Eyes On Demutualization.

Regulatory, economic and marketplace dynamics are forcing property/casualty mutuals to take another look at demutualization.

The planned demutualization of three major U.S. life insurance companies--Prudential Life Insurance Company of America, John Hancock Mutual Life Insurance and Metropolitan Life Insurance Co.--has changed forever the expectations of 30 million to 40 million policyholders and consumers. That massive "awakening" is just one of many shifting dynamics in the regulatory, competitive and economic landscapes that are fueling renewed interest in demutualization.

Most major demutualizations have been undertaken by life/health companies. Historically, several factors have dampened enthusiasm for demutualization in the U.S. property/casualty segment, but experts predict that attitudes are shifting. In a new financial-services landscape with bigger competitors, stiffer competition and greater pressure on margins, demutualization is expected to accelerate in all insurance segments.

Change is expected to be particularly dramatic for large regional and specialty-line companies that were formed as mutuals for a specific purpose. Physician-owned mutuals, for example, were developed during the medical-malpractice crisis of the mid-1970s to provide doctors coverage when commercial insurers would not, and until recently, demutualizing would have defeated their purpose.

The soft-market cycle of the last decade, however, has led competing carriers to develop a range of affordable specialty coverages while physician-owned insurers diversify into new lines of business. As the medical-malpractice market has evolved, a key reason for specialty insurers to remain mutuals has dissipated.

The option also may become attractive for insurers that previously were considered least likely to demutualize: small local or regional property/casualty companies entrenched in specific communities.

Several forces coming together may break the resistance of some property/casualty mutuals to convert to stock insurers. These include financially savvy policyholders seeking a payout and the desire of mutual management to acquire books of business and broaden distribution channels.

Robust Economics

Typically, mutuals tend to be overcapitalized in soft markets and undercapitalized in hard markets. An extended soft market, such as the United States is experiencing, creates mutual insurance companies with substantial equity. This assumption is particularly valid for specialty-line property/casualty companies with long-tailed products. Although mutuals pay dividends, management is often so conservative that the companies retain substantial portions of the surplus, whether it was derived from underwriting or investment income. Unless the mutual company demutualizes and returns this surplus or reserve equity, the policyowners will never realize these profits. Financially savvy policyholders will clamor for change--and profits--particularly in the wake of recent high-profile demutualizations.

Leading the pack of those pushing for demutualization may be graying baby boomers. This group is aware of recent life/health demutualizations, and many policyholders have profited greatly. Many of these policyholders, particularly physicians or attorneys nearing retirement, have been paying into professional liability mutuals for 25 to 30 years. For example, policyholder surgeons are charged rates based on the level of risk to which they are exposed. A surgeon in one of the higher rating classes can pay annual medical-malpractice premiums in excess of $100,000.

During a policyholder's career span, a specialty-line insurer will have built up substantial surplus The resulting overcapitalized company makes an attractive acquisition target because the transaction basically funds itself. For example, a multiline company acquiring a specialty-line mutual company can typically pull that business into its existing portfolio and write it at a much higher premium-to-surplus ratio.

The distribution in a typical demutualization is based on a policyholder's paid premium for the last three policy years, known as the "look-back period." Some policyholders, nearing retirement, may be eager to cash out in time to realize potentially sizable profits. Retirees may receive nothing in the demutualization if they retire before the look-back period.

The recent conversion of the Medical Inter-Insurance Exchange of New Jersey (MIIX) from a reciprocal company to a stock company illustrates the point. As a result of this conversion, MLIX policyholders obtained cash or stock valued at multiples of their annual premiums. Higher-rated policyholders were among the most substantially rewarded. The MIIX story is one frequently told around the proverbial water cooler at medical offices, its payout not lost on soon-to-retire policyholders, a large, powerful and outspoken demographic contingent.

Policyholder Power

The "dark side" of the MIIX conversion was the initiation of lawsuits by policyholders who felt that they had not been compensated adequately.

Before a large wave of demutualization occurs in the property/casualty segment, the issues surrounding the value of longevity equity vs. voting membership must be resolved.

Indeed, in a mutual conversion, policyholders are a force that cannot be ignored.

Mercer Mutual Insurance Co.'s plan to convert to a stock company was thwarted when policyholders failed to approve the plan by the required majority. Competitor Franklin Mutual Insurance Co. encouraged Mercer's policyholders to defeat the plan after its two unsuccessful attempts to purchase the company. This defeat marked the first time that an insurance company's demutualization plan was rejected by its policyholders.

Hungry to Buy

The underlying competitive pressures driving insurance industry consolidation also are improving property/casualty insurers' appetite for demutualization. Newly demutualized insurance companies can become serious buyers. For example, following its conversion to a public company in 1994, Medical Assurance Inc., which specializes in professional liability insurance for health-care providers, began to acquire competitors.

As a result, the group, which previously wrote most of its policies in its home state of Alabama, has established a market presence in the Midwest and Southeast. Most recently, Chairman and President A. Derrill Crowe oversaw the purchase of the ongoing book of medical professional liability insurance of Medical Defense Associates and Medical Defense Insurance Co. in Missouri.

In addition to expanding geographically and into new lines of business, insurers that demutualize are in a better position to broaden their distribution channels. For example, a large mutual insurer that sells through captive agents may want to acquire a company that has an independent agency system, thereby expanding its distribution options. Demand for greater distribution flexibility makes acquisition-driven demutualization very attractive.

Demutualization Goes Global

Although the appetite for demutualization and the level of experience with the process varies by region and industry segment, the catalysts behind it are similar everywhere. Lack of flexibility, in corporate structure and regulatory environment, is not sustainable in a business environment that has changed fundamentally in the world's major markets. The trend toward demutualization can be traced to the United Kingdom, where the process is both well received and well entrenched. In the London marketplace, the most common forms of demutualization are the acquisition of mutuals by public companies, as well as the conversion of mutuals to listed companies. The U.K. marketplace has recently completed a relatively rapid cycle of demutualizations by large life insurance companies, creating a "pause" before what many expect to be another wave of demutualization activity in the property/casualty segment.

In Canada, the business imperatives driving demutualization are similar, but the regulatory challenges are unique. Canada's financial-services industry has been integrated for some time, and thus, it is not wrestling with U.S. convergence issues. It is, however, currently addressing a number of other regulatory hurdles.

Importing Expertise

Following recent moves by regulators, five of Canada's largest mutuals are pursuing demutualization. Notably, however, some of the related demutualization work has not been done in Canada, but rather in Philippine branches of the demutualizing entities. These branch conversions represent the first demutualizations to take place in the Philippines. The Philippines is reviewing U.K., U.S. and Australian demutualization experience for guidance. In fact, "imported" demutualization expertise has been used for presentations to the Philippine government.

As in this example, the complexity of the demutualization process is driving the demand for transfer of demutualization expertise. Canada, for example, spent 21/2 years consulting other countries, including Britain, the United States and Australia, before introducing demutualization-enabling legislation.

The Asia-Pacific Region lags the Americas and Europe in demutualization, which is not surprising given the region's other economic imperatives. In some cases, this lag is attributable to the structure of the industry itself. For example, there are no mutual insurers in either Taiwan or Malaysia. In Hong Kong, the only demutualization involved the local branch of Canada's Manulife, and companies in Singapore have shown no interest.

The picture is quite different in Japan and Australia, however. In Japan, 14 of 16 major life insurance companies are mutuals, and the environment is ripe for demutualization. Two Japanese nonlife companies, Daiichi Fire & Marine and Kyoei Fire & Marine, also are considering demutualization. Japanese legislative revisions easing demutualization are planned for this and subsequent years and are expected to usher in a wave of demutualization.

Similarly, Australia is poised for extensive demutualization. Three large life mutuals, motivated by the same fundamental needs for capital and flexibility, have demutualized, and other candidates include credit unions and building societies. In Australia, mutuals are better protected against acquisition by their status, but as profits dwindle (as they have to a large extent in Australia), remaining a mutual may not be best in the long run.

An Honest Assessment

One final impediment to demutualization is subtle and reflects management fears. Demutualization is not best for every mutual, but management justification for retaining mutual status can mask financial realities. Although some companies aren't aware of their Achilles' heels, some are acutely aware. In these situations, vulnerable management eschews demutualization as a way to protect itself If a mutual demutualizes to cover trouble or save jobs, the process can set up the demutualizing entity as a hostage to be taken out of the game.

Marketplace, economic, industry and regulatory dynamics are changing to such an extent and at such a pace that no mutual insurance company can afford to put away indefinitely the subject of demutualization. Property/casualty mutuals are no exception. Mutuals need to understand their new and evolving risks and opportunities, as well as the heightened expectations of policyholders.

Clearly, choosing the status quo is not an option for financial-services companies today. Even mutuals that choose to retain their structure must prepare for new competitors and the changing marketplace. They also must be able to defend their decisions to a new breed of policyholders. Key steps toward readiness include knowing what the options are, understanding the technical and interpersonal aspects of the process and establishing clear strategic goals.

Kim E. Piersol is a New York-based actuary and a senior manager in Arthur Andersen's property/casualty consulting practice.