There's good reason to be wary of those extended warranties that retailers want to sell you when you buy a product.

Just recently it has come to light from a whistleblower in the motor vehicle warranty business that there is a plethora of illegal practices in this sector of the industry.

According to this whistleblower, not only are these practices illegal, but because of their anti-competitive nature, they contribute further to raising the premiums unnaturally for extended vehicle warranty products, meaning exorbitant insurance costs for consumers for this particular product.

Warranty included in finance costs

Typically, extended vehicle warranty products are sold by motor vehicle dealerships, who act as brokers, to provide peace of mind to motorists purchasing pre-owned vehicles. The logic is that the motor vehicle is covered for a period of two years against mechanical and engine failure where the vehicle is no longer covered by a manufacturer’s warranty or a manufacturer’s motor plan.

In most cases where vehicle finance is involved, the premium for the warranty may be included in the total finance cost and depending on the value of the vehicle, the premium may vary between R2500 to R10 000.

Unfortunately, this may be where the logical reasoning for these products ends. In terms of the Short Term Insurance Act, the dealer (broker) is entitled to 12.5 percent commission but according to the insider source, various enhanced commission mechanisms are used by the warranty company in collusion with the dealership to incentivise dealers for this lucrative business.

'Repair fund'

Depending on the warranty sold (or warranty company used), the dealer may earn up to 50 percent commission up front. The warranty company splits the invoice to the dealer and names the additional amount a 'service fee' or 'repair fund' or 'whatever' (they all call this extra amount something different).

This additional money is taken by the dealer as straight profit in flagrant contravention of section 48 5.3 of the Short Term Insurance Act. In terms of FAIS, there exists a massive conflict of interest in selling policies that pay such excessive commission to the dealer-broker.

The warranty company (called the administrator) will take the balance of the money to:

  • administration fees
  • underwriting cases (normally four to five percent)
  • dealer claims fund

    Any claims that occur during the life of the policy (anything up to four years) are paid from this fund. It must be borne in mind that this 'claims fund' is huge as all premiums are pooled nationally into the administrator's account.

    What this means in effect is that the administrator is acting as an insurer without a license. It may also appear that the administrator is acting as an underwriter at the same time, creating in effect a broker binder that flies in the face of FAIS legislation.

    Should a client cancel the policy and ask for a pro rata refund, he or she will only receive a portion less all commissions paid to the dealer.

    Here's an example:
    R6000 — paid by client (cash or financed through a bank)
    This is divided as follows:
    R750 = 12.5 percent commission as per the STI Act
    R1950 = 32.5 percent (additional earned 'commission' given some name of its own as mentioned above)
    R240 = four percent (paid to underwriter)
    R1500 = 25 percent (administrators’ costs)
    R1560 = balance left to go into claims fund

    Should the client wish to cancel the policy after six months and assuming this is a two year warranty, the refunded amount will only be in the region of R2475.

    (R6000 less 45 percent dealer earned R2700 = R3300 — divided by 24 months = a premium pay over of R137.50 per month, multiplied by six months cover already used = R825. R3300 less R825 = R2475.)

    Huge profits made

    The average claim rate on policy sales is between 50 and 60 percent so the administrators are making a huge profit.

    To compound the iniquitous nature of what is essentially an illegal scam, the warranty administrator will agree with the dealer that should policies expire and there is money left in the claims fund, the dealer may 'share' in this profit.

    Some dealers get regular cheques of up to R50 000 at a time. (Some administrators ask for a tax invoice before paying this over, but not all of them) This represents a significant profit centre for the dealership and the F&I personnel are well remunerated, earning sometimes as much as R35 000 per month to drive the warranty business.

    Incentive to sell

    Another disturbing issue is that some of the administrators will pay a portion of the "other" commission straight into the salesperson's account or give him/her cash so there is no tax deduction.

    This is done as a further incentive to sell their product. Obviously competition between warranty companies involves offering enhanced commission rewards to dealerships, where the company offering the highest commission gets the business irrespective of the benefits under the policy. In all this is rather bad news for consumers as there is no true competition in the industry as prices are driven upwards, not downwards, by these illicit practices.

    Brent Wilson is the editor of ITInews — for more, see www.itinews.co.za.

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