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Focus On The Future Options For The Mutual Insurance Company

PURSUING CHANGE: THE ALTERNATIVES

Non-Structural Capital Alternatives

In positioning a mutual insurance company for future growth, there are several capital enhancement strategies available that do not require corporate restructuring. For example, the traditional source available to mutual companies to increase capital is retained earnings. However, retained earnings are unpredictable in that they are directly affected by the underwriting and investment results of the company.

Reinsurance can provide a quick, but short-lived boost to surplus. As set forth in the NAMIC monograph Capital Enhancement Strategies for Mutual Property and Casualty Insurance Companies, financial reinsurance has a number of problems, including the significant trade-off of the company's future profitability with the reinsurer.

Securitization transactions are newcomers to capital preservation techniques. Most securitizations to date have been designed as a hedge against catastrophe (CAT) losses or other risks. Depending on the form, they are either negotiated privately or traded over-the-counter.

Surplus notes provide an immediate increase to both surplus and admitted assets through an unsecured debt obligation. From the investor's point of view, surplus notes tend to be regarded as relatively high risk since they are both unsecured and subordinated to the interests of the policyholders, as guarded by state insurance regulators. As a result such notes do not appear as a liability on the balance sheet of the issuing company, but rather as a form of policyholders' surplus. Therefore they tend to be regarded as being closer to an equity investment rather than debt. State insurance laws and regulations generally require that there may be no payment of surplus note interest or principal without the prior approval of the state insurance department, which tends to be uneventful so long as the issuing insurance company maintains reasonable profitability. However, in the event that the financial condition of the issuer deteriorates, investors may be assured that no such payments will be permitted as the assets of the mutual are preserved for the benefit of the policyholders. The situation is made more difficult since most states also artificially limit the amount of surplus note interest that the issuer is allowed to pay.

Because of these considerations there are very few potential investors in surplus notes. For example, while commercial banks are a major source of financing for most commercial enterprises, they are not interested in providing assistance to mutual insurance companies through surplus notes. Most of the investors that are willing to consider surplus notes insist that the mutual company purchase other services from the investor, the charges for which are increased to make up for the difference between the interest rate on the note and the actual interest income that the investor believes is warranted by the risk. The issuer is required to utilize these services, at the prices determined by the investor, for as long as the note is outstanding. There are a variety of possible linkages including investment management services, claims services, processing systems, reinsurance, or even a requirement that the mutual company sell the investor's insurance products through the mutual company's agencies.

Some potential investors may also require that the note be convertible into the stock of the insurance company in the event of a subscription right demutualization, or that the investor be given warrants to purchase stock in a downstream holding company in the event of a public offering. Both approaches are designed to increase the investor's rate of return and may result in the investor obtaining substantial ownership and control.

In conjunction with the National Cooperative Bank, which is the investor, and Snyder & Company in the role of investment banker, NAMIC has created a surplus note program for member companies. Available in amounts ranging from $1 million to $15 million, and for terms of up to 12 years, the NAMIC program has been approved by both state regulators and insurance company rating agencies. The surplus note is not linked to other services and the investor is not interested in becoming involved in the management of the company or the board of directors.

Capital notes, unlike surplus notes, are reported as a liability under Statutory Accounting Principles. The proceeds, to the extent that they do not exceed one-third of total adjusted capital, are considered as part of a company's total adjusted capital in the calculation of NAIC risk-based capital. Not all jurisdictions recognize this vehicle, but those that do exercise very little oversight.

Other non-structural opportunities that may enrich fiscal stature are joint ventures, shared-services and strategic alliances. These business relationships are formed either to provide a missing, vital function or to strengthen weak back-office operations such as claims, inspections, billing and collections. They may be utilized to buttress marketing arrangements, increase product diversity, expand the product distribution system or to increase staffing. These cooperative efforts are intended to serve the common good of the participating entities.

Parties to these joint arrangements may consist of any combination of stock or mutual insurers, or non-insurance entities. The goal is to preserve capital by reducing expenses by providing better service on a more efficient basis with little or no cost differential. Before entering into an agreement for shared-services, the parties must clearly memorialize in a formal written agreement how they are going to share expenses, fees, training, salaries and time.

Given the nature of these arrangements, it is equally important that any exchanged proprietary information remains confidential and is protected from being used by the other party for any reason outside of the purpose for the strategic alliance, joint venture or shared services.

Liberty Mutual Insurance Company and Montgomery Mutual Insurance Company, two NAMIC member companies, recently affiliated. In this new affiliated status, each company maintains its separate corporate identity and its own state licenses to do business. The two companies share capital, ratings, reduced expenses and pooled risks.

State Mutual Insurance Company and Michigan Physicians Mutual Liability Company are another recent example of an affiliation transaction. State Mutual is a property/casualty insurer. Michigan Physicians Mutual has a niche market providing professional liability coverage to health care providers. Under a 1995 marketing agreement, State Mutual's agents sold workers' compensation policies to Michigan Physicians Mutual policyholders. Ultimately, the alliance provided the testing ground for a relationship which evolved into a recently completed merger of the two companies. These two dissimilar organizations used their product base to complement one another and create sales opportunities. Similar affiliations could occur with thrifts, a brokerage dealer or an agency network.

An affiliation permits each participating company to maintain its autonomy. The arrangement, generally, can be created and terminated without policyholder or regulatory involvement. On the other hand, affiliations raise issues of confidentiality and competition in the same marketplace.

Structural Change Alternatives

Merger

One way to restructure a mutual insurance company to enhance its capital is by a merger, that is, one mutual company merges into another mutual company and ceases to exist. No new capital is generated by the merger, but the surviving insurer has the combined capital of the two companies, while reducing expenses through economies of scale.

Many mergers are in fact acquisitions, and the merger is merely the procedure used to acquire the other company. There have been relatively few straightforward combinations of two companies because there are practical problems of (i) choosing the name to be used for the surviving company; (ii) who will be the CEO; and (iii) which company will control the board of directors.

The Merger Agreement

A plan of merger or a merger agreement is entered into by the merging companies and sets forth the terms and conditions of the merger, including representations, warranties and covenants. Filing the agreement may be necessary in jurisdictions where each of the companies is licensed to transact business.

Approvals

A merger requires the approval of the board of directors of each company. In addition, the members (policyholders) of each company must also approve the merger by a vote margin required by the law of the state in which each company is domiciled or by a greater margin if required by the charter or by-laws of the company. Also, regulatory approval will most likely be required in both states of domicile as well as any state in which either company is commercially domiciled or where a regulator asserts jurisdiction. Additionally, a regulator may order that certain conditions be met in order to consummate the merger. In seeking the approval of the regulator, written application must be made and various documents must be filed. Most likely, the surviving corporation will be required to submit a control statement (Form A) to the regulator fully describing the surviving corporation and setting forth its future plans.

Policyholder Protection

In deciding whether to approve a merger, the regulator investigates, among other things, whether the merger would substantially reduce competition and whether the financial condition of the acquiring company would jeopardize the financial stability of the combined company or prejudice the interests of policyholders. The regulator also examines the future plans of the combined entity and looks at the competence, experience and integrity of those in control of the combined entity. The regulator may retain, at the merging companies' expense, any attorneys, actuaries, accountants or other experts to help the regulator. In addition, the law or the regulator may require a public hearing in which policyholders, competitors and consumer activists may participate.

Advantages and Disadvantages.

The advantages are:

  • the surviving company's corporate existence continues uninterrupted from its initial date of organization;
  • the surviving company retains its status as a mutual company; and
  • the capital of both companies is combined and there are economies of scale.

The disadvantages are:

  • no new capital is generated by the merger;
  • no new mechanism is created to raise capital;
  • a merger is expensive and time consuming; and
  • there are practical difficulties in choosing the name and management of the surviving corporation.

Demutualization

Demutualization is the process by which a mutual insurance company converts to a stock insurer. Demutualization is a complex and expensive process which takes a long period of time to consummate.

A demutualization can also be used as an acquisition device whereby the acquiring company purchases all of the stock of the converting company at the time of the demutualization. The two companies, the acquirer and the demutualizing company, then enter into a conversion and acquisition agreement which sets forth all of the terms and conditions of the demutualization along with the normal provisions found in an acquisition agreement.

Traditional Demutualization

In a traditional demutualization, a mutual insurer distributes its surplus in the form of stock, cash or policy credits, or some combination of such, to its members (policyholders) in exchange for their membership interest upon the conversion from a mutual to a stock company. The company is then recapitalized through a public offering of its securities. The applicable statute will provide guidance on the amount of cash, stock and policy credits to be distributed to the policyholders. Most demutualizations, including traditional and subscription rights demutualizations, may involve the creation of a new holding company which is either publicly traded or acquired by another person.

Subscription Rights Demutualization

In a subscription rights demutualization, when a mutual insurer converts to a stock company, an eligible policyholder's membership interest is exchanged for non-transferable subscription rights to purchase shares in the converted company. The subscription rights may only be exercised at the time that the securities are offered to the public. They establish the maximum number of shares that can be purchased at a fixed price per share. Statutes generally define the qualifying time period for eligible policyholders to receive subscription rights. Under a subscription rights demutualization, the surplus of the company is not distributed to the policyholders.

Eligible Members

The demutualization statutes set forth the formula or standard to be used in determining which of the policyholders (including past policyholders) are to receive stock, cash or policy credits in a traditional demutualization, or the manner of distributing the subscription rights in a subscription rights demutualization.

Public Offering of Securities

Both traditional and subscription rights demutualizations may be structured to combine a public offering of securities at the time of demutualization. In connection with a traditional demutualization, when stock, cash, or policy credits are issued to the members (policyholders), the converted company sells securities to the public to increase its capital. If subscription rights are used in the demutualization, usually the stock not purchased by the members (policyholders) is offered to the public, or if the policyholders purchase all of the stock, additional stock may be offered to the public. Appropriate disclosure must be given to all potential purchasers by means of a prospectus.

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