Retail Observer

NOVEMBER 2020 RETAILOBSERVER.COM 39 When launching an extended warranty program, retailers often rely upon a risk management structure suggested by their chosen service contract provider. Naturally, these providers negotiate with insurance companies to obtain the best financial structure for their business before they even approach a prospective retailer. Have you ever wondered why the cost of a program can vary dramatically from provider to provider? Isn't the actual risk of failure on a dishwasher, for example, the same across all retailers? So why does the cost vary so much from provider to provider? KNOW WHAT FACTORS DETERMINE INSURANCE RATES Insurance companies set rates for programs based on historical loss data, if available, which is often not the case for new technologies, plus other factors, including their internal expense ratios and desired profit margins. The desired profit margins are generally the same, usually 10%-20% across all insurers, on a combined ratio (loss ratio + expense ratio) basis. Internal expenses however, are dramatically different. For example, if an insurer has a $1B advertising budget or uses AI to predict weather patterns for CAT (catastrophic loss) exposures due to hurricanes and happens to have a warranty practice as well; guess what? Part of those expenses are allocated to the warranty practice even though they do not use or benefit from those expenses. Ask anyone who files or reviews rate filings at an insurance department and they will tell you that there is no such thing as a "me-too" rate filing because the expense portion of the rates cannot be the same across all insurers. THE MOST IMPORTANT RATIO So when a retailer asks a provider what loss ratio the program is priced at and they hear "85%," for example, does it mean the insurer is seeking a 15% profit? No, because an 85% loss ratio is only accounting for the risk portion of the rate; they haven't added the expense portion of the rate. The more important ratio to examine is the combined ratio. The Combined Ratio = Incurred Losses + Expenses / Earned premiums. This means that an insurer with an expense ratio of 25% (most do) must have a loss ratio of 65% to achieve a desired profit of 10% on a combined ratio basis. If the loss ratio were truly 85% in this example that would mean the combined ratio for this program would be 110%. A program with a combined ratio of 110% will not last long at the current rates. The insurer will have to increase rates dramatically to overcome this deficit. The chart on the previous page illustrates how the combined ratio impacts financial results and rates provided to retailers. In this example you can see that Geico has a loss ratio 10 points higher than State Farm. However, Geico's combined ratio is 4.7 pts. lower than State Farm's 93.7% vs. 98.4% because their expense ratios are lower. If these companies were competing for the same warranty business, Geico would be in a better position to provide lower rates for the program despite having an overall higher loss ratio of this entire group. EARNING PREMIUMS Added to this complexity of underwriting 1st dollar policies are premium earnings. Notice the C/R equation includes "earned premiums" in the denominator. Warranty contracts are longer in length than traditional insurance policies, they have manufacturer warranty periods, and losses occur in a variety of patterns. Additionally, extended warranty contracts can be cancelled, often providing for a pro-rata refund of the unused portion of the contract, and they do not always have set exposure lengths. For example, when a product is repaired or replaced, the obligations under the contracts are often fulfilled; therefore the loss exposure is eliminated from that point forward. Insurers insuring these contracts must have systems in place to delay or accelerate earnings of these contracts, according to the way losses actually occur, with methods other than pro-rata. The pro-rata earnings pattern earns an equal amount of premium each year or each month throughout the life of the contract. The rule of 78's method anticipates more losses occurring earlier in the contract life, while the reverse rule of 78's anticipates most losses occurring later in the contract life. This simple illustration demonstrates the problem with pro-rata earnings. Remember that the loss ratio at a given time is determined by using the formula LR= (losses due to claims + loss adjustment expense/ total earned premium). So, the more earned premium you have at a given point the lower your loss ratio will be. In this example you can see that at month 24 the pro-rata method earns about 67% of the premium; whereas the other methods that use actual loss emergence and cancellations earn about 75% of the premium. Insurers, unless they have proper systems in place and actuaries that understand the extended warranty business, may incorrectly continue to account for any remaining premium for these contracts as unearned premium reserves (UPR) according to the earnings patterns their systems are programmed to use, resulting in an inaccurate (higher) loss ratio at given points in time. For more information on how UPR impacts loss ratios: www.casact.org/pubs/forum/14fforum/Vaughan.pdf. For more information about earnings curves please visit: www.providers-administrators.com/348218/earnings-curves- matching-premium-with-losses-and-refunds.

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