A New Look at Demutualization of Mutual Insurers
Richard G. Clemens
Partner, Sidley & Austin
As the insurance industry consolidates, mutual insurance companies have begun to recognize a growing need to find a better way to expand their business by raising equity capital as well as undertaking acquisitions or strategic alliances. Recent announcements by Mutual of New York, Prudential Insurance Company and other leading mutual life insurers have generated new interest in this subject. Demutualization or a mutual holding company reorganization permits a company to raise equity capital and also offer stock as a currency for acquisitions. New York passed a demutualization statute in 1988 which has served as a model for demutualization statutes in other states. In the last several years, two new legislative approaches - one in Iowa and another one in Illinois and Pennsylvania - have been developed which permit mutual insurance companies to demutualize or reorganize in different ways. This article discusses the three approaches: (1) the New York traditional demutualization method; (2) the Illinois/Pennsylvania demutualization method; (3) the Iowa method, which involves the formation of a mutual insurance holding company.
New York Demutualization Method
A mutual insurance company traditionally undertook a demutualization by adopting a plan of conversion under which the mutual insurer converted to a stock insurance company and, as part of the process, distributed cash, stock, policy credits or other consideration to policyholders in exchange for extinguishment of their membership interests in the mutual insurer. An initial public offering of common stock is undertaken to raise new equity capital and make payments to policyowners required by the plan of conversion. It is necessary to obtain a detailed actuarial report to calculate the policyowners' past and future contributions to the surplus of the mutual insurer so that the amount of cash, stock, policy credits or other consideration to be received in the demutualization can be allocated to each policyowner. This traditional method of demutualization is authorized by the laws of New York, Maine, Nebraska, Oregon, South Carolina, and a number of other states.
The New York method of demutualization, utilized by Equitable Life Assurance in 1992, has proven to be very costly, administratively complex and very time consuming. Little new equity capital is typically raised after making the distribution of cash, policy credits and stock to policyowners required by the statute and paying the expenses of the demutualization. For example, Guarantee Mutual Life Insurance Company demutualized in 1995 under the law of Nebraska, a law very similar to the New York demutualization statute. Guarantee Life raised $32.5 million in the public offering of which $7.1 million was used to make cash payments to policyholders and $5 million was used to fund policy credits to policyowners. The company over a three-year period also incurred $16.1 million (net of taxes) in expenses incident to the demutualization, including expenses for accounting, actuarial, legal, investment banking and other consultants.
Traditional demutualizations do benefit existing policyholders who receive immediate tangible benefits in the form of cash, policy credits or common stock. After the demutualization is completed, the company is 100% owned by public stockholders and the policyholders' membership rights are extinguished.
Mutual of New York, Prudential Insurance Company of America, John Hancock Mutual Life Insurance Company and Standard Insurance Company, an Oregon mutual insurer, as well as three large Canadian mutual life insurers - Manufacturers Life Insurance Co., Mutual Life of Canada and Sun Life Assurance Co. - have all recently announced plans to do traditional demutualizations.
The Illinois/Pennsylvania Demutualization Method
In 1994, Illinois passed a statute authorizing the demutualization of mutual insurance companies which is modeled after the federal laws which permit the demutualization of federal savings and loan associations. The Illinois demutualization statute permits mutual insurance companies to adopt a plan of conversion providing for conversion of the mutual insurance company to stock form. Similar legislation has been passed in Michigan, Pennsylvania and several other states.
The plan of conversion provides that each eligible member of the mutual insurance company will receive, without payment, nontransferable subscription rights to purchase a portion of the capital stock of the converted stock company or a holding company organized for the purpose of purchasing and holding all of the stock of the converted stock company. Any capital stock not subscribed for by eligible members is sold in a public offering through an underwriter. The Illinois statute provides that the plan of conversion shall set the total price of the capital stock to be sold in the offering equal to the estimated pro forma market value of the converted stock company, based upon an independent evaluation by a qualified person.
Under the Illinois demutualization statute, mutual life insurance companies are required to establish a "closed block." This means that the Company's participating life insurance policies in force on the effective date of the plan for dividend purposes are operated as a closed block of business and one or more segregated accounts for the benefit of the closed block business are established. An opinion of a qualified actuary as to the adequacy of the reserves or assets which are segregated is required to be submitted.
The Illinois demutualization statute also contains a
provision which prohibits any one person or group of person acting in concert from acquiring, through a public offering or subscription rights, more than 5% of the capital stock of the converted stock company for a period of five years from the effective date of the plan of conversion except with the approval of the Illinois Director of Insurance.
The Illinois demutualization statute does not require any portion of the converted company's assets to be paid or distributed to policyowners in the form of cash, stock in the new company, policyowner credits or other consideration. Thus, the Illinois demutualization statute is clearly accretive to equity capital. The Illinois approach is more flexible and far less costly than mutual conversions under the traditional approach of New York and other states which require the substantial distribution of surplus to policyowners as part of the demutualization. However, this method is criticized because the policyholder interests are extinguished without any payment except for policyholders receiving subscription rights to purchase stock.
The Illinois demutualization statute also permits a plan of conversion to contain optional provisions authorizing directors and officers of the mutual insurance company to obtain subscription rights to purchase up to 25% of the total shares to be issued in the case of a mutual company with total assets of more than $500 million and greater percentages - up to 35% of total shares - for mutual companies with less than $500 million in total assets. This provision has been controversial because it affords management a substantial opportunity to participate in the initial stock offering in which the company is demutualized.
One of the potential disadvantages of the Illinois/Pennsylvania method is that it may raise equity capital substantially in excess of the real needs of the insurance company. The Illinois demutualization statute requires that the estimated pro forma market value must be set at a level necessary to attract full subscription for 100% of the shares. If excess capital is raised, as is likely, the converted company will be under strong pressure to deploy this new capital quickly in order to avoid a reduction in its return on equity. Low returns on equity typically depress the stock price of the common stock and are detrimental to the market valuation of the stock.
Stock buy-back programs could be used to reduce excess capital raised by an insurance company in a demutualization. However, it is expensive to raise substantial amounts of equity capital, incurring underwriting expenses, accounting, legal, printing and other public offering expenses only to buy back large amounts of the shares not much time later, also incurring expenses for the buy back.
In 1997, one company, Old Guard Group, Inc., completed the demutualization of Old Guard Mutual Insurance Company, a property and casualty insurance company, pursuant to the Pennsylvania subscription offering method of demutualization. This form of demutualization, which is identical to the Illinois method, extinguishes a policyholders' rights to the surplus of the mutual insurance company in the event of liquidation and eliminates policyholders' voting rights. A lawsuit challenging the demutualization, Crandall v. Alderfer et al. was filed in the U.S. District Court for the Eastern District of Pennsylvania in 1997 and is still pending. A second company, Mercer Mutual Insurance Company, has redomesticated from New Jersey to Pennsylvania and has filed an application with the Pennsylvania Insurance Department to demutualize and form a stock holding company, Mercer Insurance Group, Inc.
The Iowa Method
In 1995, Iowa passed legislation authorizing the formation of mutual insurance holding companies. Under the Iowa mutual insurance holding company law, the mutual insurance company is reorganized so that the policyowners' membership interests are automatically converted into membership interests of a mutual insurance holding company and the mutual insurance company is reorganized into a stock subsidiary which is 100% owned by the mutual insurance holding company or an intermediate stock holding company. Either the intermediate stock holding company or a stock insurance subsidiary may sell stock in an initial public offering, but the Iowa law requires that the mutual insurance holding company must at all times directly or indirectly own at least 50.1% of the voting power of the capital stock of its subsidiary. The Iowa statute is modeled after federal legislation permitting mutual holding companies to own stock savings and loan associations.
One Iowa mutual insurance company, American Mutual Life Insurance Company, (now named AmerUs Life Insurance Company) has completed a mutual holding company reorganization under Iowa law. Its intermediate stock holding company, AmerUs Life Holdings, Inc., completed an initial public offering of Class A common stock in 1997.
The Iowa statute does not require the distribution of cash, stock, policy credits or other consideration to policyholders because the policyholders become members of the mutual holding company. Unlike the Illinois/Pennsylvania approach, the Iowa law does not require that 100% of the capital stock be sold, whether or not the additional capital is really needed. In fact, a mutual insurance holding company could decide only to reorganize into a mutual insurance holding company (Phase I) and choose to do a public offering later (Phase II). A public offering of a subsidiary of a mutual insurance holding company could offer any amount of stock up to 49% of the outstanding voting shares. The traditional New York method or the Illinois method, which requires the offering of 100% of the company, will not permit this sort of flexibility.
The Iowa method facilitates acquisitions of stock insurance companies or other companies. The reorganized stock company could offer stock as consideration for a merger and the acquisition could be structured as a tax free reorganization. In 1997, AmerUs Life Holdings completed a cash acquisition (Delta Life Corporation) and a stock acquisition (AmVestors Financial Corporation) utilizing the mutual holding company structure. By contrast, a mutual insurance company can only offer cash consideration in an acquisition or undertake a merger of mutual insurance companies.
The mutual insurance holding company structure should also facilitate acquisitions and mergers with mutual insurance companies who are located in states with similar mutual insurance holding company statutes. Since Iowa adopted its statute in 1995, the states of California, Florida, Kansas, Kentucky, Louisiana, Minnesota, Mississippi, Missouri, Nebraska, North Dakota, Ohio, Oregon, Pennsylvania, Rhode Island, Texas, Vermont and Wisconsin as well as the District of Columbia have adopted various forms of mutual insurance holding company statutes. Mutual holding company legislation is pending in Illinois, Massachusetts, New York and South Carolina.
If state legislation permits, a mutual insurance company can reorganize and merge with another mutual insurance holding company. The mutual insurance company may be reorganized into a stock insurance subsidiary of the acquirer's mutual insurance holding company and its eligible policyholders obtain membership interests in the acquirer's mutual insurance holding company. The new stock insurance subsidiary could be operated as a separate subsidiary or merged with the mutual insurance holding company's existing stock insurance subsidiary.
The Iowa method does permit a gradual demutualization. The company has the flexibility to decide whether or not and when to do a public offering and may decide the amount of shares offered in the public offering. An offering could be made in several stages, depending on market conditions. If a company later decides to do a full demutualization, it can be done at a time when the company is ready to do so and has a track record and earnings history as a public company. Because of the requirement that at least 50.1% of the voting stock be owned by the mutual insurance holding company, the chances of a hostile takeover are virtually zero.
In addition to AmerUs Life, four other mutual insurance companies have completed mutual holding company reorganizations: Acacia Mutual Life Insurance Company (District of Columbia), Ameritas Life Insurance Corp. (Nebraska), General American Life Insurance Company (Missouri) and Pacific Mutual Life Insurance Company (California). Mutual holding company reorganizations are pending for FCCI Mutual Insurance Company (Florida), Minnesota Mutual Life Insurance Company (Minnesota), National Life of Vermont (Vermont), Principal Mutual Life Insurance Company (Iowa), Provident Mutual Life Insurance Company (Pennsylvania), and Ohio National Life Insurance Company (Ohio).
Potential disadvantages of the Iowa method include the fact that stocks with a smaller market capitalization and a single controlling stockholder may trade at a below-average or depressed multiple of earnings. However, this problem was not experienced with the AmerUs Life Holdings initial public offering. The organizational structure is also more complex than other structures. There is a potential for conflicts of interest between the mutual insurance holding company, whose members are the policyholders, and the public shareholders of the public stock subsidiary. The 50.1% voting requirement for the mutual insurance holding company may restrict flexibility in certain situations such as limiting the ability to make very large stock acquisitions.
In light of the recently announced demutualizations and the consolidation trend in the insurance industry, many insurance companies who previously considered demutualization or corporate reorganization to be unattractive for a variety of reasons may wish to take a close look at the new alternatives which have emerged.