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Extended Warranty as a means of Qualifying a Captive as an Insurance
Company
November 10, 2014 Don Meyers
Senior Corporate Insurance Attorney, Caterpillar Inc.
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How to Qualify as Insurance Company?
• Two Part Test (Facts and Circumstances Test):
1. Is the Captive a Valid Insurance Company? Treasury Reg. 1.801-3(a) primary and predominant business activity is issuing insurance or annuity contracts or reinsurance. Factors:
• Independent operations
• Adequate capital
• Employees paid salary and benefits by captive
• Office space for captive
• A percentage of net income is derived from insurance
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2. Is there an Insurance Risk:
i. Presence of Insurance Risk: Investment Risk, Business Risk or Timing of Loss Payment are not insurance risks but financing arrangement (be careful of retro programs on related risks)
ii. Risk Shifting (Transfer risk from parent to subsidiary but parental guarantees may defeat risk transfer) and Risk Distribution: (Over 50% Rule/Brother-Sister Risk = Quasi 3rd Party Risk/No Distribution Unless Homogeneous/No Single Insured Test – but look through principle)
iii. Commonly Accepted Notions of Insurance: Transaction must be characterized as Insurance for all non-tax purposes (be careful of circular cash flow and parent or affiliate party premium subsidies or loan-backs). Premiums based on commercial rates.
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Consequences of IRS Guidance
• Captives may need to insure/reinsure lines of 3rd party unrelated risk with insufficient expertise or sound business objectives.
• Captives may need to create multiple entities to qualify for brother-sister business, manage cash or create homogeneity.
• Captives that qualify as insurers under IRS Guidelines may need to engage in frequent program reshuffling and restructuring and other rather bizarre behavior in an attempt to comply.
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A Captive Should Act Like A Captive and Not A Commercial Insurer
• Self-insurance versus captive insurance: substantial differences in economic substance sufficient to prevent sham captive abuse.
• Captive insurance versus commercial insurance: substantial differences in mission/purpose/objective that IRS guidance should not require a captive to act like a commercial insurer.
• Using extended warranty as a source of 3rd party business to preserve insurance tax treatment of captive may allow captive to continue to act like a captive and become integral part of business model.
• Extended warranty should never be treated as brother-sister risk even if delivered via parent or affiliates.
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Wrong Reason(s) for Writing Unrelated Risk in Captive
• Tax Deduction: Tax purpose alone may defeat captive as an insurance company.
• Cash Flow: Self-insurance without captive has better cash flow.
• Use of Excess Surplus. It’s a problem if your organization can make more money investing in other companies.
• Profit Center. Can insurance return beat your average cost of capital.
Nice to Have but not Drivers of Decision. Captive should be part of your business model.
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Correct Reasons for Writing Unrelated Risk in Captive: Business Purpose
• If unrelated business supports enterprise business model: (protects distribution system, protects collateral interest in equipment, improves OEM or supplier relationships or opportunities).
• If already self-insure employee risk (life, workers’ comp., disability, health, retiree medical: move reserves to captive if you can overcome cash management pre-funding issues and, for lines other than workers’ comp., obtain DOL exemptions).
• If captive can be used to help manage cash or more properly manage risk or control claims or drive other business objectives.
• If niche market underwriting expertise produces consistent 15% ROE or parent’s hurdle rate investment return.
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Where to Find Unrelated Business?
• Pools with Other Captives.*
• Exchange: Reserve Swapping with another Captive.*
• Underwriting Pools with other Reinsurers.*
• Facultative and Treaty Reinsurance of Specific Carriers.*
• Surplus Lines.*
• Parent Distribution and Supply Chain Insurance Programs.
• Customer Insurance Programs.
• Employee Benefits of Parent, Dealers, Suppliers and Customers.
*Captive is acting like a commercial insurer.
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Unrelated Programs that Protect Product and Distribution Channel
• Cargo: Ocean Marine (warehouse to warehouse).
• Inland Marine: contractors’ equipment.
• Property (dealer/supplier inventory floor-plan).
• Dealer/Supplier Property and Casualty Insurance Programs.
• Dealer/Supplier Life and Health Programs.
• Credit Property, Unemployment, Life and Disability (for affiliate finance company).
• Extended Service Coverage (dealer-supplier or customer extended warranty programs).
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Tax Advisory Memorandum -139131-07 Captive issues CLIP to manufacturer for standard warranty. Held: such warranty is not insurance for federal income tax purposes. Standard Warranty Factors:
• Not optional but embedded in purchase price. • No separate consideration. • CLIP by front or captive to manufacturer doesn’t convert into insurance.
Not treated as customer risk - no look through. • Extended warranty represents a fortuitous event to the consumer (one that
is not in the control of the insured) and is insurance for federal income tax purposes – apply look through to extended warranty. If the consumer does not obtain the extended warranty, the consumer would be liable for the cost to repair or replace the product.
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Pros of Standard Warranty
• Avoids infrastructure costs associated with administering an extended warranty program.
• Avoids pre-funding reserves – funds invested in operations.
• 100% PODD or market share (every product gets the warranty).
• Pay retail parts/labor to avoid repair disincentive.
• Cost: avoids regulation (premium tax, front fee, rate and form filings and adjuster licensing, service contract laws).
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Pros of Standard Warranty
Will manufacturer try to offer a manufacturer-obligor wholesale extended warranty program administered like a standard warranty to get the best of both worlds (value of Extended Warranty as well as captive financing):
§ Purchase price embedded in product sale.§ Purchase price subsidized.§ Fully-earned versus pro rata refunds.§ Lack of compliant service contracts with proper disclosures.§ Raiding captive asset base to support product sales and
merchandising programs.§ Adjusting claims like standard warranty versus extended
warranty (late notice/wear and tear/product reporting).
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13 Cons of Standard Warranty
• Entitlement mentality instead of market demand dictates terms. Leads to “Warranty Wars” among manufacturers.
• Customer not willing to pay. Forces customers into long term commitments but may not positively impact customer loyalty scores. May negatively impact customer loyalty scores.
• Cannot customize coverage to satisfy customer utilization of product and coverage needs and deductible options.
• No commission mark-up to dealers.
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14 Cons of Standard Warranty
• Non-Franchise Distributors: Dealers reimbursement rates at net cost and not retail on parts and labor or parts only. Disincentive to repair if repairing dealer is not same as selling dealer or dealer may conduct retail reimbursement repairs before standard warranty repairs.
• Cannot get insurance tax treatment on standard warranty irrespective of delivery mechanism, use of front or captive CLIP.
• No accelerated reserve deductions and no premium deductions for funding reserves so standard warranty reserves are typically unfunded.
• No investment income.
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Pros of Extended Warranty
• Administer program as profit center that customer is willing to fund.
• Dealer benefits from commissions and aftermarket profit loads.
• Supports Manufacturer Quality Initiatives: Drives risk/reward of product quality to product groups.
• Support increased PINS (% of industry sales), POPS (% of parts sales) and DCAL (% of customer acceptance of dealer service based on parts sold by service department over total parts sold at dealership).
• Support life cycle solutions and financial risk management.
• Support the Cat Business Model (Seed, Grow, Harvest) Customer Loyalty, PINS, POPS, DCAL
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EPP/ESC Impact on Customer Loyalty and POPS End Users with ESC are more Loyal customers and
drive increased parts sales!
Customer Loyalty Scores
Source: Business Intelligence Group Ini=al Purchase Customer Value Survey – All territories. Cat Insurance Demonstra=ng the Value of ESC 6 Sigma Team
Source: GRUED 2006 PTOS data (includes 80% of worldwide parts sales) analyzed in comparison to ESC enrollments. Fleet age based on date of manufacturing. Fleets with one or more machine enrollments were included in the “Fleets with ESC” category.
POPS Point Increase with ESC
60
65
70
75
80
85
90
3.5 avg. 4.8 avg. 8.4 avg.
Fleets with ESC Fleets without ESC
3 POPS 8 POPS
10 POPS
_________ Average Fleet Age _________
____
PO
PS
Poi
nts
___
8
8.2
8.4
8.6
8.8
9
9.2
2004 2005 2006 2007
ESC Non ESCN=14,795 N=16,102
.82
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EPP/ESC Value
EPP/ESC builds customer loyalty and locks in future parts and service business
Coverage continuation,
used, and rental programs
EPP/ESC differentiates
prime products and supports PINS, POPS-C and DCAL
Customers manage unforeseen cost with EPP/ESC
Transferable EPP/ESC
increases resale value
Coverage for rebuild
EPP/ESC provide value throughout the lifecycle – from
selec?on to resale.
EPP/ESC helps capture ‘Do It Myself’ customer and supports CSA's
EPP/ESC Supports the Cat Business Model
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Terry Hawkins President GWSCA November 2014
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• Introduc=on
• Managing Risk • Revenue Recogni=on
• Claims Cost Controls
• Q&A
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INTRODUCTION
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• Warranty is the obligation of a product manufacturer (“OEM”) to stand behind the products it manufactures and for a defined period of time provide for repair or replacement
• Service Contracts, offered for a separately stated consideration by the OEM or a third party, to provide for repair or replacement of covered products
Warranty vs. Service Contract
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Service Revenue Optimization Levels 1 and 2
Manufacturing Service/parts Revenue Inventory Demand Marke=ng
Performance Data
Technical Risk Model
Financial Risk Model
Accrual Forecas=ng
Revenue Recogni=on
Market Based Pricing
Service Risk Modeling Reserve Forecas=ng
Modeling Revenue Recogni=on
Market Based Pricing
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80/20 Rule – 80% of sales and 20% margin from manufacturing and 20% of sales and 80% margin from aftermarket Aftermarket: • Accessories
• Retail service
• Parts
• Service contracts
Importance of Service Contracts
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Pro’s • Great margins and increased loyalty
• Stay connected to customer for entire product life cycle
• Drive parts sales
Con’s • Potential for financial loss – long term liability
• Customer service issues
• Service provider issues
Key to success is effec=ve risk management
Pro’s and Con’s
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MANAGING RISK
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Model Advantages Disadvantages
Balance Sheet Control Cash
Simple Retain Risk
Revenue Deferred
CapCve Control Cash
Simple Retain Risk
Regulatory Filing
3rd Party Insurance Transfer Risk
Revenue Recognized Give-‐up Cash
Margin Reduced
Optional Methods for Managing Risk In Warranty and Service Contracts
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Ad Hoc
Standardized
Managed
Integrated
Optimized
Reac=ve
Transac=on focused
Proac=ve
Quality focused
Keys: • Sr. Management Engaged • Whole Organization Involved • Advanced Analytics
*Carnegie Melon So_ware Engineering Ins=tute refined methodology GWSCA and IDC Warranty Maturity Model
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In a “Big Data”, “Internet of Things” World, Sound Risk Management Requires Advanced Analytics:
• Understand geographic differences in claims experience
• Evaluate various usage patterns
• “Good” customers vs. “Bad” customers – are there abusers
• Can actually forecast what part will fail on what unit, for what customer and when
The Importance of Analy=cs
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REVENUE RECOGNITION
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FTB 90-‐1: • Controlling Guidance for accoun=ng • Specifically:
-‐ Revenue from service contracts should be deferred and recognized on a straight-‐line basis, unless history dictates different schedule
-‐ Costs related to acquisi=on of a service contract should be deferred and expensed in propor=on to revenue recogni=on
-‐ A loss should be recognized if the sum of expected losses and the unamor=zed acquisi=on cost exceeds the unearned revenue Source: Financial Accoun=ng Standards Board (“FASB”), Technical Bulle=n 90-‐1, Issued December 17, 1990. Now codified as FASB ASC 605-‐20-‐25-‐1 through 25-‐6
Considera=ons
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U.S. Securi=es and Exchange Commission: • Does FTB 90-‐1 apply if obliga=ons under the service contract are insured with a third party insurance company? • Specifically:
-‐ Administrators do not sell retail goods, but work with retailers on service contracts the retailer sells
-‐ Administrator uses a por=on of the fee from the retailer to purchase insurance
-‐ In some cases retailer is obligor, in others, administrator is obligor • 90-‐1 does not apply to non-‐obligor Source: Remarks by Scol A. Taub at 1999 Twenty-‐Seventh Annual Conference on Current SEC Developments, December 8, 1999
Non-‐Obligors
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CLAIMS COST CONTROLS
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Service Cost Containment Make it Win - Win
• If price negotiations with providers are punitive – no one gains
• Pay for quality, consumer satisfaction and first time resolution
• To support service provider – use technology to improve efficiency. Moving from 6 completed calls to 7 per day is equivalent to a 16% price increase for provider - Dispatches and claims processing must be electronic - Routing and GPS are demonstrated means of increasing efficiency - Price negotiations must be tied to service providers QOS
• Dispatch systems must support the process
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Know What You’re Paying For
• Auditing is critical. It always pays for itself.
• Analytics – in conjunction with auditing produces significant results.
• Flat rate pricing – avoids arguments. One rate for major repairs, one rate for minor repairs.
• Avoid service cost pitfalls - Excessive labor charges - Parts charges (wrong part or too high) - Mileage (distance is incorrect, multiple charges to the same area on a given day)
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GWSCA Survey Q4 2013*
Twenty percent of TPAs and companies selling ESCs report experiencing a lot of suspected fraud from service providers, and 18% report experiencing a lot of suspected fraud from ESC customers.
One in four have significant problems with suspected fraud *Fulcrum and GWSCA Survey 2013
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Process
Service contracts and certain claims require prior authoriza=on
Electronic submission
Some claims reviewed: Random Exceed $ amount
Errors and missing data
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• GE Appliances handled 1 million third party service events per year for product warranty and service contracts
• Virtually all claims were submitted electronically and adjudicated based upon pre-determined criteria. Claims were subject to random manual audit and claims over a minimum dollar amount went to auditors
• By accident, uncovered a conspiracy between call taker and service provider(s)
• Needed to implement additional safeguards to avoid repeat
• Applying analytics, GE was able to save $5.1 million in first year
GE Experience
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Process
Service contracts and certain claims require prior authoriza=on
Electronic submission
Claims submiled in near real =me for scoring
Select few sent for audit
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• Charges for work not performed • Excessive charges Servicer
• Repairing floor models • Hanging parts Dealer
• No problem found • Defective product not returned Customer
Sources
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Conclusion
• Service contracts are an ideal way to improve margins and maintain connection with customers
• Risk Management is key
• Analytics essential to success
• Claims cost containment needed to maintain competitive pricing
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Contact InformaCon Tel: 502-‐418-‐3561 (mobile) Email: [email protected]
Terry Hawkins, President GWSCA