Vehicle Service Contracts (“VSCs”) are policies sold to consumers that provide coverage for a range of mechanical and cosmetic failures on a vehicle. The typical coverage areas are often for failures related to engines, electronics, windows, etc. In addition, administrators usually offer add-on options and packages for plans providing additional coverage for areas such as tires and wheels, exterior appearance, interior appearances, and even key fobs. The objective of a VSC is to provide coverage for areas that a vehicle insurance policy would not cover. For example, anything related to a car accident would be an insurance claim, not a VSC claim.
Value to Consumers
The number one value to consumers with a VSC is the peace of mind that any covered issue per the policy will not result in an expensive out-of-pocket expense for repairing their vehicle. Currently, 40% to 50% of Americans do not have $400 of assessable cash at any given time to pay for an unexpected repair of their vehicle. In addition, for most Americans, a car is a valuable asset that is utilized for work, family, and recreational needs. Therefore, mitigating the financial risks of high-priced repairs make a VSC an attractive product in many households.
While dealerships are the primary distribution channel for VSCs, third-party marketers also offer VSCs directly to consumers. Typically, an F&I agent acts as the intermediary between the administrator and dealership. When a consumer makes a claim, the VSC administrator will work with a repair facility to ensure the respective facility is compensated for the repair work.
VSC companies are consolidating because vertical integration brings synergies and additional distribution. Administrators are locking up distribution channels by buying F&I agencies and buying other administrators. Insurance companies buy administrators because they can often remove part of the cost structure.
The number one driver of M&A activity in the industry is the presence of private equity firms, which have been increasingly investing in the automotive finance and insurance products sector because of the dynamics of the industry. Favorable dynamics include the large industry size, growth, high margins, and high cash flow. Private equity firms often acquire an administrator and then make add-on acquisitions to increase distribution and recognize synergies in the expense chain by taking out a layer of the cost structure.
Administrators are generally valued on a modified cash accounting basis rather than on a GAAP basis. Modified cash accounting recognizes revenues at the time of sale, with the administrator receiving payment upfront. The associated expenses are also recognized at the time of sale. For a growing business, earnings will be higher under modified cash than under GAAP accounting, in which earnings are recognized over the life of the contract. For an administrator obligor, there is real value to the insurance funds in the trust that are set aside to pay for future claims. Therefore, income from the trust should be included in the value of the company. Other value drivers in the VSC industry include geographic reach, lack of dealership concentrations, and overall company size.
For more on the VSC administrator industry, listen to Middle Market Mergers and Acquisitions podcast by Colonnade Advisors, episode 019: Industry Spotlight – Vehicle Service Contract Administrators.
If you would like to discuss the VSC administrator space further with Colonnade, please contact a member of our team.