Contractual Liability for Warranty Contractual Liability for Warranty Business – More than Meets the Eye Business – More than Meets the Eye

Regulatory PerspectiveRegulatory Perspective

Leslie M. JonesLeslie M. Jones

Executive Assistant/Consulting ActuaryExecutive Assistant/Consulting Actuary

South Carolina Department of InsuranceSouth Carolina Department of Insurance

OverviewOverview

Evolution of the use of Risk Retention Groups (“RRGs”) Evolution of the use of Risk Retention Groups (“RRGs”) to provide Coverage for Warranty Business (“Warranty to provide Coverage for Warranty Business (“Warranty Coverage”)Coverage”)

Typical Structure of an RRG used to Provide Warranty Typical Structure of an RRG used to Provide Warranty CoverageCoverage

Typical Coverage Provided by “Warranty RRG’s”Typical Coverage Provided by “Warranty RRG’s” Regulatory ConcernsRegulatory Concerns National Warranty RRGNational Warranty RRG Regulatory ResponseRegulatory Response NAIC – CATF – Warranty SubgroupNAIC – CATF – Warranty Subgroup Regulatory Guidance DocumentRegulatory Guidance Document

Evolution of the Use of RRGs to Evolution of the Use of RRGs to Provide “Warranty Coverage”Provide “Warranty Coverage”

Federal Liability Risk Retention Act of 1986 Federal Liability Risk Retention Act of 1986 – Permitted the formation of insurance companies (called Permitted the formation of insurance companies (called

“RRGs”) by “RRGs”) by ““persons” engaged in businesses or activities similar or related with persons” engaged in businesses or activities similar or related with

respect to the liability of which such “persons” are exposed by respect to the liability of which such “persons” are exposed by virtue of any related, similar, or common business, trade, product, virtue of any related, similar, or common business, trade, product, services, premises, or operations; andservices, premises, or operations; and

which has as its owners only persons who comprise the which has as its owners only persons who comprise the membership of the risk retention group and who are provided membership of the risk retention group and who are provided insurance by such group (or a similar sole owner)insurance by such group (or a similar sole owner)

– The RRG may only offer liability coverage to owner/insureds.The RRG may only offer liability coverage to owner/insureds.– The RRG must be licensed in one state and then may, in general, The RRG must be licensed in one state and then may, in general,

engage in business in any other state by “registering” in that engage in business in any other state by “registering” in that state.state.

Evolution of the Use of RRGs to Evolution of the Use of RRGs to Provide “Warranty Coverage”Provide “Warranty Coverage”

Regulation of Service Contract Providers (SCPs)Regulation of Service Contract Providers (SCPs)– Most states do not require SCPs to be licensed as Most states do not require SCPs to be licensed as

insurance companies and therefore states do not insurance companies and therefore states do not generally regulate the reserves or investments of the generally regulate the reserves or investments of the SCP. SCP.

NAIC Model ActNAIC Model Act Differentiates between “warranties” and “service contracts”Differentiates between “warranties” and “service contracts” Requires evidence of “financial responsibility” for SCPRequires evidence of “financial responsibility” for SCP

Evolution of the Use of RRGs to Evolution of the Use of RRGs to Provide “Warranty Coverage”Provide “Warranty Coverage”

SCPs faced with availability/affordability SCPs faced with availability/affordability issues turned to the “alternative markets” issues turned to the “alternative markets” and formed RRGs to provide “liability” and formed RRGs to provide “liability” coverage for the risks under the service coverage for the risks under the service contracts they offered.contracts they offered.

Typical Structure of an RRG used to Typical Structure of an RRG used to Provide “Warranty Coverage”Provide “Warranty Coverage”

Owners of the RRG are the SCPs (also known as Owners of the RRG are the SCPs (also known as Administrator Obligors (AOs))Administrator Obligors (AOs))

The SCPs are also the insuredsThe SCPs are also the insureds The RRG provides “liability” coverage to the The RRG provides “liability” coverage to the

SCPs with respect to the service contracts which SCPs with respect to the service contracts which they offer (typically vehicle service contracts they offer (typically vehicle service contracts (VSCs) but also may include service contracts on (VSCs) but also may include service contracts on appliances or “brown and white products”)appliances or “brown and white products”)

The SCPs covered by a single RRG are often The SCPs covered by a single RRG are often related entitiesrelated entities

Typical “Liability” Coverage Typical “Liability” Coverage Provided by the RRGProvided by the RRG First Dollar (aka “Ground Up”)First Dollar (aka “Ground Up”)

– RRG is responsible for reimbursing the SCP for the entire RRG is responsible for reimbursing the SCP for the entire amount of any claim incurred under the covered service amount of any claim incurred under the covered service contracts.contracts.

Excess of LossExcess of Loss– RRG is responsible for reimbursing the SCP for claims incurred RRG is responsible for reimbursing the SCP for claims incurred

in excess of the SCPs loss reserve fund (generally based upon an in excess of the SCPs loss reserve fund (generally based upon an agreed upon loss ratio) for covered service contracts.agreed upon loss ratio) for covered service contracts.

Contractual LiabilityContractual Liability– RRG is responsible for all claims made under covered service RRG is responsible for all claims made under covered service

contracts in the event that the SCP fails to fulfill its obligation. contracts in the event that the SCP fails to fulfill its obligation. These policies are generally issued on a “one-year claims made These policies are generally issued on a “one-year claims made basis.”basis.”

Regulatory ConcernsRegulatory Concerns

Concerns primarily relate to Contractual Concerns primarily relate to Contractual Liability CoverageLiability Coverage

Example: RRG provides one-year claims made Example: RRG provides one-year claims made contractual liability coverage for underlying contractual liability coverage for underlying service contracts written by SCP.service contracts written by SCP.– Projected Future Liability for underlying service Projected Future Liability for underlying service

contracts written by SCP = $41Mcontracts written by SCP = $41M– Assets available to SCP to pay claims on underlying Assets available to SCP to pay claims on underlying

service contracts - $30.5Mservice contracts - $30.5M– i.e., the “underlying deficit” is $10.5Mi.e., the “underlying deficit” is $10.5M– Capital and Surplus of RRG is $7MCapital and Surplus of RRG is $7M

Regulatory ConcernsRegulatory Concerns

For the example, what responsibility does the opining actuary for For the example, what responsibility does the opining actuary for RRG have in forming his/her opinion to:RRG have in forming his/her opinion to:

assess the underlying reserve liability?assess the underlying reserve liability? examine the underlying assets to ensure that the assets of the SCP that are examine the underlying assets to ensure that the assets of the SCP that are

presumably “available to pay claims” are actually set aside for the purpose presumably “available to pay claims” are actually set aside for the purpose of paying claims, provide sufficient liquidity to pay claims, are invested in a of paying claims, provide sufficient liquidity to pay claims, are invested in a reasonable manner re: quality/diversification, etc?reasonable manner re: quality/diversification, etc?

Assess the financial condition of the SCPs?Assess the financial condition of the SCPs? What reserves, if any, should RRG establish?What reserves, if any, should RRG establish? What, if anything, should the actuary disclose in his/her opinion for What, if anything, should the actuary disclose in his/her opinion for

RRG regarding the underlying deficit and/or the ability of the SCP RRG regarding the underlying deficit and/or the ability of the SCP to continue to meet its obligations under the covered service to continue to meet its obligations under the covered service contracts?contracts?

Should the underlying deficit be considered a “single risk” for Should the underlying deficit be considered a “single risk” for purposes of the “10 to 1” rule (i.e., the maximum retained loss on purposes of the “10 to 1” rule (i.e., the maximum retained loss on any one risk should not exceed 10% of surplus)?any one risk should not exceed 10% of surplus)?

National Warranty RRGNational Warranty RRG

Major insolvency of an RRG covering Major insolvency of an RRG covering SCPs writing vehicle service contractsSCPs writing vehicle service contracts

Domiciled Offshore but entered through Domiciled Offshore but entered through the state of Nebraskathe state of Nebraska

Left many consumers without coverage Left many consumers without coverage for their vehicle service contractsfor their vehicle service contracts

Consumers were not covered by state Consumers were not covered by state guaranty funds guaranty funds

Regulatory ResponseRegulatory Response

GAO Report (published August 2005) GAO Report (published August 2005) RecommendedRecommended– Consistent regulatory standards for RRGs Consistent regulatory standards for RRGs

among statesamong states– With partial preemption granted only to states With partial preemption granted only to states

that adopt those standardsthat adopt those standards– Strengthening Corporate Governance Strengthening Corporate Governance

StandardsStandards

Regulatory ResponseRegulatory Response

NAIC ActivitiesNAIC Activities– RRG (E) Task Force RRG (E) Task Force

Reviewing accreditation standards to determine applicability to RRGsReviewing accreditation standards to determine applicability to RRGs The standards will likely include a requirement for RRGs to report on the The standards will likely include a requirement for RRGs to report on the

NAIC P&C statement blank and to provide the related Statement of NAIC P&C statement blank and to provide the related Statement of Actuarial Opinion (SAO)Actuarial Opinion (SAO)

The Task Force is considering the applicability of the “10 to 1” rule to The Task Force is considering the applicability of the “10 to 1” rule to RRGsRRGs

– RRG (C) Task ForceRRG (C) Task Force Reviewing recommendations of GAO reportReviewing recommendations of GAO report Requested assistance from the Casualty Actuarial Task Force (CATF) with Requested assistance from the Casualty Actuarial Task Force (CATF) with

respect to “warranty reserves”respect to “warranty reserves” Will consider whether contractual liability coverage is truly “liability” Will consider whether contractual liability coverage is truly “liability”

coverage as provided for in the Federal Risk Retention Actcoverage as provided for in the Federal Risk Retention Act

NAIC CATF – Warranty NAIC CATF – Warranty SubgroupSubgroup

Letter from Director Wagner Letter from Director Wagner – Requested CATF to “give consideration to supporting Requested CATF to “give consideration to supporting

a modification in the standards that apply to the a modification in the standards that apply to the actuarial certification of reserves held by insurers that actuarial certification of reserves held by insurers that underwrite service contracts.”underwrite service contracts.”

– The request was based on the ‘absence of any The request was based on the ‘absence of any indication of financial stress in the certified financial indication of financial stress in the certified financial statements or the actuarial opinions of several statements or the actuarial opinions of several insurers that engaged in this business and failed.” insurers that engaged in this business and failed.”

NAIC CATF – Warranty NAIC CATF – Warranty SubgroupSubgroup Letter from Director Wagner –cont.Letter from Director Wagner –cont.

– Director Wagner states that he has concluded that to protect the Director Wagner states that he has concluded that to protect the public from the failure of service contract insurers public from the failure of service contract insurers

The reserves must be “ground up” and must be reviewed and The reserves must be “ground up” and must be reviewed and opined on by a qualified independent actuary.opined on by a qualified independent actuary.

The “reserves” must be subject to a regulated investment code.The “reserves” must be subject to a regulated investment code.– However, he concedes that this is politically difficult to achieve However, he concedes that this is politically difficult to achieve

and that the only way to create a national solution is by and that the only way to create a national solution is by strengthening the standards upon which an actuary opines on the strengthening the standards upon which an actuary opines on the reserves held by a service contract insurer and the financial reserves held by a service contract insurer and the financial reporting and oversight process. reporting and oversight process.

– He concludes by stating that “This is an issue that should be He concludes by stating that “This is an issue that should be addressed by the actuarial community as part of its addressed by the actuarial community as part of its responsibility rather than through a statute or regulation.”responsibility rather than through a statute or regulation.”

NAIC CATF – Warranty NAIC CATF – Warranty SubgroupSubgroup CATF Response Letter indicates that it intends to pursue CATF Response Letter indicates that it intends to pursue

the following:the following:– Include an alert in the annual Regulatory Guidance Document Include an alert in the annual Regulatory Guidance Document

requesting that the actuary disclose in the SAO what the actuary requesting that the actuary disclose in the SAO what the actuary believes to be the financial condition of the obligor for the believes to be the financial condition of the obligor for the service contracts and/or the adequacy of any reserve funds the service contracts and/or the adequacy of any reserve funds the obligor holds for payment of claims under the service contracts obligor holds for payment of claims under the service contracts covered by the insurercovered by the insurer

– Provide educational sessions at the CLRS and the opinion Provide educational sessions at the CLRS and the opinion writers’ workshopwriters’ workshop

– Ask the CAS Research Committee to prepare an educational Ask the CAS Research Committee to prepare an educational “primer” to address issues related to pricing and reserves for “primer” to address issues related to pricing and reserves for warranty and service contract reimbursement insurance warranty and service contract reimbursement insurance exposures. Roger Hayne, Milliman, is preparing the primer. A exposures. Roger Hayne, Milliman, is preparing the primer. A draft will be available at www.naic.org/committees_c_catf.htmdraft will be available at www.naic.org/committees_c_catf.htm

NAIC CATF – Warranty NAIC CATF – Warranty SubgroupSubgroup CATF response letter further indicates CATF response letter further indicates

– That there are other initiatives that could be pursued by other That there are other initiatives that could be pursued by other NAIC groups (e.g., SC requires a semi-annual review of the loss NAIC groups (e.g., SC requires a semi-annual review of the loss reserves and an annual submission of financial statements for reserves and an annual submission of financial statements for the underlying SCPs).the underlying SCPs).

– The Blanks committee is considering making warranty business The Blanks committee is considering making warranty business a stand-alone statutory line of business. As part of this review a stand-alone statutory line of business. As part of this review Blanks could consider requiring insurers to report this on the Blanks could consider requiring insurers to report this on the “Financial Guarantee” line rather than “Other Liability”. This “Financial Guarantee” line rather than “Other Liability”. This would raise the mandatory surplus requirements and reduce the would raise the mandatory surplus requirements and reduce the distortion of Schedule P that results from reporting this as distortion of Schedule P that results from reporting this as “Other Liability.”“Other Liability.”

Regulatory Guidance DocumentRegulatory Guidance Document (draft available at (draft available at www.naic.org/www.naic.org/ committees_c_catf.htm)committees_c_catf.htm) Paragraph 4: ScopeParagraph 4: Scope

Coverage for Service Contracts. Regulators in several states have recently encountered threats to solvency involving companies that provide coverage for service contracts (automobiles, appliances, etc). Due to wide variation in state laws, this type of product may or may not be insurance. Insurance may only come into play as excess coverage for contractual liability. The insurer and the Appointed Actuary often have no underlying data on loss experience absorbed by the policyholder. When losses break through the retention, they can be catastrophic for the insurer, particularly a specialty writer or a risk retention group with concentration in this exposure. ASOP #36, Section 3.5, the CAS Statement of Principles on Loss and Loss Adjustment Expense Reserves, and other actuarial literature address the relevance of exposure to the reserve actuary’s work. The CATF expects the actuary to understand the exposure associated with the Opinion to be issued.

Questions?Questions?

Thank You!Thank You!