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Service Contract Profit: Are You in the Best Plan?

August 29, 2011

Dealers are looking for more profits in every area of their dealerships while cutting costs to weather the current economic slowdown. With gross margins getting cut to the bone, back-end profit is more important than ever. You may already be making good profit on the sale of your service contracts, but are you in a plan that maximizes the total return to the dealer?

Most dealers are either in a standard retro plan or a producer owned reinsurance company (PORC) plan. Under either plan the dealerships will sell their contracts and recognize 30% to 50% gross profit (industry average) immediately. In a retro plan, a dealership also earns a retro bonus paid monthly at a flat fee amount per contract sold, typically $125 to $200. But with a retro plan, the dealer has no opportunity to share in the underwriting or investment income earned as the contracts earn out over time.

A PORC also allows the dealer to participate in those profits. In most cases, through the use of a standard three-party agreement, the dealer can direct the investments of the PORC utilizing the services of a trust department and the appropriate insurance industry investment guidelines. These investment guidelines allow the dealer significantly more investment options than normally provided by the administrator. With a PORC, a dealer keeps the profit remaining after the service contract plan pays all claims and expenses over the life of the contract. This remaining profit may be taxed as capital gains rather than ordinary income, further enhancing the value of the investment. The better the quality of the manufacturer’s product, the greater potential there is for cash build-up inside the PORC. Below is an illustration of what the income could be per contract:

New vehicle contract premium................$1,200
Dealership profit (40%)..................................480
PORC administrative costs.......................... 120
Loss ratio (30%)............................................. 360
Net premium....................................................240
Estimated investment income................. ..... 80
Income for contract...................................$ 320


The organization and expense structure of this type of entity -- along with considerations of administrative obligor versus dealer obligor contracts -- needs to be reviewed thoroughly with your CPA. These decisions can have a significant impact on the financial success of this part of your business. It is also recommended that due diligence be performed on the service provider since not all providers offer similar benefits and services. Loss ratios will vary with manufacturer product quality, and can vary each year. Historically, dealers who have shown a willingness to take ownership in a PORC have generated a substantial amount of cash that can help them cope with slowing auto sales during recessionary times.
 

 

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