Understanding Warranty Risk: How Warranties Work – Part 1

Commercial auto, workers' compensation, and general liability insurance receive the lion's share of attention from the captive marketplace. This focus is understandable. Commercial auto and workers' compensation insurance are not only legally mandated but often contractually required. Liability insurance (CGL) indemnifies the insured against the most ubiquitous cause of action – negligence, making it a must-have insurance coverage. The top-down premium calculation method, which does not adequately reward better-in-class risks, adds to the focus. The additional input into the claims process and the ability to receive dividends for superior loss performance round out the reasons for the market's focus on primary, three-line coverages.

But these are hardly the only captive-suitable risks. Often overlooked but equally viable are warranty captives – programs that underwrite contractually imposed financial claims. This risk is stable and requires far less overhead to insure, lowering the captive's expenses. Most importantly, a warranty represents third-party risk, strengthening the captive's risk distribution profile for federal income tax purposes.

This first article (Part One) will define warranties and discuss the key provisions from the Uniform Commercial Code that explain how they operate in practice. It will also provide an overview of the warranty claims process. Part Two, will follow with a discussion of why warranties are an attractive option for captive insurance programs, including administrative, cost, and tax benefits.

Warranties Defined and Explained

For the purposes of this article, Merriam-Webster's online dictionary provides two relevant definitions. The first is, "a collateral undertaking that a fact regarding the subject of a contract is or will be as it is expressly or by implication declared or promised to be." A warranty is a secondary promise triggered by the product's non-conformity with generally accepted trade practices or a representation made during a sales presentation. If the advertisement says a product is round, the buyer can return a square product. If a salesperson states that a mobile home will be the same as the one on the sale's lot, then the buyer can reject a non-conforming mobile home and return it. The second definition from Merriam-Webster is, "a usually written guarantee of the integrity of a product and of the maker's responsibility for the repair or replacement of defective parts." This definition provides us with the two most commonly agreed upon remedies: the merchant either fixes or substitutes similar goods, whichever is cheaper.

The Uniform Commercial Code, which governs sales contracts, imposes two warranties. The first is the "Implied Warranty: Merchantability; Usage of Trade," which requires that goods:

1. pass without objection in the trade under the contract description; and
2. in the case of fungible goods, are of fair average quality within the description; and
3. are fit for the ordinary purposes for which such goods are used; and
4. run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved; and
5. are adequately contained, packaged, and labeled as the agreement may require; and
6. conform to the promise or affirmations of fact made on the container or label if any.¹

In standard parlance, goods must be what they're supposed to be. Apples sold to a supermarket must be of a kind and quality that a consumer would buy. Parts purchased to be incorporated into a larger machine must operate within that structure. Non-conformity in either case would trigger a warranty action, most likely one in which the merchant would repair or replace the defective items. The second implied warranty is fitness for a particular purpose, which, according to the UCC, occurs:

Where the seller at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller's skill or judgment to select or furnish suitable goods, there is unless excluded or modified under the next section an implied warranty that the goods shall be fit for such purpose.

Central to this warranty is that the buyer has a specific purpose in mind for the good. To illustrate the point, the comments in the UCC highlight the distinction between boots in general and those specifically designed for mountain climbing. The buyer is not required to inform the seller of a specific intended purpose. The seller can specifically disclaim both warranties, provided the limitations are not unreasonable.

According to the code, an express warranty is "explicitly stated." The UCC specifically defines three:

1. Any affirmation of fact or promise made by the seller to the buyer which relates to the goods and becomes part of the basis of the bargain creates an express warranty that the goods shall conform to the affirmation or promise.
2. Any description of the goods which is made part of the basis of the bargain creates an express warranty that the goods shall conform to the description.
3. Any sample or model which is made part of the basis of the bargain creates an express warranty that the whole of the goods shall conform to the sample or model.²

All three center on a representation – whether verbal, written, or in a form – that entices the buyer to purchase a good, and which goes to the core of the contract's subject matter. As express warranties focus on "dickered" terms regarding the contract's subject matter.

Because warranties arise from contract law, damages are based on the purchaser's expectation interest, meaning he is "put in as good a position as he would have been in had the contract been performed." The buyer may seek the "difference between the market price at the time when the buyer learned of the breach and the contract price together with any incidental and consequential damages provided in this Article ..., but less expenses saved in consequence of the seller's breach." The seller can contractually limit damages, typically to either repair or replace damaged or non-conforming goods. To limit the total amount of loss, the contract can include a liquidated damages clause, which will be upheld so long as it is reasonable.

Anatomy of a Warranty Claim

There are two types of warranty claims: "in-person" and "at the buyer's location." In-person is best thought of as those occurring at a retail store. The process is simple: the buyer returns the purchased good to the retail point of purchase, where the seller has the option to repair, replace, or refund the purchase price. Several UCC code sections cover those that occur at the buyer's location. The buyer can inspect the delivery within a reasonable time and can accept all, reject all, or reject part of the shipment. The seller has the option to cure the defect in a reasonable time.

The warranty claims process is far shorter and simpler. It's possible that, in the case of a retail store, the transaction takes less than a minute. In all situations, the event is primarily an accounting function instead of a formal, time-consuming claims process. There is no need for an adjuster or formalized process. It's therefore possible to describe a warranty captive as an accounting function memorialized as an insurance liability.

In Part 2, we'll explore why warranty programs are a smart option for captives, including administrative, cost, and tax advantages.

Footnotes

1. Id

2. UCC §2-313

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.