By now, most dealers are familiar with the “dealer-owned warranty company” or “DOWC” concept and, more likely than not, have reviewed a presentation touting the benefits of this structure.
Providers promoting this structure often highlight certain benefits that are very enticing and alluring to dealers that are currently in reinsurance. However, providers regularly fail to provide a comprehensive view of the structure, leading many dealers who elect to proceed with a DOWC to second-guess their decision shortly after making the move.
Dealers considering a DOWC should carefully analyze the reasons why a DOWC is attractive, whether they can achieve similar results using an affiliated reinsurance company (ARC), and the potential problems a DOWC may pose.
Structure and Perceived Benefits
A DOWC is a corporation formed and licensed to be the obligor on service contracts and certain other F&I products. The DOWC is often able to defer payment of federal income tax for an extended period of time using the tax laws applicable to insurance companies in the United States.
There are several features of a DOWC that are attractive to dealers:
Dealers are understandably attracted to the concept of “owning” their warranty company. The ownership concept implies lower fees and increased control of contract reserves, administration and claims processes. With respect to fees, it’s a misconception that fees are, by default, lower in a DOWC structure than those of another structure. Fees are commonly negotiated by F&I providers irrespective of the structure a deal takes.
Moreover, dealers who want better control of contract administration and claims processes merely need to choose the correct provider (rather than a particular structure). It doesn’t matter what structure is used; dealers deserve (and should demand) that their F&I provider allows dealer involvement on high-dollar claims, meets quarterly regarding trends and losses, allows a choice of investment managers, and allows loans from earned and unearned premium.
These benefits are tied to choosing the correct provider, not choosing a DOWC over some other structure.
Dealers are also attracted to DOWCs because they are (most often) domiciled in the U.S. rather than a foreign country. On first blush, this seems reasonable. However, when comparing a DOWC to an ARC, it’s important to note that both are U.S. taxpayers and file the same U.S. tax returns, and the same tax laws apply to each. This is true of an ARC that is domiciled off-shore (like the Turks and Caicos Islands) or an on-shore jurisdiction (like the Delaware Tribe of Indians). Compound that with the fact that all of these structures keep F&I reserves in U.S. bank accounts and the concept of having a domestic corporation loses most, if not all, of its allure.
A long-term tax deferral is another aspect of a DOWC that is often attractive to dealers. Under the U.S. tax code applicable to insurance companies, most DOWCs will realize a long-term deferral of income tax.
While this can be a great benefit to dealers, it’s important to consider two things:
- This is just a deferral of income tax, not an exemption from income tax like an ARC that qualifies for IRC 831(b) realizes. It’s likely that the DOWC will become liable for income tax at some point in the future — unlike an ARC, which qualifies for IRC 831(b) and is exempt from income tax altogether.
- Dealers who do not qualify for an IRC 831(b) election can achieve the same DOWC tax deferral in an ARC if they choose the correct F&I provider.
Dealers who want a DOWC effect without the hassle (more on this below) should partner with a provider who can achieve similar results using an ARC.
Drawbacks and Second Thoughts
Despite the perceived benefits of a DOWC, there are several drawbacks that dealers should consider as well.
- There is often a lengthy time period to launch a DOWC program. The company may need to obtain applicable licenses and regulatory approval of F&I products (in some states) as well as lender approval so the products can be financed.
- Most DOWC structures do not support all F&I products (two common exceptions are GAP and limited warranty programs) and those products will need to be put into another structure.
- Most notably, and commonly not disclosed to dealers, is the “controlled group” issues that can arise. If a DOWC has majority common ownership with an ARC that has historically qualified for an IRC 831(b) election, the ARC will probably not qualify to make an 831(b) election in the future leading to adverse tax results.
Industry experience shows that more than half of dealers who choose to adopt a DOWC structure change their mind within 12 months and attempt to pivot to another structure, which causes a great deal of unnecessary work for all involved.
Most, if not all, F&I providers offer a DOWC structure in some form and a discerning dealer considering a DOWC will ask the provider about the potential downsides. Dealers deserve and should demand a provider who can provide all the facts and options available, including an ARC that provides all the DOWC benefits without the inherent downsides.
Andrew Seger is chief legal officer for Portfolio, a leading provider of reinsurance and F&I programs and products. For more information, visit www.portfolioreinsurance.com.