Admittedly, three of the seven that cut accruals by more than sales fell, did so by only a slight margin. For KB Home, the difference was only 5%. For D.R. Horton and MDC Holdings, the difference was only 7%. But that still leaves unexplained the actions of Centex, Lennar, Pulte, and NVR.

They say a picture's worth a thousand words, so let's put some of this data into charts. First, let's look at a company that's held accruals more or less stable. A year ago, D.R. Horton's accrual rate was 0.53%. Now it's 0.48%. Mathematically, that's a 7% difference, but in pictures it's only a slight dip in an otherwise straight line.

In the four-plus years we've been tracking the company, D.R. Horton's accrual rate has never been lower than it is now. Yet it's never been higher than 0.54%. Again, with real world data, this is more or less a straight line.

Notice also how the company's claims rate has frequently spiked during the fourth quarter. Part of that has to do with the seasonal pattern of claims, and part of that has to do with the seasonal pattern of sales. And then notice how the claims rate soared early this year as sales tanked. But the claims the company paid in early 2007 were probably on homes built in 2006 or 2005.

Near Constant Accrual Rate

But whether a home is sold in spring or winter, D.R. Horton sets aside roughly a half of one percent of its sales revenue to finance future warranty claims. And that's the way it should be. Barring any breakthroughs in quality or efficiency or some radical price changes, the accrual rate should stay close to constant as a company continues setting aside the same amount per unit sold.

Now let's look at one of the companies that cut its accrual rate by a large margin. A year ago, Pulte Homes was setting aside 1.15% of its home sales revenue as warranty accruals. In fact, it kept to this rate throughout 2006, ultimately setting aside $165 million on sales of $14 billion.

And then in the first quarter of 2007, it set aside only half as much as it did in the same quarter a year ago. Granted, sales were down, but only by 37%. The accrual rate fell to 0.94%, as is detailed in Figure 5.

What makes the move all the more puzzling is that claims -- which were at a high point throughout 2006 -- went even higher in early 2007. The warranty reserve, which grew in size every year from 2003 to 2005, plateaued in 2006 and is now contracting. As of June 30, the reserve stood at $102 million, a reduction of more than $15 million since the beginning of the year. And the company, which made nearly $263 million on sales of $2.9 billion in the first quarter of 2006, has now begun reporting quarterly net losses.

A Public Bonfire?

In the old days, before publicly-traded and US-based companies were required to reveal the magnitude of all their guarantees, including warranties, these kinds of fluctuations took place behind closed doors. Shareholders never knew whether claims were increasing or decreasing, how much was being set aside per unit of sale, or whether the warranty reserve was growing or contracting.

If a "bonfire of the homebuilders" really is now under way, this could be the first instance where the warranty spending patterns of an industry in contraction can be measured in detail by outsiders. So far, the early results are less than reassuring.

To the editor:

I read with interest your recent article regarding ServiceBench's extended warranty solution for manufacturers [Warranty Week, July 25, 2007]. As an attorney who has handled warranty regulatory compliance matters for a variety of providers, including manufacturers, I was particularly interested in the discussion of the challenges manufacturers face with respect to compliance with the various state service contract regulatory schemes. I wanted to take this opportunity to more fully discuss these issues, including the opportunities for manufacturers to take advantage of lessened regulatory burdens that exist by virtue of the manufacturers' relationship to the products covered under their service contracts.

Several states limit, or eliminate entirely, regulatory oversight of manufacturers who issue service contracts. This is particularly true in Florida and Oklahoma, which are discussed in detail in your article. The full regulatory schemes of those states may not be applicable to manufacturer service contract providers, under certain circumstances. However, Florida and Oklahoma are not alone in their differing treatment of manufacturers.

Manufacturers may be entirely exempt from regulation under Oklahoma's Service Warranty Insurance Act based upon the Act's definition of "service warranty." See 36 Okla. St. § 6602(14). Contracts sold by manufacturers or their affiliates and subsidiaries which are backed by a contractual liability insurance policy are not included in the Act's definition of "service warranty;" likewise, the term does not include any such contracts issued by a company which has net assets in excess of $100 million. A manufacturer demonstrating that it meets either of these exemptions is not required to be licensed in Oklahoma to issue service warranties, and in fact, is exempt entirely from Oklahoma's regulatory scheme.

Florida offers a separate and distinct service warranty association license for manufacturers of consumer products which allows a company that qualifies as a "manufacturer" to obtain a license through a streamlined application process. See §§ 634.401(17) & 634.404(6), Fla. Stat. For instance, Florida does not require fingerprinting of officers and directors of manufacturer service warranty associations and, upon licensure, only requires a simplified annual financial report in lieu of the more burdensome quarterly reports required of non-manufacturers. See § 634.415(4), Fla. Stat. In addition, a manufacturer with a net worth of $100 million and net assets of $750,000 may qualify for a further exemption under Florida law which eliminates the need to comply with (1) the unearned premium reserve/contractual liability insurance requirement; and (2) the premiums-to-net-assets ratio, both of which are otherwise required of service warranty associations. See § 634.406(8). Fla. Stat.

Outside of these two states, there are further opportunities for manufacturers to limit or completely eliminate the regulatory burdens placed on service contract providers, by virtue of their status as manufacturers. Existing regulatory schemes in states such as Alabama, Arizona, Kentucky, New Mexico, New York, Vermont, and Wisconsin contain manufacturer exemptions from licensure and/or regulation, depending on the specific circumstances of the manufacturer. New regulatory schemes enacted this year in Arkansas and Missouri contain similar exemptions for manufacturers. Identifying these opportunities and constructing a compliant service contract program which limits regulatory burdens, and their associated costs, is vitally important for manufacturers who want to maintain control over their extended warranty programs.

The Frost Brown Todd Insurance Industry Practice Group has advised numerous clients regarding the implementation and maintenance of comprehensive national service contract programs, including state licensure, solvency, and disclosure requirements. We look forward to further discussion of these and other warranty-related topics in Warranty Week and welcome the opportunity to contribute to these discussions in order to enhance the understanding of this complex area of the law.

The editor responds:

Thank you for that information. I'm sure many of the manufacturers contemplating their own launches of extended warranty offers will be happy to hear they can take advantage of these and other exemptions in state laws.

But this only reinforces my point, which is that state insurance law compliance is an enormous task which will require legal advice and assistance. I have heard numerous times about manufacturers who tried to do it themselves and who found their service contract operations in one state or another temporarily shut down for noncompliance. Hopefully, everyone who reads your letter will know better than to try to go it alone without the benefit of expert advice.