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Co-authored by Amanda Conklin and Christina Henry.
Buying a vehicle can be stressful. The sheer number of decisions facing a potential car purchaser can be overwhelming. One choice a buyer must make at the dealership is whether to purchase an extended service contract (or extended warranty). At the 2017 Pinnacle U conference, we partnered with a student from Illinois State University for a presentation on auto warranties and extended service contracts (ESCs).
Auto manufacturer warranties generally cover defects in workmanship or parts for a specified time period or number of miles, whichever comes first. Manufacturer warranties are automatically included, with their cost built into the vehicle’s sale price. They are also federally regulated. The Magnuson-Moss Act (1975) requires warranties for all products worth more than $5.00. ESCs provide additional coverage beyond a warranty, often for an extended period of time. These contracts are purchased separately from the vehicle’s sale price. ESC pricing is based upon types of covered parts or repairs, the vehicle’s make, model, and condition and the contract duration (years and/or miles). Service contracts resemble insurance because the customer pays a premium in exchange for the promise of repair or replacement of covered parts that fail for specified causes during the coverage term. Unlike manufacturer warranties, service contracts are subject to state insurance regulation.
When reserving for extended service contracts, there are multiple factors to consider because ESCs are a unique line of business. One of the main reserving aspects for ESCs is the earning curve. The earning curve provides a company with the percentage of premium that should be recognized as revenue at each point in time of the contract in order to be able to appropriately match revenues with liabilities. Earning curves are needed because exposure to loss is not necessarily uniform over the life of the contract. Some of the earning curve methods used in actuarial analyses include the pro rata method, the rule of 78s, the reverse rule of 78s and experience-based. These methods give the actuary tools to vary premium earning depending on whether the losses are expected evenly throughout the period, expected to be weighted toward the beginning or end of the contract or whether they can be based on credible historical experience, respectively. Additional reserving considerations include:
Payment Lags - ESCs with certain processing features or possible batching of claims may have a longer time lag between the claim’s occurrence and loss payment.
Loss Ratios - Prior period loss ratios are not necessarily indicative of the expected loss ratios of the unearned premium due to the fact that the loss ratio is significantly dependent upon the rate at which premiums are earned. A change in the exposure to loss (or true earnings rate) could result in loss ratios that vary significantly over the term of the contract.
Usually the largest liability for ESCs is the unearned premium reserves. The companies who write ESCs often experience greater risk due to the adequacy of their unearned premium reserve than the adequacy of loss and loss expense reserves. The unearned amount is dependent upon the earning curves, which are usually not pro rata for automobile ESCs as a disproportionate number of ESC claims occur later in the contract term. Mismatches between the earning curve utilized and the true exposure to loss could cause the unearned amount to be over- or understated. For example, if premiums are earned more rapidly than losses are expected to occur, then the loss ratio will be understated in the earlier years.
We ended our presentation with a few thoughts and questions regarding future changes in ESCs and warranties. As car design improves and manufacturer warranties get longer, will there be a place for ESCs in the future? How do ESCs affect customer loyalty to a car brand? Most importantly, how will autonomous features in vehicles impact the need and costs for warranties and ESCs going forward? Perhaps the 2018 Pinnacle U will explore some of these possibilities.
Amanda Conklin is an Actuarial Analyst with Pinnacle Actuarial Resources, Inc. in the Bloomington, Illinois office. She holds a Bachelor of Science degree in Actuarial Science from Illinois State University. Amanda has experience in assignments involving Loss Reserving, Funding Studies and Loss Cost Projections. She is actively pursuing membership in the Casualty Actuarial Society (CAS) through the examination process.
Christina Henry is an Actuarial Analyst with Pinnacle Actuarial Resources, Inc. in the Bloomington, Illinois office. She holds a Master of Science degree in Actuarial Science from Illinois State University and a Bachelor of Arts degree in Mathematics from Cedarville University. Christina has experience in assignments involving Loss Reserving, Funding Studies, Loss Cost Projections and Captive Feasibility Studies. She is actively pursuing membership in the Casualty Actuarial Society (CAS) through the examination process.
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