Will the fidelity market experience the one-two punch of lower premium volume and increased claims activity in what has traditionally been a low-risk, and growing, category? While concerned about fidelity bond customer demand in the near term..
Health Club Bonds: “Recession-Resistant”, not COVID-Immune
Author: Suretypedia Team
Posted On: 04-28-2020
As governments across the U.S. enacted proactive measures to safeguard public health in response to the emerging threat of COVID-19, the fitness industry was among the first to be severely impacted. While some jurisdictions are beginning to loosen social distancing requirements, we expect health clubs, spas, gyms, or self-defense studios will be low on the priority list, leaving establishment owners to evaluate how long their businesses can survive with their paying customers in hibernation. Accordingly, Surety carriers should be turning a critical eye to the level of exposure posed by the health club bonds in their portfolio.
In Suretypedia’s continued effort to analyze the risks posed to the Surety industry by COVID-19, we examine health club bonds, their risk in more normal economic conditions, and the potential for heightened claims exposure during this crisis by addressing the following questions:
- Why do some states require a bond for health clubs?
- What do Surety underwriters need to know about Health Club bonds?
- Why is this recession different for Health Clubs??
- Is there help on the horizon for the health club industry?
- What can sureties do to mitigate the risk?
In preview, many health clubs are small businesses who collect consumers’ money upfront for services to be rendered in the future and never contemplated being shut down for months by government edict. With revenues plummeting over the past several weeks and many of these small businesses struggling to maintain operations, we expect claim frequency and severity to increase substantially.
Why do some states require a bond for Health Clubs?
The health club industry arguably owes its start in the U.S. to a young Jack LaLanne when he opened his first studio at age 21 in Oakland, California. In the decades that followed, the industry’s nation-wide growth was aggressive. Unfortunately, so were the tactics employed by studio sales staff, pushing binding long-term contracts, exorbitant initiation fees, and improbable results through questionable remedies. See the 1972 New York Times article Fraud Complaints on Health‐Spas Rise.
In an effort to shield the public against such predatory practices, state legal statutes generally protect consumers from two main categories of damages with respect to health clubs:
- Onerous contract terms that bind consumers to long term contracts without a reasonable means of exit and
- Forfeiture of pre-paid membership fees when health clubs either fail to open, experience business interruption, or file for bankruptcy
Twenty-five states require health clubs to obtain a surety bond, thereby guaranteeing a means for the customer to seek restitution should they suffer financial loss due to a health club’s practices or business failure. Statutes vary across the states (albeit not widely), but in most cases a surety bond is required to cover refund liabilities for longer contracts (12 to 36 months), and for membership fees collected prior to a studio becoming operational. Surety carriers should conduct a thorough review of the applicable statutes for their portfolio of bonds to ensure they are in compliance with payment deadlines, and fully understand their exposure on a state-by-state basis.
What do Surety Underwriters need to know about Health Club bonds?
In light of how COVID-19 shelter-in place orders impair health clubs’ ability to serve their members, Surety underwriters need to understand the club’s business risk, as well some areas of adverse language that could expose Surety carriers to increased risk.
Surety underwriters should review membership agreements and the financial stability of the business. The overriding risk of Health Club bonds stems from the club’s acceptance of pre-payment for memberships. Because the service hasn’t been provided prior to receipt of payment, the Surety is exposed to the risk that a customer suffers financial loss due to closure of the business. Lastly, as we explored in Suretypedia’s Guide to Bond Forms, some bonds contain adverse language that can pose more risk to the Surety carriers than others. In the case of Health Club bonds, those risks tend to come in two forms: demand language and extended liability tails. For a full list of states requiring Health Club Bonds, see the table below.
Some states specify the amount of time allowed for refund or claim resolution by the Surety, potentially constraining the Surety’s ability to investigate claims and pursue reasonable alternatives to a payout. In addition, Obligees can often require the Surety to reimburse them for any additional costs incurred should the Surety not comply with the demand language. For example, the Colorado’s Health Club Surety Bond form specifies as follows:
|“In the event the Surety fails to perform its obligation under this Bond within 30 days after said notice, the Colorado Attorney General may commence appropriate legal action against Surety to recover the consumer restitution plus interest, costs, and attorney fees.”|
Extended Liability Tails
Some Obligees specify the length of time to which the Surety is held liable to claims against the bond, thereby extending the window of exposure to the Surety carrier, even beyond cancellation of the bond. Some states specifically indicate the liability tail in the bond form; otherwise, the liability tail defaults to the state’s statute of limitations. Based on our research, the Wisconsin Fitness Center requirement has the longest liability tail specified in the bond form:
“Any member who suffers a loss under this bond must as a condition precedent to recovery of loss under the bond notify in writing the Wisconsin Department of Agriculture, Trade and Consumer Protection, which shall in turn notify the Surety, within three years (3) of an alleged default of the contract or within three years (3) of cancellation of the bond, whichever shall first occur.”
*Click the image above to view the full list of Health Club Bonds
Why is this recession different for health clubs?
Health Club bonds have generally experienced acceptable loss ratios in the 10-15% range nationwide during economic expansions.
In a December 2008 survey, Money Magazine asked readers which items they would forego in a recession, and which were non-negotiable. Over half of the group surveyed said that they would not give up their gym memberships, instead opting to trim vacations, dining out, etc. This sentiment captures the underpinning of what fitness insiders have long viewed as a strength of their business proposition: that fitness is recession proof, or at least robust in the face of recession.
However, in 2009, the nadir of the last major recession, losses on Health Club bonds nationwide spiked to over 30%, demonstrating that the industry still maintains substantial sensitivity to business cycles even though the majority of the exercising public cited gym memberships as a priority. With the public now forced to seek exercise alternatives, and the average gym-goer experiencing much more acute economic pain versus 2008-09, we expect loss ratios to exceed the experience of the “Great Recession”.
Even in normal economic conditions, the International Health, Racquet & Sportsclub Association estimates that 81% of new fitness studios close in their first year of operation, or simply fail to open in the first place after collecting initial membership fees. For this reason, many states go so far as to require health clubs to escrow their membership revenues prior to opening for business, to safeguard refunds to early adopting consumers. Another source of risk to Surety carriers is the lack of customer loyalty that dogs the health club business model. Big box gyms typically only have sustained regular attendance from one quarter of their membership, leaving three out of four members paying for membership but not actually utilizing the services. While this arrangement suits club owners just fine under normal economic conditions, in a recession less engaged members looking critically at monthly expenses may opt out of their contracts in droves. In the event that non-participating members demand refunds and exhaust the reserves of principals, Surety carriers would likely be exposed to increased claims activity, having just 15-30 days to refund customers, depending on the state.
The ubiquitous nature of the COVID-19 crisis may dampen the economic blow for health clubs for a few months, buying Sureties some valuable time before claim activity manifests. Many commercial lenders, landlords, and insurance carriers have extended relief measures, freezing debt payments, rent, and insurance premiums from anywhere between 60 and 180 days. This cascading relief will buy valuable time for many principals and in turn mitigate the risk of bankruptcy-related claims for Sureties, but cannot last indefinitely.
There is cause for optimism, though. Prior to the COVID-19 outbreak, the industry was growing steadily, with the biggest leaps seen away from the big box model. By August of 2019, health club industry profit had grown 8% year-over-year to just over $32 billion, employing over 900,000 people. A record 71.5 million consumers attended nearly 40,000 for-profit health clubs in 2018, according to the IHRSA. That growth was driven mainly by boutique clubs like SoulCycle, F45, OrangeTheory, Barry’s Bootcamp, and Pure Barre, up 121% over the four years from 2013 to 2017, compared to 18% growth for big box gyms like Gold’s, Crunch, and Planet Fitness. These boutique studios now fulfill a critical social need for members, beyond just a workout, and may prove to have higher customer loyalty and be more resilient than their big box competitors, once restrictions are lifted.
On another positive note, the very origin of this particular economic crisis could drive members back into the gym, limiting the potential damages to which sureties are exposed. As stay-at-home restrictions are lifted, Americans will soon be making decisions about which aspects of daily life to resume and when. The White House’s official guidelines for re-opening society state that in Phase One, “Gyms can open if they adhere to strict physical distancing and sanitation protocols.” Americans have been hearing for six weeks about the positive effects of exercise on the immune system and mental health, making a strong case that health clubs could have significant pent up demand to satisfy once they open their doors again. On the other hand, at the time of this writing, nine states have scheduled a gradual easing of their stay-at-home restrictions and among those, only Georgia opted to open gyms to the public. This will serve as a critical experiment in the coming weeks, the outcome of which will invariably influence the decision making of state and local governments nationwide. Surety carriers should watch Georgia closely for indications of how the health club industry will fare nationally.
Shelter-in-place orders hastened an already developing trend in the fitness industry: virtual offerings. Originally meant to provide members with flexibility and a better means of connection from home, (and to compete with subscription services like Peloton), nearly all major brands were exploring some kind of at-home workout offering. That has become a business necessity in the time of COVID-19, and has practically every trainer with an Instagram account live posting workouts for their followers. All of that is good news to Surety carriers, as it has allowed health clubs to maintain meaningful contact with their customers during quarantine. Connected members mean a better chance at post-quarantine solvency, fewer requests for refund, and lower risk of bond claim.
Is Help on the Way for the Health Club Industry?
In this unprecedented crisis, with nearly all economic activity severely impacted, several options for relief have been made available to help small businesses weather the storm. To the extent that health clubs fit the eligibility criteria and are approved for assistance, Surety carriers may see their downside risk mitigated. Health clubs that are able to remain solvent until the return of pseudo-normal business activity will be able to effectively reduce their refund liabilities, and continue to serve their members.
Paycheck Protection Program
The Paycheck Protection Program (PPP) within the CARES Act provides businesses with fewer than 500 employees loan values up to 2.5 month’s worth of payroll expenses (up to $10 million) to cover expenses in the short term and ultimately retain employees. The loan would then be eligible for forgiveness, (essentially converting to grant) if businesses retained their pre-crisis levels of full-time equivalent staff. If businesses had been forced to reduce headcount prior to application, they would still be eligible for loan forgiveness if they hire to pre-crisis levels by June 30th, 2020.
Unfortunately, as Suretypedia described in Sales Tax Bonds: “Tide’s Out, Time to Discover Who’s Swimming Naked”, paying employees that you would otherwise furlough, while potentially good for the employee, does not necessarily keep the business alive. Moreover, so many small businesses have yet to receive funding on a program that launched April 3, 2020 and ran out of funds on April 16th, 2020 (see section below for further developments). Many health clubs are likely down to days of cash while continuing to receive refund demands from consumers, many of whom are facing cash flow constraints of their own.
Economic Injury Disaster Loan
Additionally, health clubs that applied for the Small Business Administration’s Economic Injury Disaster Loan (EIDL) may have been able to take advantage of a $10,000 advance, also forgivable. As of Friday, April 24th, the SBA had processed 1,192,519 loans for a total dollar amount of over $4.8 billion.
While the permitted use of proceeds under the EIDL afforded businesses much more flexibility than the payroll-focused PPP, $10,000 is a small portion of the non-payroll operating budget for most health clubs.
CARES Act Funding Round II
The first round of PPP distributed $349 billion in loans in under two weeks before reaching the limit of its approved funding. LastFriday, President Trump signed legislation that would fund an additional $310 billion to PPP and $60 billion to EIDL. Many banks continued to advance applications in anticipation of additional funding in the hopes of accelerating the process for small businesses still waiting for their PPP loan. Unfortunately, the early reports have been that the resulting increase in applications overwhelmed the SBA’s systems on Monday.
What Can the Sureties Do To Mitigate the Risk?
Even with unprecedented government assistance for small businesses, virtual offerings to engender customer loyalty, and leniency on the part of landlords and lenders, the health club industry is still poised to sustain heavy losses due to the government response to COVID-19. It is difficult to forecast who will be hit hardest: big box gyms with low monthly fees but largely passive members, or boutique clubs with higher fees but a strong sense of communal loyalty. As far as Surety carriers are concerned, the main concern is refund liability. To that end, Sureties should encourage their principals to freeze billing while stay-at-home orders are in effect, extend memberships by the number of months impacted, and continue to provide value to members via virtual means for as long as required.
Bond underwriting in 2020 should contemplate risks posed by new, unproven entrants to the market, but also established players whose business model depends on long term contracts and non-participating members to remain profitable. Through the lens of the Surety carrier, the greatest risks to health club bonds in the COVID-19 era are high refund liabilities combined with an economic recession.
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