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.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI.
Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion.
If such advice is needed, consult with your attorney, accountant, or other qualified adviser.