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These guidelines are advisory in nature and set out general concepts rather than precise statutory language. The ICCFA is not recommending that the guidelines be codified into law as a whole. Instead, the guidelines are intended for consideration as a series of options to be selectively chosen by interested parties to address particular concerns.
Ronald G. E. Smith and Keith A. Heyen
1. Purpose and Acknowledgment
The purpose of this study is to determine adequate funding requirements applicable to trust accounts used in connection with preneed transactions by analyzing the conditions under which death care merchandise and services are sold and delivered under prepaid contracts.
The present study was commissioned by the International Cemetery and Funeral Association in September 1997. Certain data used herein were obtained from suppliers and providers by Mr. Lawrence F. Sloane of L.F. Sloane Consulting Group, Inc., on behalf of the Association.
The study was designed and conducted by the authors, whose affiliations are indicated here for the purposes of identification only. Dr. Smith is a professor of economics at Hunter College of the City University of New York. Dr. Heyen is an assistant professor of finance at the Graduate School of Business Administration of Fordham University. Dr. Smith is also the author of The Death Care Industries in the United States (McFarland, 1996).
The completed study was submitted to the Association in March 1998.
2. Methods of Funding
Sound business practices and the principles of consumer protection call for certain restrictions on the disposition of preneed funds prior to the performance of the prepaid contract. Without imposing unreasonable and anti-competitive restraints on the marketplace, the basic purpose of such restrictions is to provide that an adequate portion of the proceeds must be set aside to assure the seller's performance at the time of need. Any excess of sales proceeds over the portion required to be set aside may be used by sellers to cover the costs of their efforts, such as sales commissions, administrative overhead, and advertising expenses. To be viable, the preneed sales program of a provider must generate sufficient cash flows to enable a seller to cover these indirect costs as well as the direct costs of the merchandise and services sold.
A primary mechanism for safeguarding an adequate amount of the funds received from the preneed sale of merchandise and services is by placing a specified portion of the funds into a prepaid contract trust fund that is administered by a trustee pursuant to a written trust instrument. Following performance of the prepaid contract, the seller is then entitled to withdraw the funds contributed, along with any undistributed earnings attributable to that prepaid contract. This type of trust has a finite life, in that all funds are eventually distributed when each prepaid contract is serviced.
Several alternatives to trusting, such as constructive delivery, surety bonds, and insurance-funded prearrangements, are available. This study relates to prepaid contracts that are trust-funded. It uses a computer simulation to evaluate the past performance of alternative funding requirements applicable to trusts established under prepaid contracts. The simulated performance outcomes are used to determine whether a particular funding requirement enabled providers to cover the costs of merchandise and services required to be delivered under real-world conditions in the past.
3. Methodology of Study
Given the obligations of sellers of prepaid contracts to deliver merchandise and services in the future when death occurs, the adequacy of the funds made available from an individual trust account depends on a set of factors which are enumerated and briefly explained as follows:
Since it is uncertain when death will occur, even a funding requirement of 100% of the wholesale cost of merchandise or services may lead to deficits in individual trust accounts at the time of need. Such deficits may arise as a result of the failure of investment returns earned on trust funds to keep pace with cost increases during the interval between purchase and death. Thorough consideration of the adequacy of preneed funding requirements must allow for this possibility and for the occurrence of early death during the term of the prepaid contract. To do this it is necessary to recognize that during any discrete period of time, such as a year, a typical preneed seller may experience one or more calls for delivery which involve a deficit, meaning that the amount of funds available in an individual account is less than the current wholesale cost of merchandise or services. When this occurs, the seller's general operating income may be required to cover the resulting shortfall.
Over time, however, it is reasonable to assume that the occurrence of deaths will follow a predictable pattern and that investment returns (which incorporate an inflation premium) will more than keep pace with cost increases in merchandise and services. It follows, then, that in any annual operating period an established seller whose business experiences some underfunded calls will also experience a number of calls that entail an account surplus. For otherwise viable sellers, therefore, the critical issue in connection with adequate funding is the resulting aggregate amount in expiring accounts with surpluses as compared with the aggregate amount in those with deficits. As long as this "net" amount is positive, the seller is presumed to be financially able to cover the aggregate wholesale cost of deliveries with the proceeds of the accounts which become available due to death occurring during an operating period. This, at least, is the premise on which the present study is based.
In what follows, various cost and other data are used to calculate the cash flow implications of deliveries required under prepaid contracts for several different types of death care items. For each of the items, it is assumed that a similar group of prearrangers purchases the item in year one, and thereafter in years two, three, and so on, for a series of "n" years.
At the time of each preneed purchase, a designated percentage of the wholesale cost of the merchandise or services is placed in a prepaid contract trust fund and invested in one of the types of securities indicated. The population of purchasers dies in accordance with mortality experience.
The model estimates the net amount of proceeds made available from the trust funds during each year, as a result of deaths occurring and after covering the cost of delivering the merchandise or providing the services contracted for. Mathematically, the model calculates the series of annual net cash flows occurring from expirations in successive years during each of which the net cash flow is equal to the aggregate amount of funds in the affected trusts minus the aggregate cost of providing the merchandise and services contracted for.
Note that this formulation is not based on an insurance model or "pooling" approach that requires the use of any monies in the trust funds prior to delivery (death). Nor does it permit any payments of taxes or withdrawals of excess accumulation over cost increases from the trust funds. It involves calculating the aggregate amount of proceeds received from the trust funds of those who expire during a given year, with any deficits in some trusts offset partially or fully by excesses in others. For a seller, the net effect of this in a given period of time is a measure of the extent to which the wholesale costs required to be incurred under the prepaid contracts are covered by the aggregate amount of trust funds received or receivable from trust accounts. Receipt of these funds is triggered by expirations during a given year.
Data relating to the historical costs or prices of the following selected merchandise and services are presented in Appendix A:
Data relating to the annual rates of return earned on funds invested in each of three different types of securities were obtained for a series of years corresponding to the cost data series. The three different types of securities were the one-year U.S. Treasury bill, the stocks included in Standard & Poor's index of 500 stock prices, and the tax-exempt municipal bonds included in the Bond Buyer index of 20 bonds. The annual rates of return from investments in these securities were obtained from the Federal Reserve Board and selected "Statistical Abstracts of the United States, 1970-1996." Factors based on those rates are presented in Appendix B.
Data relating to mortality were obtained from the Life Tables in "Vital Statistics of the United States," 1992, Volume II-Mortality, Part A (U.S. Department of Health and Human Services, Public Health Service, Centers for Disease Control and Prevention, National Center for Health Statistics, Hyattsville, Maryland, 1996). The data used represent the number of survivors at single years of age out of 100,000 born alive; death statistics at each age up to 85 were developed from this.
Survival rates for ages beyond 85 were not readily available. Accordingly, an assumption was made that those who are still alive at 85 expire in a straight-line fashion which results in no survivors beyond the age of 90. Thus, those who reach 85, having earlier made a preneed purchase, expire at a rate of 20% per year for five years. Similarly, those who become prearrangers at age 86 and over are assumed to expire at annual rates which eliminate all of them by the age of 90. This assumption is consistent with high death rates among this segment of the population, although it perhaps overstates somewhat the actual age specific death rate among this group, which includes some members who live beyond 90. The data for survival rates at each age up to 85 are presented in Appendix C.
Data relating to the age distribution of an annual group of preneed purchasers were obtained from the recent sales experience of a large seller of death care merchandise and services during the eleven months from January through November 1997. The age distribution of the purchasers in that given period is presented in the table below.
|AGE BRACKET||PERCENTAGE OF CONTRACTS|
|39 and under||3.2|
|40 - 45||2.4|
|46 - 50||3.4|
|51 - 55||4.3|
|56 - 60||5.6|
|61 - 65||8.8|
|66 - 70||13.3|
|71 - 75||16.5|
|76 - 80||16.4|
|81 - 85||12.9|
|86 and over||13.2|
Utilizing the above-described model, the present study simulated the annual net cash flows resulting from alternative funding percentages for each of the items studied, assuming the investment of the trust funds in each of the different types of securities discussed earlier. The simulations were based on an initial group of 1000 prearrangers and used actual data representative of conditions prevailing during each of two overlapping past periods of equal length, 1970-1985 and 1980-1995.
The purpose of these simulations is to recreate the expected streams of annual net cash flows resulting from alternative funding percentages applied to each type of merchandise or service, based on its particular cost experience and the actual investment returns earned from each different type of security during two equally lengthy past periods of time. By comparing the simulated cash flow streams for each item, it is possible to determine the "lowest" funding percentage that resulted in sustainable positive net cash flows where funds were invested in securities of a particular type during each of the designated periods.
Sustainable positive net cash flows were defined as a series which included no consecutive negative net cash flows and no more than two nonconsecutive negative net cash flows during any 15 year period. For purposes of assessing the adequacy of funding requirements, this seems to present a reasonable standard of acceptable risk in that it insures against the use of a funding percentage which results in repetitive negative net cash flows. At the same time, it recognizes the inherent possibility that virtually any reasonable funding percentage may result in the occurrence of negative net cash flows for non-recurring reasons, such as the start-up of preneed sales activities, a temporary confluence of wholesale cost increases with poor short-term investment returns, and so on. The effect of the standard adopted here is to allow for such occurrences as temporary phenomena which are not recurrent.
The results of the simulations are presented in Appendices D and E as a series of "profiles" which graphically illustrate the annual net cash flows resulting from the relevant rate of alternative funding percentages applied to the wholesale cost of each item. The profiles reflect the expected annual net cash flows generated by the simulation process during each of the two overlapping 15 year periods. Hence, there are two sets of profiles for each case in which a particular item is funded by an investment in securities of a particular type. One set consists of the "1970-1980 profiles" (Appendix D); the other consists of the "1980-1995 profiles" (Appendix E). The results of the simulations from which the respective profiles were derived are presented in Appendices F and G.
The lowest funding percentage that resulted in sustainable positive annual net cash flows can be discerned by inspection of each set of profiles. For each item, the minimally adequate funding requirement associated with a particular form of investment is defined as the "higher" of the "lowest" funding percentages resulting in sustainable positive annual net cash flows during the 1970-1985 and 1980-1995 periods, respectively. The minimally adequate funding requirement obtained in this manner varied for the items under consideration and the type of securities in which the funds were invested as shown in the following table:
|ITEM||INVESTMENT||MINIMALLY ADEQUATE FUNDING REQUIREMENT|
|Casket||Treasury bills||100% of wholesale cost|
|S & P 500 stocks||110% of wholesale cost|
|Tax-exempt municipals||100% of wholesale cost|
|Outer Burial Container||Treasury bills||100% of wholesale cost|
|S & P 500 stocks||105% of wholesale cost|
|Tax-exempt municipals||100% of wholesale cost|
|Memorial||Treasury bills||105% of wholesale cost|
|S & P 500 stocks||115% of wholesale cost|
|Tax-exempt municipals||105% of wholesale cost|
|Opening and Closing||Treasury bills||110% of wholesale cost|
|S & P 500 stocks||115% of wholesale cost|
|Tax-exempt municipals||130% of wholesale cost|
In the preceding table, the minimally adequate funding requirements are expressed as a percentage of the wholesale cost of merchandise and services. Depending on markups, these results translate into adequate funding requirements that may be significantly less than the prevailing retail price charged for each item.
In general terms, if t is the applicable minimally adequate funding requirement, expressed as a decimal fraction, then tC is the amount of money required to be funded, based on the wholesale costs of merchandise or services designated by C. Since retail price is equal to C(1 + u), where u (also expressed as a decimal fraction) is the markup rate on cost, then the equivalent funding percentage of any item, expressed as a percentage of price, is given by t/(1 + u). For example, if t = 100% and u = 100%, then the minimally adequate funding requirement expressed as a percentage of retail price is 1.00/(1 + 1.00) = ½ = 0.5 or 50% and so on.
6. Limitations of Methodology
The results of the analysis presented here are subject to several limitations related to the data and method used to derive the net cash flows resulting from alternative funding percentages.
To begin with, it was pointed out that the age distribution of purchasers was obtained from the recent sales experience of a single large seller of funeral services. This distribution does not necessarily reflect the experience of other sellers.
The age-specific mortality data used here were based on survival rates per 100,000 persons born alive, as published by the United States government. For purposes of the analysis, it was assumed that smaller groups of prearrangers experience similar rates of survival and death, without taking into account any reasons why prearrangers may expire at different rates (e.g., because the act of prearranging may by nature attract those who are on average less healthy than the general population). For prearrangers over age 85, survival rates from which mortality data could be derived were not available. Members of such advanced age groups were assumed to expire at straight-line rates resulting in no survivals beyond 90.
The results of the analysis reflect actual data related to cost increases and investment returns actually experienced during the period studied. This experience may differ in other past periods of the same or different lengths. In order to address this limitation, the analysis was extended over two periods long enough to include a highly varied set of economic conditions resulting in different annual rates of inflation, cost increases, and investment returns. Even so, future conditions may produce results that differ somewhat from those obtained here.
As expected, the results reveal a sensitivity to the type of securities in which trust funds are invested. During the 1970-1985 period, in particular, net cash flows resulting from accounts invested in a portfolio of S & P stocks experienced considerable variability from year to year. With one exception (opening and closing services), this led to higher minimally adequate funding requirements for all items when equity securities were used as the funding medium. Beyond this general observation, no attempt was made to assess the extent of risk posed by the use of different types of investments to secure prepaid contracts.
Another limitation of the analysis here relates to its assumption that the initial amount placed in a trust account remained intact along with accumulated earnings. This assumption does not provide for transaction costs or permit the withdrawal of funds for any purpose, such as the payment of taxes or the withdrawal of all or part of the earnings which exceed wholesale cost increases. The adoption of a funding requirement which provides for transaction costs or permits withdrawals for tax or other reasons may be expected to reduce the net cash flows produced by the method used here.
Another limitation of this study is its exclusion of the impact of administrative and overhead costs related to the delivery of merchandise or the performance of services, which are expenses incurred by a seller in addition to the wholesale cost of merchandise or services. If these costs are not covered fully by the positive net cash flows generated by expiring trusts, any shortfall must be absorbed by the operating income or other available resources of preneed providers. Where preneed sales account for a substantial percentage of the revenues of a provider, related administrative and overhead costs may represent a significant factor underlying the ability to perform under preneed contracts. Nevertheless, no attempt was made to account for administrative and overhead expenses in the preceding analysis.
Instead, the analysis was limited to a consideration of the adequacy of funding requirements only as the term implies an ability to cover the cost of merchandise and services required to be provided under prepaid contracts. Even in this limited respect, the analysis accepts some risk since the minimally adequate funding requirements deliberately permit as many as two nonconsecutive years of negative net cash flows in a series of 15 years. No attempt was made to measure the extent of this risk or to assess the other types of risk to which prepaid contracts may be subject due to, for example, temporary insolvency or bankruptcy. Although this risk appears low, it does exist, and the potentially negative impact of such rare occurrences probably justifies the establishment of provisions for dealing with them in a systematic way.
In conclusion, it should be noted that the present study was focused exclusively on the adequacy of funding requirements applied to preneed transactions in death care merchandise and services. No attempt was made to evaluate the emotional, financial, and other effects of preneed purchases by consumers or to estimate the commercial effects of the use of preneed sales methods by sellers.