Print Print | Email Facebook Twitter Share ThisShareThis

Still Have Questions? Contact Us

Robert Detlefsen, Ph.D.

Robert Detlefsen, Ph.D.
Vice President of Public Policy

Ph. 317.876.4268
bdetlefsen@namic.org

Focus On The Future: Options For The Mutual Insurance Company


<< Return to the Introduction and Table of Contents


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.

Approvals

A demutualization will require the approval of:

  • The board of directors of the mutual company. The approval of more than a majority of the members of the Board may be required.
  • The policyholders. The statute, charter and by laws must be examined to determine the vote needed for policyholder approval. Most statutes require an affirmative vote ranging from a simple majority to three-fourths of the policyholders who actually vote. The law provides that policyholders must receive a copy or summary of the demutualization plan and other explanatory information to assist the policyholder in reaching an informed decision.
  • The insurance regulator. The regulator may impose certain restrictions or conditions with respect to the demutualization. Most demutualization statutes require that the insurance regulator find that the plan of conversion is fair and equitable to the members (policyholders) and not prejudicial to their interests. In most states, the regulator is required to hold a hearing to determine whether the terms and conditions of the demutualization are fair and whether the demutualization is detrimental to the public. The regulator may retain, at the expense of the mutual insurer, lawyers, accountants, actuaries and consultants to assist the regulator in determining whether or not a demutualization should be approved.

Takeover Defense Strategies

After a mutual company converts to a stock company, and if its stock is publicly held, the new stock company is susceptible to a takeover. This is a danger not faced by the company when it was a mutual company. A bidder wishing to make an unsolicited offer with respect to a mutual insurer is likely to first approach the mutual insurer itself. If the bidder is another mutual insurer, it might send a letter proposing a merger on better terms and threatening to go to policyholders if the offer is not accepted. A stock company, and the mutual company or financial investor could propose a sponsored demutualization on better terms under similar threat. If its proposal is rejected, a bidder may try to elect directors to the board of the company who are favorable to its proposal or seek a shareholder vote on its proposal. The board of directors of the company may, subject to the usual standard of care, have the flexibility to "just say no" to the unsolicited proposal.

There are also charter and bylaw provisions that may be put in place to give a company further control over the process in the event of a third party bid. Before undertaking a restructuring transaction, it is good practice to have the company's counsel review the charter and bylaws to determine which mechanisms it has in place to help it deal with any unsolicited bids and also which mechanisms it should put in place as part of the restructuring. Examples of such mechanisms include staggered terms for board members, director removal provisions, provisions allowing shareholders to nominate directors or to propose business at a meeting, imposing a super majority voting requirement on certain issues, requiring advance notice to the board for shareholders to take certain actions or charter and bylaw amendment process provisions.

The various strategies (often called "shark repellent") that can be used to make it more difficult for an acquirer to take over a stock insurance company (or the stock insurance holding company) are usually set forth in the charter document or the bylaws of the company.

Staggered Terms for Board Members

The Board can be "classified," which means that its members are broken down into classes, usually three, and the members in each class have a three year term. Therefore, only one-third of the Board is elected each year. Anyone seeking to replace the Board, or control a majority of its members, can only do so over a two to three year period.

Super-Majority Vote

In order for the corporation to complete a fundamental transaction, such as a merger or sale of assets, the transaction must be approved by a "super majority" of the shares of stock outstanding. That is, 66%, 75% or even 80% of the shares outstanding must approve the transaction. It is often difficult for a hostile acquirer to achieve the favorable vote of such a super majority of the stockholders. Also, members of management and stockholders friendly with management may control enough shares to prevent obtaining the required super majority vote.

Regulator Approval

In most states, regulator approval is required before a person can acquire a 10% or greater interest in an insurance company domiciled in that state. The bidder is therefore limited in terms of an advance acquisition strategy. Although the bidder may indeed be able to obtain such approval, regulatory approval requirements cause delays, at the very least, and create a forum to question the alternative proposal. (Conversely, the company's regulatory proceeding to approve its restructuring may provide a forum and delay to the advantage of a bidder.) It is also difficult to solicit policyholders, who generally do not vote.

Policyholder List

It may be possible for a board to deny the bidder access to a policyholder list on the grounds that it contains trade secrets that are confidential, making communications with policyholders difficult. However, regulators or specific state statutes could require the insurer to send out the communications at the expense of the bidder.

Advantages and Disadvantages

Traditional Demutualizations

The advantages are:

  • it provides additional capital;
  • stock ownership is available as a performance incentive to management and employees; and
  • stock is available as currency for future acquisitions.

The disadvantages are:

  • surplus depleted by distribution to policyholders must be replaced through an offering of securities;
  • it is an expensive and time consuming process;
  • after demutualization, the management/directors of the converted company may not be able to maintain control;
  • a small company may not have sufficient number of shares outstanding to have viable investment potential; and
  • it requires expensive and ongoing time-intensive SEC reporting and investor relations activities.

Subscription Rights Demutualizations

The advantages are:

  • the same as those of a traditional demutualization except there is no distribution of surplus;
  • does not require distribution of surplus so existing capital is retained.

The disadvantages are:

  • same as those of a traditional demutualization;
  • the termination of membership rights without cash or in-kind distribution is a very controversial and litigious issue that has not been resolved; and
  • exposes the converting company to a hostile takeover.

Mutual Holding Company System

Mutual Holding Company Structure

A new restructuring method for mutual insurance companies is the organization of a new mutual holding company which is created as part of a multi-level insurance holding company system. Two new entities are formed: (i) a mutual holding company (MHC), a non-stock corporation which is the holding company system parent; and (ii) a stock intermediate holding company (SHC), a subsidiary of the MHC. The original mutual insurance company is converted into a stock insurance company and is controlled by its new shareholder, the SHC.

The MHC is controlled by its members who are the policyholders of the converted insurance company. Policyholders' membership rights in the mutual insurance company are converted into membership rights in the MHC. In an MHC, policyholder contractual policy rights are separated from membership rights.

The NAMIC Board of Directors supports the MHC concept as a means of allowing mutual insurers to establish banking subsidiaries on the same basis that stock insurers may establish banking subsidiaries. The MHC structure greatly increases the mutual company's ability to raise capital, to make acquisitions and to diversify its operations, while retaining the mutual aspect of policyholder membership. The reorganization into a MHC system avoids some of the costs and delays associated with a full demutualization. As with the subscription rights demutualization, however, controversy surrounds the use of the MHC.

The Process

Under an MHC restructuring, the mutual insurer is converted into a stock insurance company. Simultaneously, a new mutual company (the MHC) is created and the membership interests of the policyholders in the former mutual insurance company (which has been converted into a stock insurer) are converted into membership interests in the MHC. All of the outstanding shares of the capital stock of the converted insurer are issued to and owned by a newly created intermediate stock holding company (the SHC), and all of the stock of the SHC is held by the MHC. Persons who purchase the converted insurer's policies after the restructuring will also receive membership interests in the MHC.

Ownership Requirements

The MHC structure allows the SHC, which is usually a standard business corporation, to issue stock to the public in order to raise capital. However, the MHC statutes, the regulations thereunder, or policies adopted by the insurance regulator usually require that at all times the MHC own, directly or indirectly, no fewer than a majority of the voting shares of the SHC. In this way, the former members of the mutual insurer, who are now members of the MHC, retain control over the converted stock insurer through the MHC's majority ownership of the SHC.

Public Offering

A public offering of the SHC's stock may take place at the time of the restructuring or at some time thereafter. The insurance regulator may retain jurisdiction over the SHC in order to approve any future securities offerings, if not by statutory authority, by a condition of the regulator's consent to the plan for the restructuring. Generally, policyholders will be given an opportunity to participate in the initial public offering (IPO).

Approvals

The approval of a MHC restructuring must be given by the board of directors of the mutual insurance company, the members (policyholders) of the mutual insurer and the insurance regulator.

Applicable Law

The statutory provisions allowing the formation of a MHC are often contained in the demutualization statutes and are sometimes referred to as a "partial conversion." Therefore, the creation of an MHC system closely parallels the processes and procedures required for a demutualization, including a public hearing. Also, an SEC "no action" letter and a tax ruling may be necessary to confirm the applicability of the securities laws and the tax laws.

Terms and Conditions for Approval

If not provided by the statute, the insurance regulator may require that certain conditions be met or that the plan for the restructuring contain certain conditions before the insurance regulator approves the restructuring. The applicable statute or the insurance regulator may require that, if the stock insurance company owned by the MHC becomes insolvent, the assets of the MHC, if any, will be available to pay policyholder claims before being used to pay other creditors. To accomplish this, the insurance regulator may require that the MHC pledge its assets for the satisfaction of policyholder claims if there is a bankruptcy or insolvency proceeding. The insurance regulator may also require that if the MHC no longer has a majority economic interest in the stock insurer, the MHC must fully demutualize and be subject to all of the requirements of the demutualization laws. This would require the MHC to either distribute assets to its members (policyholders of the stock insurer) by means of a traditional demutualization, or to issue non-transferable subscription rights to its members in a subscription rights demutualization.

Federal Law

A federal bill (HR10) passed the U.S. House of Representatives last session which would facilitate future MHC reorganizations by permitting companies to redomesticate to jurisdictions which permit MHCs.

Other Requirements

Other conditions which may be imposed in an MHC restructuring include the requirement that there be a certain percentage of outside independent directors that are not employees of the MHC or any affiliated corporation. Such requirements may also include that certain committees of the board have outside board members.

Advantages and Disadvantages

The advantages of an MHC are:

  • the converted company's corporate existence continues uninterrupted from its initial date of organization as a mutual;
  • hostile takeovers are prevented;
  • policyholders will continue to control, directly or indirectly, a majority of the voting stock of the converted stock insurance company;
  • mutuality is retained by a transfer of policyholders' membership rights from the insurance company to the MHC;
  • a flexible corporate structure is provided to engage in acquisitions, to raise capital for growth opportunities, to provide product and services diversity, and to enhance services to policyholders; and
  • capitalization may be phased in rather than 100% at the time of the restructuring

The disadvantages are:

  • the economic interests of the shareholders, who are not policyholders, to benefit from their investment in the SHC may differ from those of the policyholders; and
  • there may be litigation over policyholders' rights, interests and expectations

Downstream Holding Company or Wholly-owned Insurance Subsidiary


The Structure

A mutual insurer may establish a downstream holding company by incorporating a new intermediate stock company that would be the vehicle to oversee operating subsidiaries which may include non-insurance related companies. Such a downstream holding company subsidiary may be incorporated or acquired. If a downstream holding company is large enough, the mutual insurer may raise capital by selling shares in the intermediate holding company to the public or may use the holding company's stock as currency for acquisitions. A stock insurer owned by the downstream holding company may also be merged with another stock insurance company.

Advantages and Disadvantages

The advantages are:

  • provides access to capital (if the company performs);
  • offers availability of stock options to management and employees as performance incentives; and 
  • is relatively inexpensive and less time consuming

The disadvantages are:

  • it is difficult for a small downstream operating company to have sufficient share value to provide a viable investment potential;
  • once a company is public, it requires expensive SEC filings and investor relations activities;
  • investment law limits the capital which may be invested in the subsidiary;
  • and the mutual insurance company will be subject to the Insurance Holding Company Act requiring additional reports and advance disclosure of certain transactions or activities.

Approvals

The establishment of a downstream holding company or a wholly owned insurance subsidiary will require the approval of the board of directors of the company. The statute, charter and bylaws must be examined to determine the vote needed for board approval. The insurance regulator must also approve the establishment of a downstream insurance company.

Posted: Thursday, March 25, 2010 10:47:47 AM. Modified: Friday, April 26, 2013 9:33:04 AM.

317.875.5250 - Indianapolis  |  202.628.1558 - Washington, D.C.

NAMIC | Where the future of insurance has its voice TM