Back in the last century I briefly held a job as first VP of an insurance company, reporting directly to the president. I claimed to be head of strategic planning, but operationally I was supposed to be in charge of the company’s warranty business nationwide. I knew nothing about this business when I got the promotion, and I inherited a pretty sizable book of business from my predecessor. So I had to get up to speed quickly.
Suppose you buy a new refrigerator and the sales clerk asks if you want to buy the extended warranty. Let’s say you do. The store writes you the warranty and takes your money. After pocketing part of the warranty fee as sales commission, the store bundles your warranty with all the others it has sold and sends them, along with the rest of the money it collected from its warranty buyers, to an insurance company. If your refrigerator breaks while under warranty, it’s the insurance company rather than the store that pays for repair or replacement.
Warranties are very profitable for the stores: unlike most other forms of insurance, warranty fees aren’t regulated by the government, so the stores could charge whatever the market will bear. Warranties on “white goods” (appliances) and “gray goods” (electronics) were a very profitable line of business for my insurance company too: most of these devices held up pretty well, and the buyers often forgot about or lost their warranties. The only real loser was the automobile warranty portfolio, but it was a big loser, and here’s why: the car dealers not only sold the warranties to the customers; they also provided the repair service. So let’s say you bought a new BMW with a 5-year extended warranty. At about year 4½ the auto dealership would call you up. “Your warranty is just about ready to expire. Wouldn’t you like to get all those little problems fixed for free? If you do you’ll get top dollar on a trade-in for a brand new BMW.” The auto dealership made money on both ends: their repair shop got reimbursed by the insurer and they got the money from the new car sale. For the insurer — that was us — things didn’t look so rosy: the auto warranty loss ratios would look really good until right up to the end of the warranty term, and then losses would go sky-high.
I talked with the actuary about all this. Didn’t Hutch (my predecessor and former boss) realize what was happening here, what a potential catastrophe these auto warranties represent? After awhile it became clear: Hutch did know, but the income and cashflow were tremendous, and because this was an unregulated line of business there were no legal requirements for maintaining loss reserves commensurate with the projected risks. Hutch’s plan was to keep growing the warranty business as rapidly as possible, so that cash from the new warranties always more than made up for the losses on the old warranties. But what happens when we can’t grow this business any more, and all the losses start piling up? Well, Hutch was living in the now. He got bonuses for sales and profits, which on paper looked great. He was getting up there in years, so by the time the shit hit the fan he would have eased into a cozy retirement. Does Don (the president) know? Sure: he and Hutch came in together, he too was financially rewarded for short-term results.
I didn’t really want to run the warranty business anyway, and I knew that none of my strategic planning could possibly offset the pressure building up in this volcano. So I quit and went to work for a healthcare thinktank. Don thanked me for my service; Hutch enthusiastically told me I what a pro I was — meaning that I didn’t blow the whistle on his corrupt business dealings. About three years later the volcano blew, the losses overwhelmed the reserves, and the company had to sell itself off to a bigger firm at a drastic discount from its heyday.
What could have saved my company from this disaster? Well, of course the government could have regulated the warranty business to prevent insurers from overextending themselves and threatening their shareholders’ equity. Or my company could have never written these auto warranties in the first place. Or, once they realized what was happening, Hutch and Don could have bitten the bullet, written down their losses, and lost their bonuses for a year or two. Or they could have rebundled the warranties and sold a big chunk of them to a big reinsurer like AIG (this last move is the only one they actually did).
Or they could have waited until the federal government established a bad debt relief fund for insurers. Then they could have stripped off their entire auto warranty portfolio and sold it at a small discount to the American citizenry, while retaining the highly profitable white goods and gray goods warranties for themselves, thereby assuring their executive bonuses and securing their shareholders’ equity.
Could I have done anything? Yes, I probably could have. It would have gotten ugly, and I’d have caught a lot of shit, but I had caught shit there already and survived — hell, it’s what got me the promotion that put me in charge of warranties. I think Don the president secretly entertained hopes that somehow I’d be able to pull the plug on this imminent catastrophe because he knew it was the right thing to do but he couldn’t make himself do it. I didn’t really have anything to lose, since I had no intention of staying long-term with the company or in the industry. But I had other fish to fry. I just walked away.
Should I have done something? Well, one could argue that it was none of my concern to protect shareholder equity, that those rich bastards deserved to eat the bad along with the good. But this was a mutual insurance company, which means that the policyholders themselves own the company. Instead of building up share value or distributing dividends, the company would use its profits to reduce premiums for its policyholders. This is as close as American business structure comes to a socialist enterprise.