Extended Warranty as a means of Qualifying a Captive as an Insurance

Company

November 10, 2014 Don Meyers

Senior Corporate Insurance Attorney, Caterpillar Inc.

2  

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

3  

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.

4  

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.

5  

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.

6  

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.

7  

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.

8  

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.

9  

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).

10  

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).

12  

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).

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.

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

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

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  

Terry  Hawkins  President  GWSCA  November  2014  

•  Introduc=on  

•  Managing  Risk    •  Revenue  Recogni=on  

•  Claims  Cost  Controls  

•  Q&A  

INTRODUCTION

•  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  

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  

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  

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  

MANAGING RISK

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

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  

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  

REVENUE  RECOGNITION  

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  

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  

CLAIMS  COST  CONTROLS  

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

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)

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  

Process

Service  contracts  and  certain  claims  require  prior  authoriza=on  

Electronic  submission  

Some  claims  reviewed:      Random      Exceed  $  amount  

Errors  and  missing  data  

•  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

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  

• Charges for work not performed • Excessive charges Servicer

• Repairing floor models • Hanging parts Dealer

• No problem found • Defective product not returned Customer

Sources

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

Contact  InformaCon  Tel:    502-­‐418-­‐3561  (mobile)  Email:  THawkins@gwsca.org  

Terry  Hawkins,  President  GWSCA