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Regulation and Compliance

What Is a Contractual Liability Insurance Policy?

Aaron Lunt | November 4, 2016

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Commercial insurance is vast and complex and possesses a spectrum of different products; some are extremely esoteric. A contractual liability insurance policy (CLIP) is one such esoteric product but is an important financial instrument necessary to several industries. CLIPs are most commonly associated with service contracts but can be used in a variety of areas.

This article will explain what a CLIP is, why it's necessary, and how it's used in the marketplace to protect both businesses and consumers.

What Is a CLIP?

A CLIP is a commercial insurance product that covers the contractual obligations of the insured (always a commercial entity). The insured's need to procure a CLIP can be driven by a regulatory requirement or simple economics (e.g., shifting financial risks). Before we delve further, it is important to review a few key terms.

  • Designated contract—This is a retail contract between a consumer (e.g., Jane Doe) and a commercial entity for the conveyance of a good or service. An example would be the purchase of a motor vehicle service contract by Jane Doe (consumer) from her local franchised automobile dealership (commercial entity).
  • Insurer—The insurer is the licensed (with the applicable state insurance departments, holding a valid National Association of Insurance Commissioner's (NAIC) license) and authorized insurer to write insurance in a particular state, such as an insurer licensed and authorized to underwrite liability insurance that includes CLIP.
  • Full reimbursement—This is the contractual obligation in a CLIP policy where the insurer agrees to reimburse the insured commercial entity for 100 percent of all contractual commitments it incurs on a designated contract.
  • Failure to perform—This is the contractual obligation in a CLIP policy where the insurer agrees to reimburse (or indemnify) a retail consumer for obligations where the insured is unable to perform (e.g., the insured becomes insolvent) on the designated contract.

Understanding the terms above, a full reimbursement CLIP would indemnify the insured commercial entity for all monies it expends to fulfill a contractual commitment. To illustrate, let's say an automobile dealership sells a motor vehicle service contract to a consumer. The contract covers, among other things, the mechanical breakdown of an engine. Then suppose the consumer who purchased the contract experiences a loss (e.g., engine failure), and the automobile dealership incurs a cost of $2,000 to repair the vehicle.

Under a full reimbursement CLIP, the automobile dealership would be the insured and could submit such claim to the insurer to be reimbursed for the full contractual commitment: $2,000. The retail consumer is made whole (their vehicle engine is repaired), and the automobile dealership is reimbursed for monies spent repairing the vehicle.

Why Are CLIPs Necessary?

CLIPs can be used for a variety of reasons, but the two primary reasons are driven by regulatory requirements and economics.

Statutory and Regulatory Requirements

Most state statutory codes have special provisions for the oversight and regulation of service contracts. Service contracts most commonly fall under the states insurance codes but are not regulated to the same degree as traditional insurance. Florida is the notable exception to this standard.

In Florida, sellers of service contracts are deemed specialty insurers. The NAIC has a model service contract statute, known as the NAIC Model Act, that most states have adopted in whole or in part. According to Section 3C of the NAIC Model Act, which discusses the requirements to sell service contracts, the provider (the entity selling the obligation to repair or replace a covered item) must prove to the state it has the financial wherewithal to cover its contractual obligations to ensure consumers will have their claims paid. There are a few ways to satisfy this requirement, but one such way is to purchase a CLIP. The following is stated in Section 3C.

In order to assure the faithful performance of a provider's obligations to its contract holders, each provider who is contractually obligated to provide service under a service contract shall:

  1. Insure all service contracts under a reimbursement insurance policy issued by an insurer authorized to transact insurance in this state …

In this instance, a "reimbursement insurance policy" refers to a full reimbursement contractual liability insurance policy.

Securing a CLIP is one method, and often the most cost-effective way, for a provider to satisfy its statutory financial requirements to be authorized to sell service contracts. In addition to this requirement, most states require "cut-through" language in the retail service contracts that enable the retail consumer to go directly to the CLIP insurer for reimbursement or indemnification. This is frequently implemented when the provider fails to perform its contractual obligations, most often due to insolvency.

The presence of a CLIP can provide peace of mind to consumers who know that their service contract is backed by a regulated and licensed insurer.

Economic Requirements

Statutes or regulations are the most prominent reason why CLIPs are purchased, but economic influences are certainly present. Outside of the service contract realm, a "provider" of a good or service may feel they have too many commitments to retail consumers and desire to shift some of their financial exposure to an insurer. For example, a manufacturer of automobiles may provide a limited warranty for a specific duration, for example, 5 years or 60,000 miles. To soften the potential financial impact of losses during that period, a manufacturer may elect to purchase a CLIP to shift some of that financial exposure.

Additional CLIP Scenarios

There are many other economic reasons to purchase a CLIP, spanning across a myriad of industries. Consider these scenarios.

Scenario 1

A retailer/seller of laptop computers sells one to Consumer A and also sells a service contract. The retailer is the provider (the obligated party) to repair or replace the laptop under the service contract if there's a covered breakdown. Consumer A has a covered breakdown, and the retailer replaces the laptop, costing it $1,200. If the retailer purchased a full reimbursement CLIP from an insurer, the $1,200 loss could be submitted to the insurer, and the full $1,200 would be reimbursed to the retailer.

Scenario 2

Similar to Scenario 1 above, Consumer A purchases a service contract on a laptop from the retailer where the purchase was made. But let's assume the retailer goes out of business before there's a covered breakdown by Consumer A. At the time the laptop breaks, the retailer is out of business due to insolvency and is unable to honor the financial obligations for all service contracts sold. Consumer A can leverage the "cut-through" language in the service contract and submit a claim to the insurer. The insurer is obligated to send a $1,200 check to the retail consumer, the full cost of the laptop. Without the presence of a CLIP, it is very likely that Consumer A would not have received compensation for the covered breakdown of the laptop.

Scenario 3

A franchised automobile dealership sells an automobile to Consumer B and also sells a service contract. The automobile dealership is the provider (the obligated party) to repair or replace the automobile under the service contract if there's a covered breakdown. Consumer B experiences engine problems and takes the automobile to its local repair facility for examination. The local repair facility assesses the damage and fixes the automobile (assuming it's a covered breakdown) at the cost of $1,750, including parts and labor. The automobile dealership then reimburses the local repair facility the full $1,750, and the automobile dealership could then be reimbursed from the CLIP insurer.

Final Thoughts

CLIPs are a very important insurance product in the marketplace. They are typically used by providers of motor vehicles, consumer electronics, and home services contracts. But their use can extend well beyond these areas. CLIPs are primarily relevant because of statutory/regulatory requirements, but there are many economic benefits as well. Despite being esoteric to specific industries, the broadening use of CLIPs may continue to expand into other areas and be a useful risk-shifting product.

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