The Pre-Need Industry

I. The Pre-Need Industry The Pre-Need Industry, like the Banking, Mutual Fund or Insurance industries, is an integral sub-sector of the Financial Services Industry. Pioneered as a uniquely Filipino creation in the ‘60s, preneed plans accomplish the critical function of financial intermediation by building-up the Filipinos’ propensity to save and delivering essential products and services that cover the Filipinos’ basic needs in Education, Retirement and Death. Since its inception in 1966, the Industry has grown to benefit millions of Filipinos, providing not only the aforementioned academic, pension and memorial products and services but also jobs and income-earning opportunities to thousands of agents and employees. The Industry has also been a driver and key link to the nation’s progress through capital formation, moving moneys and investments, currently in the range of over P60Billion, and managing these through trust funds of universal banks and investment houses. Through over two decades, the Industry registered double-digit growth in the late ‘80s and early ‘90s when annual growth averaged over 20% and total assets were in the hundred billions of pesos. At its height, there were over 100 registered companies in the Pre-Need Industry. The success of this Filipino Industry and the validity, in fact, of its original business model, has been bolstered through the years with the entry of multinational giants such as the AIG group through Philam Plans, Berkeley International Group and Sunlife Financial Group.

II. Basis for Industry Failure Principally, there are four major, external factors that have caused the Industry’s temporary illiquidity and brought on impending inability to service debts : (1) the reality of Uncontrolled Tuition Increases (“UTI”) – where tuition fees have increased 15 times to 30 times the original assumptions; (2) Restrictive trust fund rules – which have constrained pre-need companies to receive trust fund yields well below the returns needed to allow pre-need companies to sufficiently meet obligations under all the plans; (3) the untenable Actuarial Reserve Liability (“ARL”) scheme – which has negatively impacted the financial position of pre-need companies, and; (4) the Asian financial crisis of 1997 – whose protracted effects has prevented the economy from fully recovering – and the Industry Meltdown (Domino Effect) that has sent industry sales and collections on a downward freefall and plan terminations rise to an unprecedented scale and seen the collapse of a number of companies.

1. Uncontrolled Tuition Increases (“UTI”) The problems experienced by the Industry are peculiar to it. In fact, it is an industry-wide contagion afflicting pre-need companies offering traditional open-ended education plans. This contagion is Uncontrolled Tuition Increase (“UTI”). Pre-need plans are contracts which provide for the performance of future service/s or payment of future monetary consideration at the time of actual need, payable either in cash or installment by planholders at prices stated in the contract with or without interest or insurance coverage. Typically, these would include life, pension, education and interment plans. Because of the stringent capital

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requirements accompanying the regulatory approval to sell each product, most pre-need companies would only carry one or two product lines.1 Pre-Need plans may also be categorized according to plan value or the value of the benefits that the pre-need company undertakes to deliver. The two types of pre-need plans based on this classification are fixed value plans and actual cost plans. A fixed value plan has the amount of the benefit fixed at the time the plan is purchased.2 Actual cost plans, also known as traditional open-ended plans, on the other hand, are plans where the amount of the benefit is dependent on the cost of such benefit or service at the time of availment.3 Most major companies in the Pre-Need Industry such as College Assurance Plan (“CAP”) and Pacific Plans offered such traditional plans. In 1966, Pacific Plans offered traditional memorial or life plans where Pacific Plans guaranteed the provision of the agreed-upon memorial service regardless of its actual costs at the time of availment. Similarly, CAP first introduced traditional educational plans in 1980, guaranteeing the payment of tuition and other educational fees prevailing during the time of delivery or maturity. The nature of traditional open-ended plans, which protected the planholder against, what at the time was simply real inflation and not artificially-induced or a manufactured rise in the cost of the products or services they represented, proved to be a compelling market need. As a result, traditional or open-ended plans comprised a significant share of the product mix of pre-need companies. Then the contagion called Uncontrolled Tuition Increase (“UTI”) turned this once premier product, the traditional open-ended education plan, into the bane of the industry. On September 11, 1982, B.P. Blg. 232, known as the “Education Act of 1982” was passed. As a consequence, each private school has the authority to determine its rate of tuition fees, other school fees and charges.4 1

Minimum paid-up capitalization is based on the type and number of plans being sold. Pre-need companies selling traditional education plans or selling three types of plans are required to have P100 million minimum paid-up capital. Two-type and single-type pre-need companies are required to have P75 million and P50 million minimum paid-up capital, respectively. 2

As defined in the Actuarial Society of the Philippines Guidelines to Actuarial Practice in Pre-Need. The New PN Rules define Fixed Value Plans as “Pre-need Plans whose benefits and costs are fixed and pre-determined at the inception or purchase of the Plan.” 3

As defined in the Actuarial Society of the Philippines Guidelines to Actuarial Practice in Pre-Need. The New PN Rules define Actual Costs or Traditional Plans as “Pre-need Plans wherein the benefits or services at the time they are due are guaranteed, regardless of any increase in cost from the originally assumed values since the date of issue of the Pre-need Plan.” 4

Section 42 of B.P. Blg. 232 provides: “Sec. 42. Tuition and Other School Fees – Each private school shall determine its rate of tuition and other school fees or charges. The rates and charges adopted by schools pursuant to this provision shall be collectible, and their application or use authorized, subject to rules and regulations promulgated by the Ministry of Education, Culture and Sports.”

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This was further reinforced by the promulgation of the 1987 Constitution which emphasized that the power of the state over educational institutions is not one of control, but only reasonable supervision and regulation.5 On April 15, 1994, DECS Order No. 20 S. 1994 was issued whereby the Department of Education Culture and Sports, the Commission on Higher Education (“CHED”) and the Technical Education and Skills Development Authority (“TESDA”), adopted a policy of deregulation as regards the determination of tuition and miscellaneous fee increases of private educational institutions. As a result, studies have shown that from 1990 to 1995, the national average for tuition fee increases among private higher education institutions are estimated at 275%. In fact, many schools have increased their tuition fees as high as sixteen percent (16%) to twenty eight percent (28%) every year. Based on studies from the CHED, a continued tuition rate increase for the next five years would bring the national average tuition per unit up by One Thousand Two Hundred Fifty Seven percent (1,257%) by year 2010 from 19906. In contrast, historical trust fund yields of pre-need companies have, in periods prior to 1992 reached as high as 18% but after 1992 have been in the range of only 8% to 10%. For the past few years, in fact, with the onset of various political and economic crises within the country, the bulk of trust fund investments of pre-need companies have been limited to the low returns offered by government securities, in the range of 5% to 9%. This is visually represented in the diagram below.

UTI

destroyed the business model UTI overtook trust fund yields!

Table 2.0 Metro Manila Schools 5

Section 4 (1), Article XIV of the 1987 Constitution provides: “Sec. 4. (1) The State recognizes the complementary roles of public and private institutions in the educational system and shall exercise reasonable supervision and regulation of all educational institutions.”

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Studies from CHED

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San Sebastian (College) Gross Price (Php) Total Availment (Php) Compounded Return Cumulative Return

17,712 94,310 18% 432%

Gross Price (Php) Total Availment (Php) Compounded Return Cumulative Return

Univ. of Nueva Caceres (College) 17,157 67,005 12% 291%

Far Eastern Ateneo de Manila University (High School) (College) 17,712 17,712 273,563 344,500 32% 35% 1,494% 1,845% Non-Metro Manila Schools Sacred Heart Cebu (College)

Angeles University (College)

17,157 86,944 15% 407%

17,157 176,736 26% 930%

As shown in Table 2.0 above, Returns on the Gross Price of traditional or open-ended education plans are well beyond the average trust fund yields capable of being generated. Also apparent, despite having the same Gross Price for a traditional or open-ended education plan, UTI favors enrollees of exclusive schools and prejudices those from non-exclusive schools who end up subsidizing these higher availments. Finally, UTI erodes the value of the plan benefits. Continued unbridled returns and inequitable pay-outs will prevent future servicing of plans and will eventually affect servicing of fixed-value plans as well. While the deregulation of tuition came about in 1982, pre-need companies with traditional or open-ended education plans began to feel the full effects of UTI only in recent years as the availment period for the bulk of these traditional or open-ended plans only started in the late ‘90s up to the present. In conclusion, the three devastating effects of UTI are: 1) unbridled returns on the traditional or open-ended plans, 2) inequitable pay-outs, particularly versus planholders who utilize the plans for lowtuition schools and versus non-open-ended education plans, in general, and; 3) loss of value in terms of plan benefits. The Pre-Need Business Model for traditional open-ended education plans was premised on a fixed rate of increase in Tuition Fees7. With a safe margin from its trust fund yields, pre-need companies could well cover the promised plan benefits. However, UTI destroyed this business model, compromising the positions of the pre-need companies and their respective trust funds considering that such additional costs could not be passed on to planholders. In support of the foregoing, the Philippine Federation of Pre-Need Plan Companies, Inc. (“PFPPCI”) declared in its position paper submitted to the Securities and Exchange Commission that, “The indefinite availment of open-ended educational plans is not sustainable. Any liquidity assistance can only be available if those with open ended plans fix their liabilities.” 7

10% per annum, inclusive of Miscellaneous and other Enrollment Fees

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Support for this position has, likewise, been echoed by government and by the academe. This was made apparent at a Symposium on the Pre-Need Industry held in July 2005 at the Asian Institute of Management were proposals were set forth addressing the structural and regulatory issues that were leading the industry into crisis.

2. Restrictive Trust Fund Rules The Pre-Need Business Model was premised, not only on a fixed rate of increase in Tuition Fees8 in the case of traditional or open-ended education plans, but also a safe margin from trust fund yields to cover the promised plan benefits for any and all plans, whether traditional open-ended education, fixed-value education or fixed-value pension plans. Thus, among the major factors that brought on the Pre-Need Industry crisis are the restrictive trust fund rules and regulations. These restrictive rules specified unreasonable limitations on the investments of the trust funds in light, not only of the runaway tuition fees under traditional open-ended plans, but also the high yields required under fixed-value plans for them to be competitive in the financial marketplace. Historically, the trust funds of pre-need companies have been invested primarily in government securities followed by equity and real estate. Ironically, while the investment limits and criteria were established to help ensure the delivery of the guaranteed benefits under the plan contracts of pre-need companies, the low returns provided by the instruments in the past ten years, especially since the Asian financial crisis, has in fact prevented the trust funds from providing the required yields to meet plan obligations. Investment yields in the past ten years have been well below the required levels to meet plan obligations of the Pre-Need Industry. Time Deposit rates, for example, net of the 20% withholding tax, have average below 10% from 1992 to 2005. Likewise, the average net rate of the 364-day Treasury Bills has dropped drastically since the Asian financial crisis of 1997 from 14.4% to 6.6% by end-2005. This deficiency in investment or trust fund yields has compromised not only the ability of the pre-need companies to meet the required reserve levels under the ARL scheme for both education and pension trust funds but has also compromised their ability to meet impending obligations for all currently availing plans, whether traditional open-ended plans, fixed-value education or fixed-value pension plans, without putting its non-availing planholders in a severely disadvantaged position. Table 1.0 below is a summary of the limits and criteria 9 governing the investment of the trust fund. Table 1.0 Investment Instruments 1. Fixed Income Instruments a) Government Securities b) Savings/time deposits and common trust funds 8

Criteria

With a commercial bank with recent satisfactory rating by the BSP

10% per annum, inclusive of Miscellaneous and other Enrollment Fees 9

Source: SEC, PN New Rules

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Allocation Not to be less than 10% of the trust fund No limits

c) Commercial paper

Duly registered with the SEC with credit rating of “1” or “Aaa” by the PRA or its equivalent

d) Direct loans to corporations

Profitable for the last 3 years and record of paying loans of the trust fund. Secured by mortgage up to 60% of appraised value; property covered by Transfer Certificate of Title (TCT) and free of liens and encumbrances Duly registered with the Commission; invested only in fixed income securities and blue chip securities Limited to listed companies on the local stock exchange; must be companies with actively traded stocks, financially stable, have good growth track record and declared dividends in the past 3 years Properties located in strategic areas of cities and first class municipalities; Transfer Certificate of Title (TCT) free of lien/encumbrances; transferred to name of the trustee; recorded at acquisition cost; to be appraised every three years by accredited appraiser; should recognize only 60% of positive revaluation increment and 100% of the negative revaluation increment; increment should not be used to cover the required monthly contribution to the trust fund.

2. Mutual Funds 3. Equities

4. Real Estate

Not to exceed 15% of the total trust fund and not more than 10% of any company’s commercial paper Not to exceed 5% of the total trust fund and not more than 10% granted to any corporate borrower No limits Not to exceed 25% of the total trust fund and not more than 10% of each issue Not to exceed 25% of the total trust fund. Any real estate investments exceeding 25% should be leveled off to the prescribed limit by June 30, 2002.

To cite an example, the Industry is only allowed to lend up to 5% of its trust fund portfolio to its planholders, unlike the Banking sector, which also has fiduciary duties to its depositors, but which can lend up to 100% of deposits against said placements. If pre-need companies were allowed to lend on a larger scale to their planholders, in this risk-less transaction, this could earn the trust funds yields equal to or greater than the credit card business of 30% to 40% per annum.

3. Actuarial Reserve Liability (“ARL”) From 1966 to 1978, no government agency regulated the Pre-Need Industry. In the absence of direct legislation covering the Pre-Need Industry, the Securities and Exchange Commission (“SEC”), in 1978, working closely with the industry, promulgated the “Rules on Registration and Sale of Pre-Need Plans, Pension Plans, Life Plans and Similar Contracts and Investments” and started to regulate the industry. Then in 1982, upon the passage of the RSA, which included pre-need plans in the definition of “securities”, SEC jurisdiction over pre-need companies and the plans sold by them was clearly mandated. The initial rules were replaced in 1984 by a “Revised Rules on Registration and Sale of PreNeed Plans, Pension Plans, Life Plans and Similar Contracts and Investments” and in 1987 by “New Rules on the Registration and Sale of Pre-Need Plans and Similar Contracts and Investments” (“PN Rules”). Subsequently, in 2001, the SEC updated the rules anew by issuing “New Rules on the Registration and Sales of Pre-Need Plans under Section 16 of the Securities Regulation Code”. The new rules consolidated the SEC’s various rules, circulars and administrative orders on pre-need and introduced changes aimed at improving the regulation of the industry.

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In 2002, the SEC implemented the Pre-Need Uniform Chart of Accounts (“PNUCA”) as a standard of accounting and reporting finances and liabilities for pre-need companies. It required that preneed companies should: (i) provide for Actuarial Reserve Liabilities (“ARL”) that represent accrued net liabilities of the pre-need company to its planholders; (ii) separately account for trust funds; and (iii) establish the liability accounts for the Estimated Benefit Provision in Installment Contracts Receivables and Unrealized Gross Income in Installment Contracts Receivables. It also requires that, at all times, the net asset value in the trust fund should not be less than the ARL. In effect, under the PNUCA, pre-need educational and pension plans were treated not as investment contracts anymore but as insurance contracts. The implementing guidelines for the Actuarial Reserve Liability (“ARL”) scheme detailed this change. In particular, the SEC issued Circulars 6, 7 and 8 (Standards for Valuation of Actuarial Reserve Liabilities for Pre-Need Plans, Required Information to Accompany the Actuarial Reserve Valuation Report of Pre-Need Companies and Responsibilities of Actuaries in Pre-Need Actuarial Reserve Valuation) that imposed changes affecting trust fund distribution, deferment of commissions, requiring the set-up of insurance premium liability and stricter actuarial guidelines. With the imposition of Circulars 6, 7 and 8 in conjunction with the implementation of the ARL scheme, pre-need companies previously deemed to be financially healthy were perceived as insolvent overnight. To quote the pertinent statements in the letter of the Philippine Federation of Pre-Need Plan Companies, Inc. to the SEC, dated November 14, 2005, which is attached as a schedule to this Rehabilitation Plan: “…the seeming insolvency of companies because of the implementation of the ARL in conjunction with circulars 6, 7 & 8 – without proper consultation with the Industry as well as a transition plan. Overnight, companies that have long maturity to liquid ratios and are deemed financially healthy were ‘perceived’ to be bankrupt.” The computation for the level of reserves or ARL depends heavily on the trust fund yield assumptions as a percentage drop in the yield assumptions results in a 10% increase in the ARL. More importantly, the numbers analysis under ARL not only impacts pre-need companies’ perceived solvency but also, in fact, has serious negative repercussions on pre-need companies’ balance sheets and income statements as the increase in ARL, as part of convention, is booked as part of expenses. As this normally involves amounts in peso millions or billions, in most instances, this results in net losses for pre-need companies. This is, in fact, what happened “overnight”, in the last few years since 2002. If a historical timeline is traced back to show milestones, the years 1993 to 1997 saw the Industry experiencing high growth with revenues averaging of 20% growth per annum, total assets growing at an average of 30% per year and net profit averaging 28% per annum. Over P4Billion benefits were paid to over 4Million planholders and over P10Billion in premiums were collected annually. From 1998 to 1999, the number of pre-need companies grew to over 88 with the Top Ten companies accounted for 80% of Industry sales. Not only has the Industry been a major proponent nationwide for mobilizing savings, it has also been a prime source of employment for over 180,000 sales agents and over 20,000 employees all over the country. 7

Moreover, the Industry has attracted significant foreign investment. The years 2000 to 2003 saw the entry of a number of multinationals that immediately became top players in the Industry: Berkely (in 2000), CMG (in 2001; bought by Manulife in 2002) and Sunlife (in 2000). However, beginning in 2002, aside from the competitive shakeout, because of the introduction of the new pre-need regulations and the ARL scheme, a number of acquisitions, consolidations and closures occurred. Industry players contracted from 90 to 45. In fact, Industry sales declined by 2% in 2002 and by 13% in 2003. As a result, 80% of Industry sales then were accounted for by Top 7 pre-need companies. On top of the new pre-need regulations and the ARL scheme, stricter implementation of the Trust Fund rules were imposed, requiring pre-need companies to make monthly deposits vis-à-vis deposits at the end-of-year, a practice that previously allowed companies to manage the seasonality of sales and collection efforts. By this time, the industry had contracted further with 80% of Industry sales accounted for by only the Top 6 companies. Likewise, the crisis had already further accelerated with the situation of CAP. The progressively deteriorating industry situation not only brought with it a host of technical and regulatory compliance issues among the pre-need companies, more seriously, it caused a severe crisis in confidence in the planholders and target market of the industry. In the financial service industry where the main “currency” for any company to gain the business of its customers is “trust”, a crisis in confidence spells the death of the company. Even if, in many instances, the problems involve perception issues such as the perceived insolvency of pre-need companies in light of the ARL scheme, to the customers and market, “perception” is “reality”. Like the banking industry, where a bank run can severely damage even the biggest banks, the crisis in confidence for the Pre-Need Industry spared and continues to spare no company. In fact, the reality of the erroneous application of the accounting system to pre-need companies has been accepted by the House of Representatives with the adoption of Resolution No. 1049 dated 05 December 2005 that urged the SEC to suspend the implementation of the controversial ARL since it was passed without consultations with the pre-need sector, particularly on the drafting of the new formula. Currently, newspaper reports already indicate possible adjustment of the application of the ARL as Congress calls on the SEC “to arrive at a new formula” since, in a series of investigations, Congress “has seen the disastrous results of a policy fundamentally unsound and tainted with vested interests.” 10

4. Asian Financial Crisis and Industry Meltdown The Asian financial crisis impacted negatively on the whole Financial Services Industry, particularly the banking and investment banking sub-sectors, resulting in a number of closures. The PreNeed Industry, as a sub-sector of the Financial Services Industry, of course, suffered as well. With the fate of pre-need companies already hanging in the balance due to UTI, ARL and restrictive trust fund rules, the Asian financial crisis in 1997 pushed the companies closer to the precipice. Because of the harsh business climate and a steeper drop in yields, pre-need companies began experiencing trust fund deficiencies, eighty percent (80%) of which were reported to have been caused by availments on traditional or open-ended education plans. 10

“ARL not actual, present liabilities of CAP, says SEC”, The Philippine Star . 06 February 2006

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In response, in 2002, the SEC suspended the further sale of traditional or open-ended education plans considering their inability to cope with tuition fee increases. The suspension was intended to be temporary, pending an extensive review of the traditional or open-ended education plan product.11 The suspension, in fact, has remained in force until today. Nevertheless, while the sale of traditional open-ended education plans had been suspended, this did not address the repercussions of plans sold in prior years in light of UTI, restrictive trust fund rules, the ARL scheme and the Asian financial crisis. There was a lack of legislative action / government support in light of the debilitating effects of these factors on the Industry. This is in contrast, for example, to Japan, where their parliament issued an edict to its pre-need companies to cut the guaranteed benefits of plans in light of the downturn of the Japanese economy and financial markets. In 2002, the Non-Traditional Securities and Instruments Department (“NTD”) of the SEC also reviewed the performance of pre-need companies and documented a number of companies with trust fund deficiencies, the highest of which, reportedly, was for CAP in the amount of Two Billion Five Hundred Million Pesos (P2,500,000,000.00). In the review, the NTD concluded that the trust fund deficiency of CAP resulted from: (a) the decline in market value of its investments; (b) low investment yields; and (c) the high cost of education. 12 With the unrelenting effects of UTI, ARL and the restrictive trust fund rules, the Industry Meltdown (Domino Effect) had already begun. By mid-2004, College Assurance Plan, Inc. (“CAP”), which used to be the largest pre-need company, was already in dire straits. By August, its Dealers’ License was not renewed by the SEC. In April 2005, Pacific Plans, Inc., a pioneer which started operations in the ‘60s and previously ranked in the Top Five of the Industry, filed for corporate rehabilitation, causing an even bigger crisis with heightened negative media exposure. Within a few months, Platinum Plans, Inc., also previously a Top Ten-ranking pre-need company, filed for corporate rehabilitation. And in September 2005, CAP filed for corporate rehabilitation. By the end of 2005, the corporate rehabilitation plans of Pacific Plans, Inc. and Platinum Plans, Inc. had been given approval by the Rehabilitation Court. Not unlike the Tsunami catastrophe, the implementation of the restrictive trust fund rules and ARL scheme in 2002, coupled with UTI and the Asian financial crisis, has ‘ripple’ or ‘domino’ effects on the Industry participants that return with greater force as the economy continues to deteriorate.

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“SEC temporarily suspends sale of new education plans,” Business World. 30 July 2002

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“SEC evaluating CAP trust fund enhancement scheme” by Cathy Rose A. Garcia with Cecille E. Yap, Business World. 30 July 2002

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