Service Contract Risk Management: What you may not know…

Over the past 20 years I’ve learned a lot about service contract risk, risk structures, loss cost analytics, and program optimization. During these years, I’ve had an opportunity to develop and manage large retail Extended Service Programs (ESP), to serve as an officer of one of the world’s largest service contract underwriters and administrators, and, more recently, be directly involved with many OEM and retail service contract programs since joining Fulcrum. My experiences, mistakes and successes have led me to a somewhat unique perspective around Service Contract Risk Management.

Two important things I’ve learned from this vantage are:

1. When properly managed, service contract programs are a significant contributor to profitability and customer loyalty, and should be used as an integral component of CRM.
2. Significant risk management opportunities exist in every program, regardless of who carries the risk. It’s often an area that can yield rapid improvement, but that also needs to be monitored continuously.

Nate Baldwin just wrapped up a series on the first of these points. In this article, I’d like to focus on the second point.

Often, when we first become involved with a company’s ESP program, it becomes evident that the manner in which risk is managed has not been reviewed in many years. In fact, it’s not uncommon to see the current structure date from the inception of the program, and many of these programs are several years old.

Modernizing the way risk is structured and measured is a simple way to uncover significant opportunities within a program for enhanced profitability. Such opportunities exist whether a company carries the risk on their own balance sheet or employs an external underwriter, although the details of those opportunities often lie in somewhat different areas.

For companies that carry the risk on their balance sheet, an immediate area to review includes the size of the reserve relative to expected claims for the in-force contracts. In many cases, our analytics reveal that a company has been too conservative in its revenue recognition (if the program claims are front-loaded), which might allow them to either accelerate some earnings or to restructure the program to have a wider appeal. On the other hand, we have also seen a few cases where the reserve amounts are not adequate. In such cases, it is important to take action to either reduce future claims costs by implementing better entitlement and adjudication, supplier management, and other process improvements, or to increase program reserves in a manner that meets requirements and stated guidelines.

Some of the largest opportunities exist in companies that employ third-party underwriters and/or third-party administrators (TPAs). We have many friends in the U/W/TPA business, and they perform valuable services for the industry (including some of our clients). But many of these programs are marked by legacy business models, portfolio-style management, a lack of detailed understanding of the client’s unique historical claims, and sometimes even outdated actuarial quantitative methods.

Here are a few cases to illustrate some of the opportunities we’ve seen:

• An OEM/retailer ESP program (managed by the same underwriter for 6 years) was contractually obligated to a 90% loss ratio (90 cents of each reserve dollar would be spent in claims). The underwriter provided quarterly risk updates showing close to a 90% loss ratio. However, our more detailed analysis demonstrated the ultimate run-off loss ratio was actually 53%. Clearly, the original loss ratio calculations or quantitative methods no longer held; moreover, the client was paying a 15% risk fee as part of the underwriting fees, something that also was no longer warranted given the lower loss ratio and stability of the program.
• A large OEM was carrying their own risk, and we found they were not earning their reserves correctly. In fact, there was over $20 million in excess reserve. We helped them structure an arrangement where they were able to recognize the excess reserves immediately. (We have found this windfall situation for several clients, resulting in immediate income recognition of between $3 and $9 million in each case).
• Conversely, we worked with a large manufacturer carrying their own risk, which was nearly $50 million under-reserved, because their claims were back-loaded and they were earning pro rata. They had no idea because rising sales revenue was masking the issue. We worked with them and their auditors, structured a way to handle the shortfall, and made go-forward changes to ensure future contracts were profitable.
• A major OEM program, in place with the same underwriter for over 10 years, was paying nearly 40% of their premium in risk fees, underwriting profits, and investment income. For their $75-million-dollar annual program they should have been paying approximately 6%. The savings of 34% of $75 million amounted to additional profits of over $25 million per year.

I could keep citing examples, but I think these convey a good idea of how pervasive the issues are and how significant the gains can be. Here are a few tips every program manager should consider implementing:

• Make sure your ongoing analytics are detailed and complete. One endemic problem is that much of the reporting in this area is highly aggregated: quarterly reports at the entire portfolio level. My eyes were opened many years ago, when claims for one of the categories I managed shot up. The top-level report suggested we raise rates across the category, but more detailed analysis revealed almost all of the incremental claims were being driven by a handful of models from a single manufacturer. Instead of raising rates that would have hurt sales, I was able to get a rebate from the manufacturer instead – and that manufacturer in turn was able to get relief from a supplier.
• Get knowledgeable help. The intricacies of extended service plans are difficult to grasp, because there are so many interrelated elements. For example, if you raise rates too high, you may get a good short-term boost in revenue, but the smaller pool of customers that results may have a significantly higher risk of claims. As a result, program profitability and viability could suffer. True expertise is often hard to find. When you do, work hard to retain and grow those resources.
• Find advisors that share your passion for your business. Too often, the folks helping review program performance are in finance or at an underwriter, and your program’s success is not their main job. It’s one of the reasons Fulcrum structures many of it clients’ relationships on a performance basis: we’re fully invested in our clients’ success because that’s how we get paid. No matter whom you work with internally or externally, they should care about helping you improve your business.
• Determine if the fox is guarding the hen house. Most underwriters and administrators in this sector are ethical companies. However, we have sometimes seen situations in which a vendor’s analysis was geared toward steering profits their way, rather than serving their client’s interests.

In the next installment, I’ll share some additional reasons that we should care about proper risk management, risk structure, loss cost analytics, and program optimization. I’ll also look at when and what to outsource to build a stronger program.

In the meantime, if you have any examples of ways risk has been analyzed or restructured to improve program performance, please leave a comment below.