On Warranties and Demography

In my day job, we work with companies (manufacturers and retailers) on optimizing their extended warranty businesses. Recently, I was struck by how a common problem that these businesses face is analogous to a more general problem that Western nations face. In a nutshell, it's the problem of switching from a Growth Mode to a Stable/Declining Mode.

The way extended warranty programs work is that the company takes money from customers when they sell a contract, covers marketing and overhead costs with some portion of that money, and puts the remainder of the money in a reserve fund to cover future claims. At the end of the coverage period monies remaining in the reserve fund (plus accrued investment income) are profit.

Under this system (as with all insurance plans) it's obviously incredibly important that you put the right portion into the reserve fund. If you put too little, you'll run out of money to cover claims, if you put too much, then you're tying up your capital in low-risk, low-return investments (which may cause you to underinvest in acquiring new contracts, hamstringing your whole warranty business). (For now, I'm just focusing on the cash side of the accounting, but there are similar issues with accrual accounting and revenue recognition. I've also limited this to situations where the manufacturer or retailer is the obligor, which still happens even if less frequently than it once did.)

So, now that I've bored you with a refresher on extended service contracts, where am I going with this? Well, it turns out that many companies put too little money in their reserve fund, but this fact is masked by the growth in the warranty business. If my warranty business is growing fast enough, my reserve fund will also grow and money from new contracts will cover old claims – even though I'm not actually reserving a large enough percentage on each contract.

To give a concrete example, assume I'm reserving 60% of the price of my contracts but that claims costs are actually (presumably unbeknownst to me) running at 65% of contract price. If my warranty business is growing at 10% a year, which is not that uncommon, I may never realize it because 60% of the 110 contracts I sell this year is enough to cover the 65% costs of the 100 contracts I sold last year. But, at this point everyone should realize where this ends – and it's not pretty. Eventually the pyramid collapses, like bacteria in a petridish doubling every hour, eventually the trend hits the limits of the environment, and growth will slow, stop, or even reverse – the market is saturated. At this point, the firm could have a huge liability – perhaps so large that they can't fund it. But even if they can, it can have really unpleasant effects on their bottom line when it finally happens. (Especially for retailers where their entire profits might come from their extended warranty business.)

So, on to the analogy. It should be clear that a lot of our social security and other social insurance policies are predicated on population growth. The post-War baby boom fed our growing warranty business. We've effectively been putting 0% in our reserve fund and relying on the growing business to save us. But now we have two things happening: (1) growth is slowing as reproduction rates drop well below 2.1 replacement rate and (2) claims are going up significantly as people are getting older on average (both claim frequency and claim severity are rising).

So what is to be done? A lesson from business shows that the problem can be easy (if somewhat painful) to fix by upping your reserve rate – so long as you act before the growth flattens. The problem is the pain: in the short term your cash flow (or profits) are going to go down severely as you catch up your reserve and you're going to look like the person who screwed up a good thing. Neither businessmen or politicians like to take that on, especially if it can be deferred to their successor.

And it also leads to a bigger question. In the short run, immigration is surely an important part of the solution (although European experience warns of the dangers of unassimilated immigration). But in the long run, with better birth control technology, increased secularism, and higher standards of living, it seems likely that decreasing birth rates will become a global phenomena. While this may take a while, eventually even immigration will dry up as a source of population growth. So, the question is: what does a sustainable economic and social policy look like under stable or even declining population? Will productivity growth allow a stagnant population to continue the Ponzi scheme indefinitely? What is the analogy at the national level to a properly-funded, steady-state warranty business? Posted by richard at February 18, 2006 12:13 PM