1. NOT INSURANCE, NOT A WARRANTY

Many consumers think of extended warranties as insurance. That's not by accident. Marketing materials promise "peace of mind," or "fully insured," describe their business as "insurance-related," and point to their financial "strength and stability."

But extended warranties are not insurance in most states. They're not even warranties as defined by federal law. These arrangements are most accurately described as prepaid repair contracts, also known as extended service contracts. Here's how they work:

A car dealer usually sells a contract that is handled by independent auto warranty companies called administrators. The dealer just makes the sale, so the contract is between you and the administrator, which might be a carmaker's subsidiary or a separate company. The administrator pays the repair shop or reimburses you only for covered problems. Another company might insure your contract against default.

"Auto extended warranty companies are not subject to the same close regulation and oversight as insurers," says Jane Cline, the insurance commissioner of West Virginia, who spoke with us on behalf of the National Association of Insurance Commissioners. That means that buyers of extended service contracts in states that don't consider them to be insurance don't enjoy the same regulatory safeguards that they get from, say, auto insurance, whose price must bear a reasonable relationship to cost.


2. HIGH SALES COMMISSIONS

Since extended service contract pricing is not regulated, dealers charge whatever the market will bear, and a 50 percent cut for sales commissions is not unusual. That means on a $1,500 to $2,300 contract, $750 to $1,150 can go to the administrator, minus that company's own costs and profits.

By contrast, only 17 percent of your annual premium for auto insurance goes to commissions and other selling expenses. On average, dealers collected $795 per new-car extended service contract last year, according to Superior Integrated Solutions, a dealer management consulting firm. Such sales contributed 14 percent to dealerships' bottom line, according to CNW Marketing Research, which covers the automobile industry.

Stephanie Marquis, a spokeswoman for the Washington State Insurance Commissioner's Office, says if there's a state-licensed insurance company or lesser-regulated risk-retention group behind the plan, "only $300 actually goes to the insurance company" in her state.

In other words, a very small portion of the price you pay for an extended service contract actually goes to repairs after intermediaries get their cut.


3. UNLIKELY CATASTROPHE

The standard sales pitch for extended service contracts includes invoking fears about the breakdown of big-ticket items. Promotional materials for the GM Protection Plan, for example, show an array of pricey internal parts under the skin of an SUV—$1,200 for an air-conditioning compressor, $2,600 to replace the transmission, $7,300 to switch out an engine.

Concern about future repairs is what mainly drove people to sign up for an extended service plan, but for the most part, their worst fears did not materialize. Plans were used by 58 percent of buyers, and the average repair savings were less than what they paid for the contract. Only about a third of all respondents who bought an extended warranty actually used their plan to cover a serious problem.

Another way to look at this is through the experiences of people who had vehicles four to six years old and who did not have extended warranty coverage.Analysis from our extensive reliability database showed that only about 4 percent of those cars had repair costs of more than $1,700 in a one-year period, and fewer than 1 percent had $3,700 in such costs.

A Ford official acknowledges that big-ticket repairs are rare during the life of its biggest-selling five-to-six-year Premium Care Extended Service Plan. "What you tend to see is a few small repairs as the vehicle gets older," says Mark Bardusch, Ford's ESP sales manager. "Major repairs are decreasing." But Bardusch says Ford's plans, for which consumers pay about 2 percent of the vehicle price per year of extended service, are a much better deal than those offered by the home-appliance industry, which usually charges a higher percentage of the product's price.

For additional information on extended warranties, see How they work: Terms and coverage.