Capital Ideas.

Several capital-raising alternatives are available for small to midsized property/casualty insurers.

A property/casualty insurance company must have access to capital to withstand underwriting losses and fluctuations in the market value of its investments and to finance future growth. Small to midsized insurance companies often have difficulty accessing necessary capital from traditional sources. This is because institutional investors are generally reluctant to invest in small companies, and the special regulatory environment governing the insurance industry makes an insurance company uniquely difficult to evaluate from a financial perspective.

One frequently used source of financing for small, growing property/casualty companies is quota-share reinsurance. In the long term, however, if an insurance company wants to expand into new lines of business or new states or needs to finance investments in technology or infrastructure, it will require "real" capital to support this growth.

There are several capital-raising alternatives available to small to midsized property/casualty insurance companies. Financing alternatives differ based on whether the insurer is a stock or mutual company.

Usually, stock insurance companies are grouped under a holding company In addition to legal and other advantages of a holding company, benefits include fewer restrictions on obtaining cash flow from noninsurance company subsidiaries and greater flexibility in accessing the capital markets.

In this type of structure, funds are raised by the holding company and contributed to its insurance subsidiaries. The obligations of the holding company--dividends on equity capital or interest and principal on debt--are then serviced primarily through dividends and fees received from the insurance company or other subsidiaries. In many cases, this structure will include a management or "service" company, which houses all the employees of the holding company and its subsidiaries. This service company generates cash flow by charging a management fee to the other companies for the services it performs on their behalf.

In this context, two types of outside capital commonly available to holding companies for small stock insurance companies are commercial bank loans and private-placement capital.

Typically, commercial bank loans have restrictive covenants and maturities of five years or less and are repaid either through a sinking fund or with a "bullet" payment at maturity. The interest rate on the loan is usually linked to either the prime rate or the London Interbank Offered Rate and the loan is normally secured with a pledge of assets or other collateral.

While useful in certain circumstances, the restrictive nature of bank debt makes it a less attractive form of capital for an insurance company, particularly from a rating agency's perspective. Even if raised at a holding-company level, rating agencies will measure the impact of debt on the underlying insurance company's capital growth and cash-flow requirements and factor this into the rating.

A private-placement financing, on the other hand, can be in the form of either debt or quasi-equity, such as preferred stock. The financing will be placed directly with an investor the Securities and Exchange Commission deems "knowledgeable," usually a sophisticated financial institution. Unlike a public offering, a private placement does not have to be registered with the SEC, because the securities are purchased for investment purposes and not for resale. However, SEC Rule 144A permits unlimited resale of these restricted securities to certain institutional investors without regard to holding period.

The structure of a private-placement investment is the most flexible alternative, since there is a limited number of investors and the investment terms can be tailored to suit companies with special problems or opportunities. Additional benefits of a private placement include a more flexible relationship between the investor and the insurance company and the ability to structure a longer maturity than a bank loan (assuming the financing is in the form of debt).

These advantages, however, are somewhat offset by a higher cost of capital for the investment as potential investors wish to be compensated for higher risk, the costs of structuring and due-diligence review and for holding what can be an illiquid asset. In addition, care must be exercised in selecting a private-placement provider as many operate in relatively short time frames and expect a quick payback.

With the surging stock market, a public offering of common stock seems to be an obvious way for a private company to raise capital. While common stock offerings are theoretically an option for all private companies, their viability for a specific company is often subject to outside forces beyond the control of company management.

The market appetite for initial public offerings, in general, can vary dramatically, depending on market conditions, the relative perception of a particular industry and the "story" an individual company has to tell to investors. This "story" is critical to the success of an IPO.A company that is issuing stock for the first time must have subsequent coverage by one or more equity analysts to give initial investors some degree of confidence that there will be ongoing liquidity for their stock.

Even if demand exists for a company's stock, there are other factors to consider. Reporting and accounting requirements become significantly more complicated when a private company becomes public. Plus, the company's management suddenly has to deal with a powerful new constituency--public shareholders. For all of these reasons, an IPO by a small to midsized insurance company can be a difficult proposition. While there have been a few recent examples of successful IPOs by these companies (sometimes in conjunction with a demutualization), they were companies with a unique "story" that differentiated them from others.

Mutual Companies

A mutual insurance company has fewer and more restrictive capital-raising options than a stock company. Unless a mutual goes through a major restructuring, such as a demutualization or merger, it has only two alternatives to raise growth capital: the issuance of a surplus note or the creation of a down-stream holding company, which can then raise external capital.

Surplus notes are unsecured debt issued by an insurance company that are subordinate to all claims of policyholders and all other indebtedness, such as borrowed money. Issuing surplus notes requires the approval of the insurance commissioner in the issuer's state of domicile; the regulator also may limit the interest rate charged on the note. Furthermore, the repayment of principal and interest can be made only from the issuer's earnings and only with the go-ahead from the commissioner--conditions that allow the notes to be considered surplus for statutory accounting purposes. These regulatory constraints, however, make surplus notes unattractive to many institutional investors because the notes effectively carry the regulatory risk of repayment blockage with no economic upside and, therefore, have limited liquidity and a very narrow potential investor base.

The other capital-raising alternative for a mutual insurance company is to create a subsidiary, or downstream holding company, that owns one or more newly created operating companies. A downstream holding company can increase a mutual insurance company's access to equity capital because shares in the downstream holding company can be sold to third-party investors, or it can issue debt or other securities. The funds raised by the downstream holding company can then be contributed to capitalize the holding company's new operating subsidiaries or loaned to the parent mutual company via a surplus note. While this has been a fairly widely used technique, it does carry some disadvantages:

* The amount that the mutual insurance company can invest in a downstream holding company is limited by state insurance regulations.

* The structure is more complex than a surplus note, and the amount of time and expense involved in setting up a downstream holding company and its operating subsidiaries can be prohibitive.

* There are potential conflicts of interest between the mutual company's board, which represents the policyholders, and the external shareholders of the holding company, particularly with regard to future strategic directions and exit strategies for investors.

* The insurance company created by the downstream holding company must generate sufficient earnings to provide potential investors with an adequate return. In many cases, this will require a pooling arrangement with the existing mutual company.

Although it does not directly raise capital, a strategic alliance can have the same impact if it involves a pooling agreement. A strategic alliance allows a group of insurance companies to share resources to assemble similar or complementary books of business, in essence forming a joint venture without merging legal entities. Each insurance company maintains its own licenses and corporate identity. A strategic alliance does not have to be a permanent arrangement, but once the alliance is in place, unwinding it can be a difficult process. An example of a strategic alliance is the 1996 agreement between Montgomery Mutual Insurance Co. and Liberty Mutual Group. Montgomery Mutual joined the Liberty Mutual pool and was upgraded by A.M. Best Co. to the higher rating of the Liberty Mutual pool. Liberty Mutual gained access to Montgomery Mutual's underwriting expertise in the Maryland, North Carolina and Virginia markets.

Executing the Strategy

Regardless of the type of financing ultimately chosen, successful execution of any capital-raising strategy is primarily dependent on two factors: Competent management and a good business plan. The business plan should be a sales tool that emphasizes the strengths of the company and its growth opportunities. The business plan also must be realistic about the company's weaknesses and the obstacles it faces in the market. Finally, the financial section of the business plan should provide potential investors with information about the type and amount of funding being requested, the proposed use of the funds, the expected return on the investment and the anticipated exit strategy for the investors.

Byron Wilson is vice president of Strategic Investments, American Re-Insurance Co., Princeton, N.J.

Parties Influencing the Financing Decision

Several parties influence the decision regarding whether a commercial loan, private-placement investment, surplus note, downstream holding company or strategic alliance is best for a mutual insurance company. The challenge for management is to find a solution that is acceptable to all of the parties involved in the financing decision.

Interested Party      Goal
Management            Financing that will strengthen the company,
                      maintain management control, and provide
                      an incentive for their performance.
Prospective investors Financing that provides a good
                      after-tax return, possibly with the
                      opportunity for capital growth.
Current shareholders  Financing that will not significantly dilute their
                      owner-ship interest or significantly increase the
                      financial risk of their current investment.
Current policyholders Financing that is fair, that will not
                      adversely affect their interests and will
                      not unreasonably enrich management.
Insurance regulators  Financing that will not adversely
                      affect the policy-holders.
Rating agencies       Financing that will not adversely affect
                      the financial viability of the insurance
                      company and its ability to meet its
                      policyholder commitments and its debt obligations.