Warranty, Service Contract, and Insurance

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.