1. 2009

2. “Warranty Profitability –
An Actuarial Approach”
Doug Nishimura, ARM
Mike Paczolt, ACAS, MAAA
Milliman
March 12, 2009

3. Agenda
Background
Actuarial Considerations
Alternative Risk Financing
Questions
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4. About Milliman
• Internationally Recognized Global Firm
• Independent – Not broker or insurance carrier
• Over 2,100 Employees
• Office in most major cities
• Multi-Disciplined Practice
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5. Our Experience
Past and Current Clients
National Retailers
Major Insurance Companies
Major Electronics Internet Provider
Major Electronics Manufacturer
Household Service Provider
Major Electrical Service Provider
Plumbing Manufacturer (Warranty and Products Liability)
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6. Our Expertise
• Brown Goods - Typically small household electrical appliances
• Televisions
• Stereos
• DVD Players
• Cameras
• Telephones
• Computers
• Video Game Consoles
• White Goods - Comprised of major household appliances
• Freezers
• Refrigerators
• Dishwashers
• Microwaves
• Washers
• Dryers
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7. Actuarial Considerations
• Data Needed
• Loss Distributions
• Adverse Selection
• Goodwill – Out of Warranty Costs
• Seasonality
• Pipeline Claims
• Earnings Pattern
• Unearned Premium Reserve vs. Loss Reserve
• Other Common Pitfalls
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8. Data Needed
• Raw data by claim
• Transaction dates
• Occurrence
• Report
• Record
• Paid
• Claim Amount
• Product Sales
• Product Information
• Coverage Periods
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9. Warranty Loss Distribution
Seasonality
Product Mix
Mechanical
Breakdown
(Weibull
Distribution)
Trends
Total Loss
Distribution
Obsolescence
Goodwill
Consumer
Behavior
Non-
Defective
Pipeline Length of Returns
Claims Coverage
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10. Loss Distribution -
Mechanical Breakdown
Weibull Distribution
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11. Loss Distribution -
Consumer Behavior
Cause Effect
Consumer Awareness Bump in development throughout warranty life
Length of Warranty Bump in development at end of warranty coverage
Obsolescence No development as product ages
Can be difficult to quantify!
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12. Loss Development –
Actuary’s Solution
(Time from sales quarter)
326/50 = 6.533
24 Months of Coverage
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13. Adverse Selection
• Tendency of people with significant loss potential to obtain
insurance coverage
• Need to be aware of adverse selection in pricing
• Can reduce adverse selection at point of sale
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14. Goodwill
• Continued payments after warranty coverage has expired
(Out of Warranty Costs)
• Very common
• 2 reasons goodwill exists:
• Keep consumers happy
• Unable to track warranty policy inception
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15. Seasonality
• Warranty estimates are usually based on monthly or quarterly data
• Geography of exposure may cause complexity
• Must recognize seasonality
Quarter Quarters of Development
Ending 6/3 9/6 12/9 15/12 18/15 21/18 24/21 27/24 30/27 33/30 36/33 39/36 42/39
6/30/2005 2.334 1.271 1.092 1.363 1.158 1.034 1.071 1.028 1.064 1.001 1.000 1.004 1.000
9/30/2005 1.905 1.260 1.545 1.334 1.080 1.003 1.095 1.128 1.005 1.001 1.000 1.001
12/31/2005 1.965 1.689 1.427 1.248 1.122 1.040 1.100 1.099 1.005 1.014 1.001
3/31/2006 3.453 1.690 1.156 1.134 1.199 1.135 1.021 1.033 1.042 1.001
KEY:
6/30/2006 2.398 1.264 1.178 1.340 1.110 1.080 1.010 1.085 1.022
9/30/2006 1.703 1.305 1.536 1.352 1.092 1.064 1.145 1.049
12/31/2006 2.043 1.793 1.415 1.263 1.119 1.143 1.058
3/31/2007 3.678 1.646 1.207 1.142 1.235 1.115 Spring Summer
6/30/2007 2.340 1.349 1.090 1.367 1.132
9/30/2007 1.898 1.224 1.610 1.299
12/31/2007 2.162 1.747 1.406
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3/31/2008 3.254 1.718
6/30/2008 2.364 Fall Winter

16. Pipeline Claims
• Lag between occurrence, report, recorded and paid.
Occurred Reported Recorded Paid
• The triangles must be adjusted for this lag
• Reported in warranty period paid after policy expiration
• Development appears less for recent calendar quarters
• Complete development for apples to apples basis
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17. Earnings Pattern
• Must be based on an incurred (not paid or reported) basis
• Earnings pattern calculated after lag adjustment
• Match premium and losses
• Mismatch can show unprofitable policies as profitable
Losses Premium Loss Ratio Losses Premium Loss Ratio
1st Quarter 50 100 50% 1st Quarter 50 67 75%
2nd Quarter 10 100 10% 2nd Quarter 10 13 75%
3rd Quarter 40 100 40% 3rd Quarter 40 53 75%
4th Quarter 200 100 200% 4th Quarter 200 267 75%
300 400 75% 300 400 75%
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18. Unearned Premium Reserve
vs. Loss Reserve
• Loss reserve = incurred claims but not yet paid
• Typical insurance has a long lag occurrence to payment
• Warranty claim is for when claim is reported not sold
• Warranty claims are paid quickly after the loss occurs (days)
• Warranty liability is almost entirely an unearned premium reserve
for an insurance company
Product Loss Loss
Unearned Premium Reserve Loss Paid
Sold Occurs Reserve
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19. Other Common Pitfalls
• Tail development is unique to warranty (bump in tail)
• Repeat breakdowns
• Non-defective returns
• Long Duration Contracts
• Trend
• Product Mix
• Underlying Warranty
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20. Alternative Risk Financing
Typical Self-
Insurance Insurance
Do not Subsidize
TPA Included
Profit, Commission
Less complex to
Tax Advantages
insured
More control over
Retain less Risk
losses
Legal Expenses Cash-flow
Covered advantages
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21. Captives
• Subsidiary Corp. to insure its own risks Captive
Premium
• Recognize premium earlier to reduce income
for tax advantage
• Tax deductible for 1st party coverages, only if >30%
1st Party
>30% of premium are 3rd party coverages <70%
3rd Party
(general rule)
• No tax advantage for warranty itself
• Should consult with Tax Professional
1st Party 3rd Party
Coverages Coverages
• Workers’ • Warranty
Compensation • Credit Card
• General • Employee
Liability Benefits
• Auto Liability
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22. Contact Information
Doug Nishimura, ARM
Tel: 312-499-5591
doug.nishimura@milliman.com
Mike Paczolt, ACAS, MAAA
Tel: 312-499-5720
michael.paczolt@milliman.com
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