Last Updated on 2, April 2014
Time again and again, we hear of customers demanding back their money for their Spa packages. News such as 70 customers demanding S$249,000 from True Spa have become too common and most people would just skip reading the news.
In 2010, the top number 1 and 2 complains which CASE handled were related to ‘Beauty’ and ‘Timeshare’ respectively. According to the report HERE by CASE, “The beauty industry is the most complained against industry in 2010… This can be attributed to the closure of major spas in 2010”. As for time share, customers prepay an amount for the right to use vacation home or luxurious hotels at certain time and frequency in the year. There are many variations of timeshares but they work in similar fashion – which is to reduce the average cost per individual by pooling large number of people to use expensive facilities/services since not everybody will be using the facilities at the same time. Similar to the problem of Spa, many of these time shares were oversold resulting in purchasers unable to use the facilities.
What these Spa packages and timeshares have in common? They are prepaid packages. Prepaid packages have the risk of default. In the credit risk analysis world, the purchaser of these packages bear all credit risk of the issuers of these packages.
To be fair, prepaid services are nothing new. For example, I know of a lawyer who works with insurance agencies and IFAs providing Will writing services. These financial advisory firms prepay the legal firm the right to use the lawyer’s service for certain number of Will writing packages. Because it is a ‘bulk purchase’ paid upfront, the lawyer’s average fee per Will is lower. But of course, the financial advisory firms bear the entire risk of the legal firm closing down since these prepaid Will writing packages are not used immediately.
As for man-in-the-street, they too have made large prepaid services. Life insurance products pay large amount of commissions for the first few years. Some even pay the entire amount of commission on the first year despite the product designed for long-term basis. What clients do not realized is that if the adviser leaves the company or retires, the takeover adviser does not get any of these commissions since it was already been paid to the previous one. Investments also pay large commissions upfront. These tend to be packaged into an ‘ILP’ except that there is no protection amount.
Prepaid packages – whether it is Spa, Timeshares, legal services, life insurance or investments have the following flaws:
- Prepaid packages encourage sellers to oversell their packages. Why? Because not all customers will exercise the use of such package immediately, sellers underestimate the resources required to deliver these promised packages. In the financial services, many insurance agents underestimate the large amount of after-sales required and as a result have no choice but to provide poor after-sales service. For take over case, the new adviser will not be keen to provide any service since he or she isn't paid to do so. In a sense, this is a 'default' for the policyholder.
- Prepaid packages encourage sellers to focus on short-term instead of long-term because there is no more incentive to provide long-term service since customers paid everything upfront. In other words, there is no more future sale to close from these existing customers.
- Prepaid packages increases default risk. Why? In the accounting world, prepaid services should not be recognized as revenue until it is utilized. Prepaid services should be recognized as a liability. The liability is reduced when the service utilized and revenue recognise correspondingly. But do note that if the firm oversells its prepaid services, the liability is large and the firm becomes highly leverage and thus increases the probability of default.
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