The difference between a warranty, service contract, and insurance can often
be confusing. In fact, most insurance-industry professionals lack the basic
understanding to differentiate between these three types of contracts.
Let's review the key differences and primary benefits of each.
What Is a Warranty?
Regardless of the type of warranty purchased—whether for a vehicle or a
consumer good such as a laptop, television, or home appliance—there are two
regulatory bodies that govern the warranty industry: federal and state law.
At the federal level, the Magnuson-Moss Warranty Act (MMWA), enacted in
1975, speaks to a variety of items, including limited written warranties. The
MMWA provides minimum standards on what must be included in a limited written
warranty and how to protect consumers from misleading or deceptive
representations. As a general principle, MMWA covers areas such as who can be a
warrantor (the entity holding the risk of loss), what disclosures must be made,
prohibitions on certain statements, and/or certain conduct and other
consumer-focused protections.
For purposes of this article, MMWA contemplates a third-party warrantor, but
most often the warrantor will be a manufacturer, wholesaler, or retailer who is
in the "chain-of-custody" for the item covered under the warranty.
For example, a television manufacturer may provide a 3-year warranty on the
product should it stop performing as intended. Further, a wholesaler or
retailer may also provide a warranty as they are in the chain-of-custody, which
basically means they exert some level of control or knowledge over the
television.
Another important distinction of a limited warranty is the fact that there
is no additional cost to the consumer. If a consumer purchases a television
that includes a limited written warranty, there is no separate cost to the
consumer. The warranty is part of the offering to the consumer. If there is a
separate charge, regardless of what it is called, it almost always will not
legally be considered a warranty.
State law may add additional requirements. Guided by the principle of
federalism, states may impose additional requirements on warranty products and
warrantors but must, at a minimum, adhere to MMWA requirements. The
requirements of each state differ but are necessary to understand. State law
may prohibit a third-party warrantor and mandate the warrantor be in the
chain-of-custody. The legal obstacle is to ensure a contract is a warranty, not
rising to the level of insurance, which introduces a parade of additional legal
requirements, such as producer licensing, product and rate filings, and many
other conditions. Regulations remain easier to navigate and comply with for a
warranty.
What Is a Service Contract?
Oftentimes, a consumer has the option to purchase a service contract that
can be referred to as an "extended warranty." The coverage of a
service contract may be the same, less, or more than the underlying warranty.
The service contract is always a written contract that the consumer must
purchase at an additional cost. Unlike a manufacturer or retailer's
warranty, where there is no additional cost, a service contract must have a
cost (legally referred to as "consideration") and can have a coverage
term that spans anywhere from a few months to several years.
In a service contract, much like in a warranty, there is usually an
indemnification component where the obligor (the entity making the promise to
the consumer—frequently a third party) agrees to repair or replace the covered
item. So, if a component part breaks down and fails to perform, a claim may be
submitted to the obligor. This indemnification element is sometimes referred to
in the legal community as a "fortuitous event."
Interestingly, the United States has a very sophisticated web of state laws
that govern service contracts. When you analyze the key components of insurance
(shifting of risk/liability, a "premium" or cost to the consumer and
the need for a fortuitous event—something that is not expected or intended),
you are correct to observe that it's virtually identical to the components
of a service contract. True! A service contract is insurance but for
the fact that virtually every state has explicitly declared it not to be
insurance, which injects a lesser degree of regulation, taking it outside most
rigors of insurance regulation.
Approximately 38 states have passed a Service Contract Model Act (NAIC Model
Act) that lessens the degree of regulation. Service contracts and the
obligors that provide them are usually still under the oversight of the
Department of Insurance, but there are laws that either remove or reduce the
burdens of compliance. In the balance of states, except Florida, the laws are
either silent, or there is a regulatory authority that extends similar benefits
to service contracts and its obligors. Florida is the only state that treats
service contracts as insurance, labeling obligors as "specialty
insurers."
What Is Insurance?
There is much commentary, case law, and other sources discussing the
definition of insurance. According to the IRMI Glossary of Insurance
and Risk Management Terms, insurance is defined as "a contractual
relationship that exists when one party (the insurer) for a consideration (the
premium) agrees to reimburse another party (the insured) for loss to a
specified subject (the risk) caused by designated contingencies (hazards or
perils)." We can use this definition to elicit the following key
components.
First, there is a premium charged to the consumer (or business). The premium
is generally calculated by an actuary that is designed to cover the
insurer's expected losses (e.g., loss fund), expenses (e.g., real estate
rents, employee salaries, administrative expenses), and profit. Premium, the
entire amount including any commission paid to a broker, is taxed in the state
jurisdiction where the applicable insurance policy is issued.
Second, there is often a shifting of risk to a third party. An
"insurer" is frequently the entity that holds the liability—subject
to reinsurance or another financial mechanism to shift liability—and holds the
risk of loss from an unexpected event. For example, in a standard homeowners
policy issued to a retail consumer, the insurer is required to repair or
replace the insured's loss, subject to the terms and conditions of the
insurance policy.
Third, there is the need for the covered loss not to be expected or
intended. For example, let's take a look at property loss on a homeowners
policy. When insurance is purchased, there is not an expectation that the roof
will be blown off in a windstorm. It is clearly possible but not expected or
intended. This event is frequently referred to as the "fortuitous
event" that creates a covered loss.
Importantly, the insured must also have an insurable interest (e.g., risk of
financial loss) in the item. An individual may take out a homeowners policy on
their own home but not their neighbor's home in which there is no financial
interest.
There are many other subtle nuances to the business of insurance and obscure
exceptions on the periphery, but the above is a foundational, basic
understanding of insurance.
Final Thoughts
Warranties, service contracts, and insurance policies have many similar
components, but their dissimilarities are important under the eyes of the law.
In addition, depending on how the law classifies the product, states heavily
dictate what laws, regulations, and rules govern the development and sale of
that product. As a consumer, it is important to understand where you have risk
and may have a gap or misunderstanding in coverage.