Service contracts have been around for decades, yet many insurance
professionals do not fully understand what a service contract is, how it’s
different from traditional insurance, and how service contracts are
regulated.
This article is designed to shed light on those three components at a high
level.
What Is a Service Contract?
A service contract is defined by the National Association of Insurance
Commissioner's Service Contracts Model Act (a model act is a proposed
statute for each state's legislature to consider for adoption) as
"a contract or agreement for a separately stated consideration or for a
specific duration to perform the repair, replacement, or maintenance of
property for the operational or structural failure of any motor vehicle,
residential or other property due to a defect in materials, workmanship, or
normal wear and tear."
Said another way, a service contract provides coverage to a consumer when a
covered product (e.g., an automobile, television, or refrigerator) fails to
perform as originally intended. For example, an automobile may break down, wear
out, or simply stop functioning due to a defective part. While there may be
other coverage terms, conditions, and limitations that may apply, at its core,
this is the basic concept of a service contract.
Service contracts are frequently referred to as "extended
warranties" because they can extend the manufacturer's warranty for a
specified period of time. One of the key differences between a warranty
(provided by the manufacturer, retailer, or other entity in the product's
chain of distribution) and service contract is that a consumer must pay an
additional sum of money for the service contract instead of having the cost be
included in the purchase price of the covered product.
Key Differences between Service Contracts and Traditional Insurance
While there are some similarities, there are critical differences between
service contracts and traditional insurance policies. Automobile insurance
typically covers negligent behavior or an intervening event that causes
property and/or liability damage. For example, a driver who runs a red light
and smashes his automobile into another driver's automobile would arguably
be liable to the other driver for negligent behavior, subject to the other
terms and conditions that may exist in the applicable insurance policy.
In contrast, if the engine in an automobile overheats and breaks down while
being operated properly, the product may have experienced an "operational
failure" due to either a defect in materials, workmanship, or normal wear
and tear. In this case, the service contract provider, sometimes referred to as
an obligor, is obligated to repair or replace the engine if it's within the
coverage term and no other condition, limitation, or exclusion applies. This
type of event would not be covered under a traditional automobile policy. The
nature of the coverage being offered in a service contract has necessitated
state regulation to classify service contracts as noninsurance products.
Regulating Service Contracts
With a few exceptions, service contracts are generally regulated by state
insurance departments with the governing laws and regulations frequently
falling within the insurance code. States regulate service contracts
differently, however, than traditional insurance, and that regulation can fall
within one of four general frameworks.
- The Service Contracts Model Act, which was introduced by the National
Association of Insurance Commissioners (more than 30 states have adopted this
approach).
- Exclusionary regulations (a few states have adopted this approach).
- Limited or no regulation (laws are silent or unclear—a very limited
number of states has adopted this approach).
- Quasi-insurance. In this approach, service contracts are regulated
similarly to insurance. Currently only one state (Florida) uses this
approach.
When looking at the majority of states that have decided to adopt the
Service Contracts Model Act or exclusionary regulation, a few themes emerge.
First, these statutes or regulations expressly state service contracts are not
insurance and exempt service contracts from certain portions of the insurance
code. For example, most states do not require form and rates to be filed prior
to use (although there are exceptions). Further, licensed and appointed
producers are often not needed to sell service contracts. The adjudication of
claims often does not need to be handled by a licensed adjuster.
Despite the reduced regulatory oversight in comparison to insurance, service
contract statutes and regulations are designed to protect the consumer.
Protections include regulation of the solvency and financial stability of
service contract providers to ensure claims can be paid to consumer. To
illustrate, providers of service contracts have to become registered in many
states and satisfy certain financial responsibility requirements prescribed by
statute or regulations. Providers can post certain assets, meet a minimum net
worth, purchase a letter of credit, or secure a contractual liability insurance
policy (CLIP) from a licensed insurer. Purchasing a CLIP is usually the most
obvious and cost-effective option for service contract providers. Since a
service contract is not considered an insurance transaction, the provider may
purchase a commercial insurance policy (the CLIP) that shifts 100 percent of
its liability to the licensed insurer. This is regularly referred to as a
"full reimbursement CLIP."
There is one notable exception to this practice—Florida treats service
contracts as quasi-insurance. Service contract providers are considered
"specialty insurers" under Chapter 634 of the Florida Insurance Code.
In effect, service contracts retain the same level of regulatory scrutiny and
oversight as traditional insurance, such as the requirement to distribute
products through licensed and appointed producers, ensuring licensed adjusters
perform claim adjudication, and satisfying more rigorous solvency and capital
standards.
Why Are Service Contracts Important?
Whether you function as a consumer in the marketplace or support the
industry from a professional perspective, service contracts are omnipresent and
a growing industry. As applied to the an automobile, a consumer electronic
good, or an appliance, service contracts remain a critical risk-transferring
option for consumers, and the industry pays out millions of covered claims
annually. Raising awareness around the value and benefits of service contracts
helps support the insurance industry and provides greater transparency to
consumers, regulators, and the media. Service contracts help absolve the
burdensome costs of replacing or repairing a consumer good when there's a
failure or component breakdown.