While commercial auto and workers’ compensation dominate captive discussions, warranty programmes offer a streamlined, cost-effective alternative with simpler claims processes and stronger risk distribution profiles, argues Hale Stewart, Of Counsel, Dickinson Wright.
Commercial auto, workers’ compensation, and general liability insurance receive the lion’s share of attention from the captive marketplace. This focus is understandable. Commercial auto and workers’ compensation insurance are not only legally mandated but often contractually required. Liability insurance indemnifies the insured against the most ubiquitous cause of action – negligence, making it a must-have coverage. The top-down premium calculation method, which does not adequately reward better-in-class risks, adds to the focus. The additional input into the claims process and the ability to receive dividends for superior loss performance round out the reasons for the market’s focus on primary, three-line coverages.
But these are hardly the only captive-suitable risks. Often overlooked but equally viable are warranty captives – programmes that underwrite contractually imposed financial claims. This risk is far more stable and requires far less overhead, streamlining the captive’s expenses. Most importantly, a warranty represents third-party risk, strengthening the captive’s risk distribution profile for federal income tax purposes.
This article will first define warranties and then discuss the key provisions from the Uniform Commercial Code (UCC) that explain their practical operation. This will be followed by an overview of the far simpler warranty claims process. The article will conclude by explaining the key administrative benefits of a warranty programme.
Warranties defined and explained
For the purposes of this article, Merriam-Webster’s online dictionary provides two relevant warranty definitions. The first is, “a collateral undertaking that a fact regarding the subject of a contract is or will be as it is expressly or by implication declared or promised to be”.
A warranty is a secondary promise triggered by the product’s non-conformity with generally accepted trade practices or a representation made during a sales presentation. If the advertisement says a product is round, then the buyer can return a square product. If a salesperson states that a mobile home will be the same as the one on the sales lot, then the buyer can reject a non-conforming mobile home and return it.
The second definition from Merriam-Webster is, “a usually written guarantee of the integrity of a product and of the maker’s responsibility for the repair or replacement of defective parts”. This definition provides us with the two most commonly agreed upon remedies: the merchant either fixes or substitutes similar goods, whichever is cheaper.
The UCC, which governs sales contracts between “merchants”, imposes two warranties on sales contracts. The first is the “Implied Warranty: Merchantability; Usage of Trade”, which requires that goods must be what they’re supposed to be. Apples sold to a supermarket must be of a kind and quality that a consumer would buy. Parts purchased to be incorporated into a larger machine must operate within that structure. Non-conformity in either case would trigger a warranty action, most likely one in which the merchant would repair or replace the defective items.
The second implied warranty is fitness for a particular purpose, which occurs where the seller at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller’s skill or judgement to select or furnish suitable goods. Central to this warranty is that the buyer has a specific purpose in mind for the good. To illustrate the point, the UCC comments highlight the distinction between boots in general and those specifically designed for mountain climbing. The buyer is not required to inform the seller of a specific intended purpose.
An express warranty is “explicitly stated”. The UCC specifically defines three: 1.) Any affirmation of fact or promise made by the seller to the buyer which relates to the goods and becomes part of the basis of the bargain; 2.) Any description of the goods which is made part of the basis of the bargain; and 3.) Any sample or model which is made part of the basis of the bargain.
All three centre on a representation – whether verbal, written, or in a form – that entices the buyer to purchase a good, and which goes to the core of the contract’s subject matter. As noted by one UCC scholar, express warranty cases all centre on whether “the plaintiff recover[s] because the goods did not do what the defendant said they would do”.
Because warranties arise from contract law, damages are based on the purchaser’s expectation interest, meaning he is “put in as good a position as he would have been in had the contract been performed”. The buyer may seek the “difference between the market price at the time when the buyer learned of the breach and the contract price together with any incidental and consequential damages […], but less expenses saved in consequence of the seller’s breach”. The seller can contractually limit damages, typically to either repair or replace damaged or non-conforming goods. To limit the total amount of loss, the contract can include a liquidated damages clause, which will be upheld so long as it is reasonable.
Anatomy of a warranty claim
There are two types of warranty claims: “in-person” and “at the buyer’s location”. In-person is best thought of as those occurring at a retail store. The process is simple: the buyer returns the purchased good to the retail point of purchase, where the seller has the option to repair or replace the item.
Several UCC code sections cover those that occur at the buyer’s location. The buyer can inspect the delivery within a reasonable time and can accept all, reject all, or reject part of the shipment. The seller has the option to cure the defect in a reasonable time.
The warranty claims process is far shorter and simpler. It is possible that, in the case of a retail store, the transaction takes less than a minute. In all situations, the event is primarily an accounting function instead of a formal, time-consuming claims process. There is no need for an adjuster or formalised process. It is therefore possible to describe a warranty
captive as an accounting function memorialised as an insurance liability.
Administrative benefits of a warranty programme
In a fronting programme, the insured still pays a premium to an insurer. But it cedes most of the funds received to the insured’s captive, which is then financially responsible for claims. Third parties interacting with the programme do so with a known and rated insurer.
Insurers are paid handsomely for their services; the minimum fronting fee is US$250,000. Fronting is mandatory for commercial auto and workers’ compensation coverage due to both risks’ administrative and legal complexities. Fronting also requires collateral, which is often the reason why a company does not form a captive programme.
A warranty programme does not need to file paperwork with a federal agency nor comply with the extensive regulatory framework of state-level workers’ compensation law. The programme must comply with the state-level UCC section 2 laws, but these are not administered by any regulatory agency. Additionally, buyers of the company’s products do not need to see insurance papers to verify the validity of the warranty programme. They instead rely on the contract terms and any additional documentation to understand the warranty programme. Therefore, there is no need for a fronting carrier and, as a result, no collateral.
Additionally, the claims process is much simpler. No truck has hit a car or pedestrian; no employee has broken a limb; a store patron has not slipped in an aisle.
A seller must instead repair or replace an item sold to the buyer. There is no need for a third-party claim administrator. The process can also be automated through an accounting programme, significantly reducing costs.
The two largest expenses associated with liability captives are not present in a warranty captive, significantly reducing the minimum amount of premium required to make the captive a viable option.
To be recognised as an insurance company for federal income tax purposes, a captive must comply with the Harper test, of which risk distribution is the most challenging element. Facts supporting the presence of this factor include third-party (non-parent) risk and sufficient “statistically independent risk exposures” – individual things covered by an insurance policy, such as individual trucks for commercial auto or each employee for workers’ compensation.
Each warranty is non-parent risk; each thing sold is a “statistically independent risk exposure”. While an actuary’s opinion should be the final opinion, both facts are strongly indicative of risk distribution for tax purposes.
Conclusion
Warranties represent a great opportunity for placement in a captive. Since a front and claim TPA is not needed, the ongoing cost is greatly reduced, lowering the bar for companies wanting to form a programme.
The sponsoring company should have a wealth of historical information in its accounting records to base premiums on. The fact that a warranty represents third-party risk greatly increases the programme’s potential attractiveness. For any company with this exposure, a captive should be considered.
