No Claim? Your Gain : Design of Residual Value Extended Warranties Under Risk Aversion and Strategic Claim Behavior

Traditional one-price-for-all extended warranties do not differentiate customers according to their risk attitudes, usage rates or operating environment. These warranties are priced to cover the cost of high usage customers who experience more failures and are willing to pay a risk premium for their risk aversion. This makes traditional warranties economically unattractive to low usage customers and those who are less risk averse. Residual value warranties can help address these issues. Residual value warranties refund a part of the upfront price to customers who have zero or few claims according to a pre-determined refund schedule. However, a warranty with residual values may induce strategic claim behavior as customers may prefer to pay for small failures out of pocket rather than to claim failures now and give up potential refunds later. Taking into account the claim behavior and risk attitudes of customers, we design and price residual value warranties. In a constant absolute risk aversion model, we characterize customers’ optimal claim strategy as well as the structure of the net value and support cost for residual value warranties. Surprisingly, the total support cost to the service provider, including repair cost and refund, is lower for more risk-averse customers under the residual value warranties, while their willingness-to-pay is higher. This implies potential profitability of residual value warranties. Moreover, residual value warranties, as contingent contracts, can better price discriminate customers than traditional warranties. We identify conditions under which residual value warranties are strictly more profitable than traditional warranties in a homogeneous market, as well as in heterogeneous markets differing in various dimensions, such as risk attitude, failure rate and repair cost