Service contracts, regardless of what they're called, aren't warranties. A warranty is a guarantee, usually in writing, by a seller or manufacturer, stating that it will stand behind its product in a specific way for a specific period of time. Although companies are not required to warrant their products, federal warranty law creates specific legal obligations when warranties exist. These obligations help consumers in a big way if a product is defective or if the manufacturer doesn't live up to its obligations.
Take, for example, a marine engine that breaks down due to a faulty water pump. If the engine is under the factory warranty, the manufacturer will replace the pump and cover damages caused by overheating. Say the manufacturer got a bad batch of pumps and the replacement fails for the same reason — or even a third failure occurs — a reputable manufacturer will take care of it, along with the attendant damage.
Suppose, however, that the first water-pump failure occurs after the factory warranty has expired and only the extended service contract is in effect. Water pumps usually are covered components, so the contract will handle repairs. But, damage due to overheating, regardless of cause, may be excluded from the policy. The manufacturer is unlikely to step in, even in the case of a pump that's known to be faulty, as the failure didn't occur on its watch.
Service-contract companies are obligated only to provide the services described in their contracts. Many contracts have maximum pay-out limits for the total number of claims against the contract or even for repeat failures of the same component. Limits are often based on the value of the covered product, in this case, the marine engine. Service-contract underwriters can cancel contracts when paid claims exceed the value of the engine. On the other hand, warranty law allows manufacturers to make a "reasonable number" of repair attempts before they're obligated to provide a replacement or refund. Before you buy a service contract, ask to see the actual contract, not the sales literature. The exclusions sections are often a lot longer than the "Items Covered" sections. Also, service contracts will not cover engine breakdowns resulting from shoddy workmanship, even by its authorized service centers.
Finally, as service contracts are essentially insurance policies, they fall under insurance regulations in many states.
However, not all states view them as such, so consumers may have little recourse if claims aren't handled equitably or if the company underwriting the contract folds.