Service-Warranty Companies—the Hybrid of the
Insurance Industry

¹ Circuit City, 2006 Annual Report.

² Sykes, “Extend The Warranty Or Cut Your Losses?” Black Enterprise (November 2005), available at www.blackenterprise.com/
ArchiveOpen.asp?Source=ArchiveTab/2005/11/1105-29.htm.

³ Spahn, “Service Warranty Associations: Regulating Service Contracts as ‘Insurance’ Under Florida’s Chapter 634,” 25 Stetson L Rev. 597 (Spring 1996).

⁴ See, e.g., Griffin Systems v. Ohio Dep’t of Ins., 575 NE2d 803 (OH 1991), and Transportation Guarantee Co. v. Jellins, 174 P2d 625 (CA 1946); see also Samini, “Third-Party Extended Warranties and Service Contracts: Drawing the Line Between Insurance and Warranty Agreements,” 54 Ohio St. LJ 537 (Spring 1993).

⁵ See, e.g., Griffin Systems, Inc. v. Washburn, 505 NE2d 1121 (IL App. Ct. 1987); Jim Click Ford, Inc. v. City of Tucson, 739 P2d 1365 (AZ Ct. App. 1987).

⁶ Chapter 634 of the Florida Statutes is broken down into three separate sections: motor vehicle service agreement companies, home warranty associations and service-warranty associations. Only the first and last deal with the consumer-type warranty contracts this article discusses. The chapter gives the State Department of Insurance the right to oversee operations of the entities, and regulate and set certain reserve requirements and deposits.

⁷ See CA Civ. Code §1791 and CA Bus. & Prof. Code §9855; see also MN Stat. Section 59B.01. These are merely examples of two states’ definition and regulation of service-warranty contracts.

⁸ Rev. Proc. 97-38, 1997-2 CB 479.

⁹ Rev. Proc. 2004-34, IRB 2004-22, 991.

¹⁰ See Sec. 461(h)(1) and (4).

¹¹ The 7% selected as the discount rate is merely for example purposes.
If the discount rate were smaller or larger, the fair market value of the cashflows would change appropriately. If operating losses could not be used until a later period, the contract’s net present value (NPV) would be less.

¹² The service-warranty income method described in this procedure is the same method of accounting described in Rev. Proc. 92-98, 1992-2 CB 512.

¹³ The AFR is normally lower than a company’s after-tax rate of return. Thus, a 2% differential is included in the fact pattern. The difference is for example purposes only; the actual difference will depend on the company’s investment strategy and the AFR. If a company’s after-tax rate of return is at or below the AFR, the service-warranty method would generate a lower NPV than any of the other methods. Thus, any company considering this method must compare its return to the AFR.

¹⁴ See Rev. Proc. 71-21, 1971-2 CB 549, amended and superseded by Rev. Proc. 2004-34, note 9 supra.

¹⁵ Helvering v. LeGierse, 312 US 531 (1941).

16 Humana Inc., 881 F2d 247 (6th Cir. 1989).

¹⁷ United Parcel Service of America, Inc., 254 F3d 1014 (11th Cir. 2001).

¹⁸ See Rev. Proc. 71-21, note 14 supra.

¹⁹ See, e.g., IRS Letter Rulings 200042018 (10/23/00); 200140057 (10/9/01); 200147052 (11/26/01); 200403024 (1/16/04); 200525004 (6/24/05); 200416006 (4/16/04); 200138010 (9/24/01); 9225003 (2/28/92); 200119039 (5/14/01); 200416006 (4/16/04); and 200509005 (3/4/05).

²⁰ IRS Letter Rulings 200042018, note 19 supra; 200140057, note 19 supra; 200147052, note 19 supra; 200403024, note 19 supra; and 200525004, note 19 supra.

²¹ IRS Letter Rulings 200416006, note 19 supra and 200138010, note 19 supra.

²² IRS Letter Rulings 9225003, note 19 supra; 200119039, note 19 supra; 200416006, note 19 supra; and 200509005, note 19 supra.

²³ The 20% commission and 30% claims figures are merely for example purposes. The commission depends on the profitability of the warranty policy. The claims percentage varies depending on the product, life of the policy and actual claims filed.

²⁴ See Rev. Proc. 97-38, note 8 supra.

²⁵ See, e.g., FL Stat. Ch. 634, note 6 supra.