Safe or Sorry?

Extended warranties are a cash cow for retailers. Why do we buy in?

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If you’ve ever shopped at Best Buy, Office Depot, or any other retailer where the sales associates all wear polo shirts in the same color, then you know what an Extended Service Contract is — it’s that piece of paper covered with tiny print that you agree to buy for $69.99 because you’re so happy you’re saving $40 the price of your new digital camera. According to WarrantyWeek.com, American consumers spend approximately $15 billion on Extended Service Contracts, or ESCs, each year.

In theory, you’re not just buying an expensive piece of paper, of course. You’re protecting your investment. Buying peace of mind, as you’re doing the prudent thing now to avoid headaches and unexpected expenses in the future.

In practice, well….let’s say you don’t buy an ESC. Two weeks after your manufacturer’s warranty expires, your camera contracts a Stage IV case of LCD touch display fuzziness. Without an ESC, you’re totally responsible for paying the repair costs. And because the repair costs are so high, and digital camera technology has advanced so much in the last 12 months, and Best Buy is having an awesome summer sale, well, guess what — you’ve got a great excuse to buy yourself a new camera!

Now let’s say you did buy an ESC. Your camera breaks, and you spend three hours ransacking your house for that $69.99 piece of paper, which you lost track of within seconds of bringing it home 12 months ago, but you know has to be in your files somewhere. Then you lose an hour looking at phone bills from 1994 — who the hell did you know in Chicago, and why were you spending hundreds of dollars a month calling them? Then you spend another hour on the phone, trying to find out if Best Buy has a record of the ESC you bought, which it doesn’t, because you actually bought the camera at Circuit City. (RIP!) Aren’t you glad you went the peace of mind route?

Of course this isn’t the only scenario. You may be one of those extremely organized types who fills a spreadsheet with the GPS coordinates of where all your important documents are stored.  If your camera’s malfunctioning LCD touch screen isn’t working due to defects in materials or workmanship, rather than, say, abuse, fire, flood, wind, freezing, power failure, inadequate power supply, unusual atmospheric conditions, acts of war, acts of God, improper storage, improper ventilation, or utilization of the equipment in an industrial or commercial setting — which are just some of the situations a typical ESC doesn’t cover — then you made a smart choice! Especially if the necessary repair ends up costing more than $69.99.

Not surprisingly, however, the odds favor those who sell ESCs over those who buy them. Warranty Week estimates that while consumers spend $15 billion a year on ESCs, ESC administrators pay out only $3 billion a year in claims. In part, this is because ESCs are pre-paid repair contracts rather than insurance products.

While the latter are monitored by government regulators to ensure that the rates they charge are fairly tied to the benefits they may return, ESC administrators are free to charge whatever they like. According to research compiled by Warranty Week, this ranges from 1.2 to 43 percent of a product’s retail price!

But it’s not just high prices that make ESCs attractive to retailers, manufacturers, and third-party administrators. Another factor is the reliability of most products these days. As this graphic from the Cleveland Plain Dealer illustrates, a 36-inch plasma TV has only a 7 percent chance of needing repairs during its first three years of operation. A camcorder has an 8 percent chance of breaking down; a refrigerator has a 17 percent chance. Or to put it another way: As long as you avoid improperly ventilated war zones in freezing countries God hates, your digital camera is unlikely to need service.

Even though ESCs may only be protecting you from break-downs that are unlikely to happen, even though they’re often overpriced (given the value they are likely to return), millions of people are willing to pay for them. These people may complain that ESCs cost too much, or that ESC administrators do everything they can to avoid paying repair costs they should be covering. But where is the Michael Moore documentary passionately advocating for our right to free extended repair service? How come Barack Obama never highlighted his desire to overhaul the costly and inefficient laptop insurance industry on the 2008 campaign trail? And why do millions of people keep paying for a service most consumer advocates characterize as unnecessary?

Two professors and one Ph.D. candidate at Carnegie Mellon’s Tepper School of Business recently published a paper (PDF) in the Journal of Consumer Research that may shed some light on this mystery. Using field data collected from the electronics department of a major retailer, they identified several factors that are in play when people purchase ESCs.

For example, one determining factor is whether or not a product is “hedonic” or “utilitarian.” A hedonic product, the study’s authors explain, is one associated with “fantasy, fun, and pleasure.” A utilitarian product is one that is “useful, practical, and necessary.”  In previous studies, researchers found that people tend to form greater emotional attachments to hedonic products. In this study, the authors hypothesized that people would be more likely to purchase ESCs when buying products generally considered to have high hedonic value, and indeed, the field data supported this theory.

The study’s authors also hypothesized that people would be more likely to purchase ESCs after taking advantage of unadvertised promotions. Their rationale: Unadvertised promotions create a positive mood in consumers, and a positive mood typically increases risk aversion. You don’t want your good mood to end, so you take whatever steps you can to ensure that it doesn’t.

Once again, the field data supported this hypothesis — people who saved money on an unexpected sale were more likely to purchase an ESC. On the one hand, this seems perfectly rationale: If you were planning to spend $199.99 on a camera, but only end up paying $159.99 for it thanks to an unadvertised promotion, why not spend $69.99 for an ESC? It may not be a very good bet, but at least it’s being largely subsidized by “free” money. On the other hand, wouldn’t it be far more prudent to invest that $40 savings into something truly hedonic, like a bottle of scotch? If your camera breaks down within three years, you’ll have something with which to drown your sorrows. If it survives, you can toast your good fortune. Either way, you win. • 4 August 2009

Greg Beato is a contributing editor at Reason magazine. Follow @GregBeato on Twitter.

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