Focus On The Future Options For The Mutual Insurance Company

Focus On The Future: Options For The Mutual Insurance Company

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Pursuing Change: The Process

Identifying the Need for Organizational Change

A fundamental question in determining how to meet the challenges of a competitive insurance market is "does the company need to change?" In other words, evaluating the need for change is as important as the review of the various directions for change.

Solutions to the problems of property and casualty insurers are as varied as the problems they are meant to address. The first step is to identify the specific challenges of a company and to determine whether altering the traditional mutual structure is appropriate as a solution. Reasons for considering restructuring include: providing a more flexible operational structure to complement the insurer's strategic plan; facilitating business diversification; and promoting financial incentives to key management employees. Problems and solutions often have the common requirement of more capital from a dependable source at an affordable price.

Not every financial problem should be addressed through structural change. One rule-of-thumb discourages any structural change when the following elements are present:

  • the expense ratio is no higher than the expense ratio of your principal competitors;
  • the loss ratio is comparable to that of your principal competitors; and
  • the capacity for modest growth (an annual growth rate of at least 5%-6%) exists without being over-leveraged.

Awareness of Structural Alternatives

There is no graph which charts a company's capital deficiency and correlates it to a specific solution. Determining a structural alternative is not a mechanical process. A CEO's sound judgment and analytical ability need to be supplemented with as much reliable information on the available options as possible. Only a well-informed CEO will be equipped to make the appropriate recommendation for the company's future.

Sources of information are abundant and, in most cases, free. They include:

  • business, industry and trade association periodicals,
  • web sites of reputable publications,
  • informational pieces from professionals who provide restructuring services, such as investment bankers, accounting firms, attorneys and financial consultants,
  • seminars on restructuring offered by professional organizations and trade associations,
  • personal discussions with CEOs of other mutual insurers who have undergone similar structural changes.

It is important to distinguish marketing materials from factual information and to develop a firm understanding of the mechanics, time, and expense that will arise out of the various options. Results promoted by investment bankers, law firms, and consulting firms are not guaranteed. Each company must determine if a particular strategy will produce the anticipated solution at a tolerable cost.

Analyzing Organizational Alternatives

Before electing to pursue a specific strategy, a CEO must thoroughly comprehend the advantages and disadvantages of various alternatives for enhancing a mutual insurance company's capital. Capital-enhancement strategies can loosely be divided into two categories: (1) non-structural alternatives; and (2) alternatives which would result in a restructuring of the company. Non-structural alternatives include utilization of retained earnings, certain reinsurance transactions, securitizations of risk, surplus notes and certain forms of joint ventures. Restructuring alternatives would include traditional and subscription rights demutualizations, mergers, and the creation of downstream and mutual holding companies.

Impact on a Company's Constituencies

When the CEO of a mutual insurer begins to focus on a particular structural alternative, it is important to carefully consider the impact that the alternative, if implemented, would likely have on each of the mutual insurer's various constituencies. For most mutual insurers these constituencies include:

  • policyholders
  • appointed agents
  • employees
  • communities where it has a substantial business presence or office
  • insurance regulators of the various jurisdictions where it is licensed
  • rating agencies
  • reinsurer(s)

Since it is not an exact science, a CEO's knowledge, judgment and intuition are critical in making educated decisions on how these constituencies will react to change. Gauging the impact on a company's constituencies can be achieved by observing how another insurer's structural change impacted that insurer's constituencies. Sharing experiences with others engaged in a similar structural change also provides an excellent forum to prepare for constituency reactions.

Part of the evaluation should include the recognition that it is human nature to dislike or fear change. Change becomes more acceptable, however, in direct proportion to the efforts made to communicate the need for change and the impact on each constituency. Attention must be given to the company's internal constituencies, since all change affects the overall corporate culture in some fashion. For example, a demutualization enables the insurer to use stock-based compensation as recruitment and performance incentives. Stock-based compensation, however, is a two-edged sword. It subjects management to the scrutiny of investors. Employees may perceive a demutualization as the abandonment of an esteemed corporate culture in which service to the policyholder is paramount. Including employees, officers and agents as part of the team will enhance the acceptance quotient. Misperceptions should be identified and dispelled as early as possible.

As expected, the more complex structural alternatives presented, demutualization and reorganizing into a mutual holding company, most significantly affect the mutual insurer's constituencies. For example, a demutualization may be viewed as impacting policyholders negatively by forcing management to focus on the interests of the shareholders over those of policyholders. On the other hand, demutualization may positively impact policyholders by financially strengthening the insurer, thereby enhancing the insurer's ability to meet its future contractual obligations to its policyholders.

The community in which a mutual insurer operates is a separate and important constituency. The community may have become reliant upon the company's employment opportunities, volunteer efforts and charitable contributions. It is important to identify and address the community's expectations as well as how the proposed structural change may impact the community.

A rating agency is concerned with a company's financial ability to meet its debt obligations and contractual commitments. Rating agencies should be brought into the process fairly early to discuss, in confidence, a company's proposal and to obtain a preliminary assessment of whether the agency's reaction will be a positive one.

Not all structural alternatives impact reinsurers. However, where a proposal will affect ceded business, it is important that the reinsurer concur that such action does not exceed its reinsurance capacity or raise other issues which may interfere with an ongoing relationship. Inquiry should also be made, where applicable, as to whether the change will favorably impact reinsurance costs.

Regulatory Issues and Climate

Most of the strategies discussed in this White Paper require some degree of regulatory oversight. In some instances, a transaction merely warrants advance disclosure. In others, a detailed filing of related documents and prior regulatory approval is required. Key statutes which may affect a particular transaction in the domiciliary state include the Insurance Holding Company Act, investment laws, and minimum capital/surplus requirements.

The insurance regulator's reaction to or acceptance of the mutual company's preferred structural alternative will be measured on a case-by-case basis. It is important to evaluate the regulatory climate of the domiciliary jurisdiction as well as any jurisdiction in which the company is licensed or otherwise subject to regulatory review. In view of the standards imposed under the National Association of Insurance Commissioners (NAIC) accreditation of insurance regulatory agencies, restructuring mutual insurers should expect close scrutiny. Prior decisions granting or denying applications for similar transactions are public information that provide insight into the issues important to the regulator.

Clearly the most volatile proposal is one involving demutualization, with or without a restructuring under a mutual holding company system. Today's regulatory climate reveals many questions about subscription-rights demutualizations. Most jurisdictions are proceeding slowly and with extreme caution. If the regulator's sentiments towards a particular type of restructuring have not been clearly expressed, the mutual company should consult with other companies who have completed similar transactions.

Identifying the Preferred Restructuring Option

The first option is to make no structural changes. For many mutual companies, the status quo is more advantageous in the long run than the risks and financial costs of restructuring. If change is indicated, both the hard and soft costs of the selected option must be identified, quantified and measured against the benefits offered to determine a realistic estimate of the net value expected to flow from the strategic change. This cost-benefit analysis should be reflected in pro forma financial statements, with practical underlying assumptions, that project the overall effect that the transaction will have on the insurer. For example, a structural strategy involving a public offering of stock would require an investment banker's estimate of the capital the public offering would raise. At this stage, seeking affirmation of the mutual company's anticipated choice should not be limited to professionals who may ultimately be hired to carry out the structural strategy. The most practical litmus test is discussion with others in the insurance industry who either have a similar structure in place or who are undergoing a similar restructuring.

Selling the Concept to Constituencies

Before hiring professionals and executing a plan, the chosen concept must be shared with and accepted by affected constituencies beginning with the senior officers of the company and the board of directors. The mutual insurer's key stakeholders must be convinced of both the appropriateness of the selected strategy and the probability of its success. The CEO should be briefed by investment bankers and other consultants on the questions (as well as the proper answers) to be raised by these constituencies.

Board approval generally triggers the need to introduce the idea to the company's external constituencies, including policyholders, rating agencies and the community. The presentation of information should be as simple and as objective as possible. More than one mailing to the policyholders is valuable in winning support, particularly where obtaining regulatory approval will take at least a few months. The principal aspects of the structure should be revealed to constituents as early as possible in the process.

Today, regulators are closely examining these structural options and may require a public hearing. If so, appeal to their support by providing the subject constituencies with adequate responses to their concerns well in advance. It is essential to properly disclose information and explain what the transaction means to the affected constituencies in a timely fashion. Notices for either a public hearing or a special meeting of policyholders should be mailed as early as possible and within any regulatory, statutory, charter or bylaw requirement. Doing so demonstrates good faith and fair dealing on the company's part.

If local protocol permits, an informal, preliminary, confidential session with your regulator is strongly recommended in order to present the proposal in general terms and obtain feedback before committing extensive effort and expense.