Follow the Dollar: Where Service Contract Money Goes

Start with the product

A vehicle service contract (VSC) is an optional contract that pays for certain repairs after the sale. People often call it an “extended warranty,” but it is a separate product from the manufacturer’s warranty.

The CFPB explains the difference. A manufacturer’s warranty comes with the vehicle. A service contract is an optional add-on, often sold by dealers, and its price can be negotiated. The CFPB also notes that a customer usually cannot be required to buy one to get a loan.

Tire and wheel protection and key replacement follow a similar money path. How those products are classified, and where they can be sold, varies by state.

Two prices: retail price and dealer cost

Every contract sale has two prices.

• Retail price is what the customer pays.
• Dealer cost is what the dealer sends to the program for that contract.

The difference between the two is the dealer’s front-end markup. It stays with the store whether or not the dealer owns a reinsurance company.

This article follows the dealer cost. That is the money that pays for administration, the insurer’s role and, above all, future claims.

What happens to the dealer cost

The dealer cost is not one lump. It is usually split into several parts. Names and structures vary by program, but the common pieces are below.

The administrator’s fee

The administrator is the company that processes contracts, handles claims and runs cancellations. It takes a fee for that work.

The insurer’s fee

A licensed insurer issues the policy that backs the contracts. When the risk is passed on to a dealer’s reinsurance company, the insurer is “fronting.” According to IRMI, a fronting insurer charges a fee for this role. It also remains responsible on the policy if the reinsurer does not pay.

The premium ceded to your reinsurance company

“Cede” means to pass on. After the fees, the remaining premium is ceded to the dealer’s reinsurance company to pay future claims. Mercer Capital describes premiums flowing into the dealer’s company after administrative and risk-management fees.

That ceded premium is usually held in a trust account. The NAIC’s Credit for Reinsurance Model Regulation sets rules for trusts that secure reinsurance, including limits on the kinds of assets they may hold.

A practical tip: fee names and amounts differ from program to program. Ask for a written breakdown of every piece of the dealer cost before you sign anything.

Reserves: why the money is not yours on day one

When your company receives premium for a multi-year contract, it has not yet provided the coverage. Most of that coverage lies in the future.

Insurance accounting handles this with two terms. Both are defined in the NAIC glossary:

• Unearned premium is premium for coverage that has not yet been provided.
• Earned premium is premium for coverage that has already been provided.

The money for unearned premium is held as a reserve. A reserve is money set aside to meet future obligations, here claims and refunds. As time passes, premium moves from unearned to earned.

How fast that happens depends on the program. Contracts can earn out evenly over the term, or follow a pattern that tracks when claims tend to happen. The method is set by the program and its actuarial assumptions. There is no single standard method.

Claims

When a covered part fails, the customer or repair shop files a claim. The administrator reviews the claim and pays the repair facility according to the contract. Paid claims reduce the money held in your company’s reserves.

A useful number to watch is the loss ratio: claims divided by earned premium. Many things drive it:

• Vehicle age, mileage and make mix
• The contract terms and coverage levels you sell
• Labor rates in your market
• The quality of your reconditioning

A higher loss ratio means more of the premium went to claims.

Cancellations

Customers can usually cancel a service contract. Early loan payoffs, trade-ins and total losses all lead to cancellations.

Refunds follow the contract and state law. There is no single national rule. Florida is one example. Its statute sets a minimum refund formula based on the unearned pro rata premium, less claims paid. Other states set their own rules, and some allow a capped cancellation fee.

When a contract cancels, the unearned portion of the premium is generally returned to help fund the refund. That includes your reinsurance company’s share. So cancellations matter for planning, not just claims.

When can money be released?

As premium is earned and claims are paid, money in the reserves may grow beyond what is needed to back the remaining contracts. Whether and when any of it can be released depends on several things:

• The terms of the reinsurance agreement
• The terms of the trust
• The requirements of the insurer and any regulator
• The company’s own capital needs

The key point for a dealer: release of funds is never automatic. The timing and amount depend on how the book of contracts performs, and nothing is certain until the contracts behind the money have run their course.

The path at a glance

Here is the full path, in order:

1. Customer pays the retail price.
2. Dealer keeps the markup and sends the dealer cost to the program.
3. Administrator takes its fee and handles contracts, claims and cancellations.
4. Insurer takes its fee and cedes the risk.
5. Your reinsurance company receives the ceded premium, usually into a trust account.
6. Reserves pay claims and fund the reinsurer’s share of cancellation refunds.
7. What remains after all contracts expire and all obligations are met belongs to your company. If claims and refunds exceed the reserves, your company covers its share of the shortfall.

Key takeaways

• The dealer’s markup stays in the store either way. A reinsurance company changes what happens to the dealer cost.
• Part of the dealer cost pays the administrator and the insurer. The rest is ceded to your company, usually into a trust.
• Premium is earned over the life of each contract, so money stays in reserves for years.
• Claims and cancellations both draw on the reserves. Loss ratio is the number to watch.
• Release of funds depends on the agreement, the trust, the insurer and any regulator. It is never automatic.