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Extended Warranty Providers What You Need to Know
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Introductions
Michael Wright
Partner, Assurance
Chad Bullard
Director, Tax
Jordan Foley
Manager, Assurance
DHG INSURANCE SERVICES GROUP
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DHG Overview
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NAVIGATING COMPLICATED MARKET TRANSACTIONS
Our professionals have solid industry knowledge plus a multi-disciplined approach to
financial, accounting and operational solutions by offering coordinated comprehensive
services and strategies.
DHG Private Equity
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DHG Insurance
The Insurance practice is one of
DHG’s largest industry segments
30+
100+
150+
Years Serving the
Insurance Industry
Insurance Industry
Clients Nationwide
Collective Years
of Leadership
Team Experience
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Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we
inform you that any tax advice contained in this communication is not
intended or written to be used, and cannot be used, for the purpose of
avoiding penalties under the Internal Revenue Code.
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An Overview of
Extended Warranty Providers
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WHAT DO YOU KNOW ABOUT EXTENDED WARRANTY PROVIDERS?
A. I don’t know anything about extended warranty providers
B. I’m somewhat familiar
C. I’m extremely familiar
Poll #1
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1. Understand how different
programs/contracts are
structured
2. Discuss the types of entity
structures used and the
associated cash flows
3. Identify key federal and
state tax benefits and
considerations
4. Identify common audit and
due diligence considerations
Objectives For Today
EXTENDED WARRANTY
PROVIDERS
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Types of Extended Warranty Providers
Extended Warranty Providers
Original Equipment
Manufacturers (OEMs)Administrator Obligor (AO)
Dealer Owned Warranty
Company (DOWC)
Contract Obligor
Dealer Obligor (DO)
*PEGs Investing*
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Types of Distribution Channels
Administrator Obligor
▪ Market Entry/Expansion
▪ Relocations/Consolidation
▪ Mergers & Acquisitions
Dealer Obligor
▪ Federal, State, Local, Public and Private
OEM Dealerships Financial
institutions
Direct-to-
consumer
*PEGs Investing*
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Primary Types of Products
Administrator Obligor
▪ Market Entry/Expansion
▪ Relocations/Consolidation
▪ Mergers & Acquisitions
Dealer Obligor
▪ Federal, State, Local, Public and Private
Vehicle Service
Contracts (VSC)
Guaranteed Asset
Protection (GAP)
Key Considerations:
The Contract
The Coverage
Key Considerations:
The Contract
The Coverage
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Common Add-On Products
Dealer Obligor
▪ Federal, State, Local, Public and Private
Lifetime Powertrain
Warranty
Etch/Theft
Protection
LoJack Prepaid
Maintenance
Programs
Key Replacement Roadside
Assistance
Programs
Tire & Wheel
Protection
Other
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Administrator Obligor Program
Administrator Obligor (AO)Dealership ($650 Commission)
CLIP Insurer
Customer
Trust
Account
$350
Profit /
Expense
$1,200
$50
Profit /
Expense
$150$550
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Dealer Obligor Program
Administrator (TPA)Dealer Obligor (Dealership)
CLIP Insurer
Customer
Profit /
Expense
Profit /
Expense
$50
Trust
Account
$350
$1,200
$250 TPA Fee
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Contractual Liability Insurance Policy:
• Insurance that covers liability of the insured assumed in a contract.
• Most commonly associated with service contracts but can be used
in a variety of areas.
• CLIPs can be used for a variety of reasons, but the two primary
reasons are driven by regulatory requirements and economics.
• Policy issued to the VSC Company that guarantees the performance
obligation of the VSC Company.
CLIPs
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Affiliated Reinsurance with CLIP
Administrator Obligor (AO)Dealership($650 Commission)
CLIP Insurer
Customer
Profit /
Expense
$50 CLIP Premium
Custodial
Trust FBO
Insurer &
Reinsurer
Profit /
Expense
Reinsurance CompanyProfit /
Expense
Dealership Owner
$1,200
$550
$350 Reserve Premium
$350 Reserve Premium
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An Overview of
Revenue Recognition &
Why Correct Earnings Matter
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Poll #2
HAVE YOU INVESTED IN OR ARE YOU CURRENTLY EXPLORING AN
INVESTMENT IN AN EXTENDED WARRANTY PROVIDER?
A. Yes
B. No
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Revenue Recognition
• ASC 605-20-25- “Separately Priced Extended Warranty and Product
Maintenance Contracts”
• Similar to short-duration insurance contracts
• Should be pro rata, unless evidence suggests cost are incurred in a
different pattern (“Loss Emergence”)
• Also allows for deferral of certain costs, amortized on same pattern
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Earnings Patterns or Curves
• Calculated actuarially and generally expressed as a cumulative
earned percentage by term month
• Curves will vary based on term, coverage, initial mileage, make, etc.
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
100.00%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
PR Experience
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Loss Ratios
• A measure by which to express losses as a percent of premiums
• Calculated as total incurred losses over premiums earned
• Incurred losses = paid losses + any loss reserves
• Can be used to estimate future losses
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An Example of Why Correct Earnings Matter
Assumptions:
• Total premiums written = $10 million
• Total ultimate losses = $8 million
• Ultimate loss ratio = 80%
• Currently half way through term (24/48 mo.)
• $5.9 million incurred through 24 mo.
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Earnings Patterns
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
100.00%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49
PR Experience
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Loss Ratios
Pro Rata
• Prem. Earned $5 million
• Losses incurred $5.9 million
• Loss ratio 118%
Loss Emergence
• Prem. Earned $7.4 million
• Losses incurred $5.9 million
• Loss ratio 80%
0%
20%
40%
60%
80%
100%
120%
140%
-
1,000,000
2,000,000
3,000,000
4,000,000
5,000,000
6,000,000
7,000,000
8,000,000
PR Loss Emergence
Losses Incurred Earned Revenues Loss Ratio
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An Overview of
Audit & Financial
Due Diligence Considerations
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1. Databases
2. Revenue Recognition
3. Working Capital
4. Other
Key Audit & FDD Issues/Considerations
EXTENDED WARRANTY
PROVIDERS
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Audit & FDD Considerations
Databases (Internally
Developed)
Revenue Recognition
Working
CapitalOther
- Lack of proper controls
- Incorrect data input, mappings or logic
- Earnings / expense deferrals may not be accurate
- Calculated amounts may be priced incorrectly
- Mismatch in earnings pattern to loss emergence
- Incorrect earnings start date
- Incorrect obligor classifications
- GAAP revenue may be misstated (QofE adj.)
- GAAP unearned premium may also be misstated (working capital adj.)
- Treatment of unearned revenue in working capital
• Ensure consistency
• Inclusion generally favorable to seller
• Exclusion generally favorable to buyer
- Unearned revenue current vs. non-current liability
- Cash requirements for liabilities acquired
- DAC and prepaid insurance premiums
- Claims liabilities
- Revenue on a ‘written’ vs. earned basis
- Private company expenses
- Employee compensation
- Profit sharing and “Retro’ liabilities
- Seasonality and product trends
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An Overview of
Tax Treatment & Benefits
for the ESC Provider
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TRUE OR FALSE?
Companies issuing extended service contracts (“ESCs”) qualify as
insurance companies for federal tax purposes.
Poll #3
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Qualifying as Insurance for Tax
Extended Service Contract (ESC)
Administration Fee Insurance Premium
THE 50% INSURANCE TEST
Included Not Included
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Private Letter Rulings (PLRs)
Multiple PLRs have been issued concluding that companies issuing
ESCs qualify as insurance companies for federal tax purposes:
*A sample of such PLRs*
PLR 200042018
PLR 200028018
PLR 201419007
PLR 200340011
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Federal Vs. State Taxes
Extended Service Contract Providers
Federal Taxes State Taxes
Might be subject to state
income taxes
Might qualify as an
insurance company
WAYS TO ACHIEVE DESIRABLE TAX TREATMENT
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Federal Tax Benefits
WHY IS INSURANCE TAX TREATMENT DESIRABLE?
• A mismatch of revenue and expense in favor of the taxpayer
• Loss reserves for known incurred and IBNR can be established and
deducted subject to a small discounting percentage
Extended Service Contract
Loss
Reserves
Insurance
Premium RevenueAcquisition Costs
Expenses are deducted
as incurred
80% of revenue is
deferred & recognized
over the policy life
• ESCs can have a coverage period of 3-7 years
• Some ESCs aren’t effective for years after which the policy is sold
Tax reserves are
generally 90% to 95% of
GAAP reserves
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Federal Tax Provisions
• Warranty companies file GAAP financials and most likely are not
filing statutory statements
• Regulation 1.6012-2 states that insurance companies are required
to file with its tax return a copy of the annual statement (or proforma
annual statement)
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State Tax Provisions & Benefits
STATE TAX SAVINGS:
• ESCs are generally subject to state income tax in lieu of premium
tax
Extended Service Contract (ESC)
State Income Tax Premium Tax
Taxed on Written
PremiumTaxed on Profit
Higher Tax CostLower Tax Cost
May Not Pay State Income
Tax For Many Years
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State Sales & Use Tax Considerations
STATES DIFFER IN THEIR TREATMENT OF ESCs:
• ESCs will generally fall into 1 of 2 categories
Extended Service Contract (ESC)
Sales Tax Use Tax
Exempt the sale of the
contract
Exempt any subsequent
services of the contract
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State Sales & Use Tax Considerations
TAX COMPLIANCE:
1. The non-filing of returns and remitting of the respective taxes is
quite common
2. States are becoming aware of such underreporting and are
initiating sales and use tax audits with success
3. If ESC companies have not yet been contacted by a state, they
can mitigate exposure through voluntary disclosure agreements