FOO Law and Economics

Sunday, February 1, 2009

Why pre-need plans are attractive to their holders

As noted in my other piece on rural banks, a Ponzi scheme is one where investors are paid out of money from subsequent investors. As a rule, a Ponzi scheme involves an element of fraud, since the operator of the scheme does not intend to repay the returns promised to all investors, but only to those who participated early in the scheme.

What about pre-need firms, some of which have recently closed? The pre-need industry has also recently been seeking a government bailout. Would such a bailout be in order? Should the bailout be denied if a pre-need firm has been operating a Ponzi scheme?

The sensible rule on bailouts seems to be one that has been applied to banks. Going back to the days of Bagehot (1873), lenders of last resort have established a rule to help maintain stability of the banking system, while containing moral hazard on the part of banks. (Moral hazard, an insurance concept, is defined as the presence of incentives for certain parties to act in ways that incur costs that they do not have to bear. Since the activities of a lender of last resort act as a form of insurance that the banking system will remain in place, there is an element of moral hazard on the part of banks or their depositors who expect a bailout.)

The rule is: Lend to solvent banks on sound collateral, but at a penalty interest rate; but let the insolvent banks fail. A further modification of this rule is that some banks are “too big to fail.” A failure of such a bank would have catastrophic effects all around, and it should be bailed out simply to preserve the banking system as a whole.

While the rule looks simple enough, it may be difficult to apply in practice. In particular, disputes on the valuation of bank assets and liabilities have to be resolved. Such disputes pose difficulties when some of the assets or liabilities do not have a ready market price, or if the market valuation is distorted for reasons unrelated to the activities of the bank in question. It is also arguable that in the depths of a deep recession or depression, even the best banks are technically insolvent because the market valuation of their assets is temporarily and irrationally too low.

With pre-need firms, the potential to do a “Ponzi” exists if their owners or stockholders also manage them. It does not follow that because such a potential exists that any of the pre-need firms actually operate a Ponzi. The fact that a pre-need firm is illiquid or insolvent is, by itself, not enough to establish that it has run a Ponzi. Nonetheless, it is illuminating to try to find out how a pre-need firm might be able to operate a Ponzi.

The following is a sketch of such a Ponzi scheme. A firm would sell some of its assets, realizing the capital gains on these because they had appreciated in value. The firm may also gain from forfeitures of customer payments if, under a default clause, such customers fail to keep up their payments on their plans. The stockholders of the firm might then find a way to pay themselves large salaries and dividends because the audited financial statements would show income from such forfeitures and capital gains. The result is a high probability of insolvency later on, when loss-producing assets eventually have to be liquidated, which usually occurs when new business slows down or ceases. An indicator of such a fraud is when a pre-need firm’s expenses for salaries and dividends, or for some unexplained expenses, are high in “good” years, where “good” depends on forfeitures of customer payments and recognition of capital gains on assets held. Of course, how high salaries and dividends are is a subjective issue, but there could be benchmarks from industry practice in insurance companies. Unexplained expenses are “red flags” for auditors, but a Ponzi operator will make fraudulent claims as to their legitimacy.

What if it is impossible to determine if a pre-need firm has been running a Ponzi? What if it can prove its good faith, and that its illiquidity is temporary? It seems that a pre-need firm that is solvent should qualify for a bailout in the form of loans to relieve it of its illiquidity. Under the Bagehot rule, the loan will have to be given on good paper, properly discounted, and the lender doing the bailout will be charged with overseeing the rehabilitation of the firm into a state of liquidity. A pre-need firm that is insolvent qualifies for bankruptcy protection, but transactions made prior to such a bankruptcy may be attended with indicia of transactions in fraud of creditors. Under the applicable legal rules, such transactions may be reversed, and recovery can be had against the counterparties of the pre-need firm.

As a matter of public policy, what is the remedy when pre-need firms have a tendency to fail? One remedy is to subject them to the minimum capital rules imposed on insurers. In my view, this may or may not be a sufficient remedy. Pre-need firms are more like banks, where the regulations impose a duty on a bank to maintain reserves based on possible “loan losses” on its investments. Pre-need firms who invest in risky assets, such as real estate or the stock market, should, like banks, be required to set aside reserves against the possibility of capital losses on all such investments. If a pre-need firm guarantees the quantities (and not just the value) of the plan, reserves should also be set aside against price increases of such quantities.

What is the likely effect of imposing a more stringent minimum capital requirement on pre-need firms? Inadequately capitalized firms will have to drop out of the business. As to the remaining firms, obviously, the likelihood of insolvency is reduced, and their plan holders would be better protected. But the need to maintain adequate reserves also means that pre-need plans will be more expensive. Consequently, a potential plan holder may opt to simply manage his own savings in order to have enough funds for the day when the “need” arrives. After all, a pre-need plan is another form of savings.

One final word. If a pre-need firm has been doing a Ponzi, its operator has committed fraud. It does not make sense to bail out such an operator. A more difficult question relates to any remedy that would be sought by its “victims,” i.e., the plan holders who have not been paid. Ideally, recovery can be had against the operator if he has assets, and the doctrine of piercing the corporate veil should be invoked. But that is an ideal world. Alternatively, a form of “default insurance,” similar to deposit insurance for banks, may be contemplated: Pre-need firms would pay periodic premiums into such an insurer, who would protect plan holders against a default of a pre-need firm. Such an insurance scheme would provide incentives for pre-need firms to police each other’s practices since, obviously, the premiums that have to be paid to the insurance fund would rise with an increase in the probability of insolvency of any pre-need firm.

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Having long toiled within a behemoth, I have since decamped to a quiet bay, at times on a single outrigger. I contemplate how social order and the economy interact. And what it's all about.

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