If you've ever wondered why you receive so many calls promoting extended auto warranties, Dr. Pope is just the expert to ask. He takes us into the world of extended warranties, what they are, if they're good deals or scams, who should buy them and how to protect yourself in the case you want to purchase one. Click below for everything you always wanted to know about extended car warranties but were afraid to ask.

What are extended warranties?
Extended warranties, also commonly known as service contracts, are contracts typically sold to a consumer at the same time of the purchase of a larger asset (93% of the time), e.g., a car, TV, computer, etc., but are the subject of a separate negotiation. Extended warranties are not to be confused with the warranties provided by the manufacturer as part-and-parcel of original equipment. Extended warranties typically become active when the original manufacturer warranty expires, e.g., about three years after purchase, and have a duration of about three years, although this may vary across different contracts. Auto extended warranties (vehicle service contracts) own about 37% of the market share – almost double that of the next largest segment (mobile phones, 19%)  
Why do I get so many calls warning me that my auto warranty is about to expire?

Spam marketing is not uncommon in our current system – many product distributors now buy lists of potential consumers who may, or may not, have an interest in the distributor’s products. Some of those lists are refined, e.g., they identify people who actually may have a specific need, while other lists are far more generic in terms of the customer’s potential interest in the product in question. In particular, the vehicle service contract distributors have been very prolific in this marketing method in recent years. Actual sales through this channel represent only 7% of the extended warranty industry’s total annual revenues.
Are extended warranties insurance and why should I even care about that point?
Consumers often confuse extended warranties with insurance contracts because the contracts make similar promises, i.e., a consumer’s asset stops working and the provider of the contract fixes the problem. But in the eyes of the legal system, they are not the same and thus, the execution of the contract and the available oversight of the operation of the system are very different. Insurance is one of the world’s most highly regulated industries while the regulation of extended warranties varies from jurisdiction to jurisdiction. As a result, there is far less regulatory consistency in the extended warranties industry.

What triggers extended warranty coverage?
Insurance contracts almost always are triggered by an accident or an unintended event from the perspective of the insured. Insurance contracts almost always specifically exclude losses caused by product defect and/or wear-and-tear. On the other hand, these are precisely the triggers covered by extended warranties. In the eyes of the legal system, this difference in the contract-trigger is a seminal point of difference in the two contracts and the application of insurance laws (or not) could hold big implications in a legal setting.
Are extended warranties big business in the U.S.?
Extended warranties are typically associated with a handful of industries, e.g., autos, homes, electrical appliances, etc. Based on annual revenues, the market size is estimated to be around $50 billion. While that may sound like a lot, those amounts are dwarfed by the revenues of the property/casualty insurance industry which are more than 12 times those of the extended warranties industry. The value of extended warranty sales to a distributor varies across industries. For example, in the auto dealership setting, it is not uncommon for the finance & insurance (F&I) person to start with a 100% commission tacked on the actual cost of the contract – expecting the customer to negotiate that price downward. As most people are aware, auto dealerships frequently operate very much on the "Marquess of Queensberry Rules" principle – protect yourself at all times. Naive customers are easy pickings for experienced F&I agents. The current pickup rate for vehicle service contracts is about 45% -- so F&I agents are successful in making a vehicle service contract sale almost half of the time. Additionally, profits from the sale of vehicle service contracts are usually the single largest source of dealership profits, so the dealership invests significantly in preparing F&I agents for these sales opportunities.
Are extended warranties a scam?
Not likely – although “scams” may exist in almost all markets. Perhaps a better question is whether they are a good deal. If "good deal" is defined to be a "fair value," the answer is probably no. Without sufficient regulatory oversight, sellers of extended warranties are allowed to put whatever price they might want on these contracts and some tack-on exorbitant commissions.
Who should buy an extended warranty?
From a purely academic/theoretical perspective, the only people who should buy an extended warranty are those who would anticipate economic hardship in paying for a loss, if it were to occur; if such a loss would represent a minor expense to the individual, a "rational" consumer should not purchase the contract. That said, people are not purely rational creatures and are influenced by irrational (in an academic sense) behavior. Some individuals value the "peace of mind" that comes with owning such contracts, regardless of the pure economics of the matter. What you are likely never going to obtain is an "economically fair" price for the contract because the consumer does not have complete information on which to base his/her buying decision.
Can extended warranties be a good deal?
Just like insurance, the majority of people who purchase an extended warranty will not make a claim under the policy. Like insurance, extended warranties are designed to spread the cost of mechanical breakdown across a pool of similar contract owners. So, the majority of contract owners are not likely to make a qualifying claim, thus may feel as though it was a wasted purchase. That said, if a contract holder makes a claim on a significant loss they are likely to feel that they made an excellent decision. A better way to think of such purchases is that the consumer is buying a promise from the seller of the contract, a promise to be ready to step in and cover qualifying costs. The value of the contract is embedded in securing that promise – not necessarily exercising the options embedded in the contract.
What should I do to protect myself if I want to purchase a vehicle service contract?
Read the fine print in the contract and know: 1) who is selling you the contract, 2) who is the obligor, i.e., the entity that would actually provide the services if you were to make a claim and 3) check to see if the contract has an underlying financial guarantor, e.g., does the obligor have an insurance/surety contract in place that would complete the terms of the contract if the obligor were to default on its responsibilities. The auto dealership is often just the distributor with no actual contractual obligations – all of their money is made off of the commission. The financial strength of the obligor is the key issue, but some states don’t provide sufficient regulatory oversight of the financial strength of the obligor. Some states will require the obligor to buy a contingent liability insurance policy (CLIP) that will stand behind the promises in the contract.