Make me a perfect match: a sponsored demutualization can be an attractive affiliation option between complimentary companies. (Industry Strategies: Demutualization).

The insurance industry has seen significant changes over the past several years, including consolidation, restructurings and demutualization. These days, the industry has been taking a breather, but if U.S. consolidation trends continue to mirror those of Europe, it's likely more companies will combine with each other in the next few years.

In the Running

As many of the most likely candidates for acquisition--health-care entities and property/casualty companies--are mutuals, one type of acquisition likely to be attractive is the sponsored demutualization.

In a sponsored demutualization, a mutual company opts to demutualize as part of a decision to be acquired, most typically by a stock company. Both the policyholders of the mutual and the insurance department of the state where the mutual is domiciled must approve the request. The acquiring company is considered the sponsor of the mutual's demutualization.

To date, sponsored demutualizations have been more popular outside the United States. In 1997, the French insurer Axa sponsored the demutualizadon of the Australian insurer National Mutual, and the U.K. insurer Scottish Amicable underwent a two-part hostile sponsored demutualization (policyholders instigated the process against the wishes of the company) before it was taken over in November 1997 by Prudential plc.

Axa Did It

Although they are less frequent in the United States, Axa sponsored the demutualization of Equitable Life Assurance Company of the U.S. in 1992 in exchange for a 49% stake. In addition, Nationwide Financial currently is sponsoring the demutualization of Provident Mutual. And Anthem West, an Indiana-based company that itself demutualized recently, is looking to acquire Blue Cross & Blue Shield of Kansas in a sponsored demutualization to strengthen its geographic presence.

Being acquired in a sponsored demutualization is a good option for solid mutuals that have strong management, good books of business, a stable and growing geographic base, and good products and systems, but that feel it isn't possible to maintain all of this on a stand-alone basis.

On the flip side, sponsoring a mutual in a demutualization also is a good way for companies to make an acquisition, enabling access to new products, customers and markets.

Future Considerations

As top executives and directors of several mutuals develop their long-term strategic plans, they quietly are realizing that they might be better positioned for the future if they go forward as part of a larger entity, rather than continuing solo.

Several good reasons exist for a mutual to do so: Even though the market for insurance has hardened, it hasn't stopped being competitive. Depressed interest rates, a slumping stock market, fallout from Sept. 11 and individual market conditions mean that mutuals are under more ratings pressure than ever. Even the stronger mutuals are concerned about indemnity losses and downgrades.

In addition, insurance needs are continuing to develop, and especially for property/casualty insurers, the ability to develop and offer new products and support them is essential to maintain future viability. Even just keeping up to speed technologically is expensive; it takes capital and knowledge.

A strategic scenario where a company maintains control of its future by choosing its acquirer and then cutting the best deal for its policyholders can be preferable to, in the worst case scenario, struggling along alone, enduring a slow erosion and then being taken over, either by an acquirer not of the company's choosing or by its state insurance department.

Even for a smaller mutual, deciding to pursue a sponsored demutualization can be a lengthy and complex process, involving extensive discussions among the mutual's top management, board members and regulators, as well as a lot of communication with policyholders and agents. A notable amount of due diligence and analysis is required.

Playing the Field

The preliminary strategic discussions are the most critical phase of the sponsored demutualization process. In this phase, executives and board members talk about the company's long-term direction, how best to implement it and how best to serve its policyholders. This includes continuing to develop and offer appealing, reliable products, attracting and retaining talent, and maintaining viability amid ongoing pressure to be profitable. This phase, which can last anywhere from several months to a year or more, is necessary to align the board and the management and to lay the proper groundwork. It might be beneficial to bring in an objective, outside consultant and other advisers to analyze all of these issues.

Once a company decides that a sponsored demutualization is the best way to accomplish its strategic goals, the search begins for a good sponsor. A potential sponsor doesn't need to be an insurance company: any company with stock currency--a bank, a stockbrokerage firm, an investment bank or even a nonfinancial services company--can be a sponsor.

Sponsors themselves have strategic goals that they want to implement, which can range from extending geographic reach to acquiring product lines, servicing capability or expertise in specific markets. The sponsor also needs to analyze the capital structure of both organizations to determine the available sources of funds to cover the fair compensation to policyholders, as well as other acquisition costs. The goal of this analysis is to ensure that all capital outlays have been identified and to ensure that in the end, the new combined entity is financially as strong or stronger than the two stand-alone companies.

Two to Tango 

Once a sponsor is identified, and the two companies agree to combine in a sponsored demutualization, the next step is for them to develop a mutually agreeable plan that describes in detail the nature of the combined organization.

Several potential pitfalls can emerge as the two develop that plan. Companies must walk a fine line to align the financial interests of their policyholders, their employees and their management. Any portion of the plan that will result in "cost savings" and "synergies" that generate cuts to staff and management must be addressed carefully.

The plan also must provide policyholders with fair and equitable compensation for their loss of ownership interest. Whether to do so via cash, stock, a combination of the two or some other way must be considered carefully. Determining this value requires the mutual to pull together a complete valuation of itself This might require some data cleanup to arrive at a good valuation.

Retaining Talent

When a mutual is managed well by a good executive team, the sponsor will try to retain such talent. The sponsor can do so by structuring compensation packages with incentives (without providing windfalls) such as retention bonuses, equity grants and other incentives that won't diminish the value given to policyholders. Whatever the proposed package is, it must conform to the relevant state demutualization statute.

The benefits packages for executives and staff also must be reviewed and aligned; if compensation and benefits at the two companies are out of sync, it can cause morale issues for either company.

Another important factor to consider is culture, and the potential for culture shock. Mutuals can have a very entrenched culture, which can be very different from that of a stock company Analyzing the cultures and philosophies of the two companies, and finding ways to bring the cultures together and foster a rapprochement, are essential for the success of the newly combined company.

Once the plan is drafted, it must be submitted to the department of insurance in the state where the mutual is domiciled. If the sponsor is also an insurance company, the plan must be submitted to that insurer's state as well.

Change of Ownership

From this point on, the sponsored demutualization process is nearly identical to that of a stand-alone demutualization. The major difference is that once the mutual is demutualized, the owner of all the stock will be the acquiring company rather than the open market.

If the regulators approve the plan, it is then presented to the mutual's policyholders for a vote. The acquiring company must also comply with any relevant securities regulations.

The most important aspect to stress, especially for the mutual, is communication--to policyholders, to employees, to management and especially to agents. The agents often are part of the intangible value of the company and can be among an insurer's closest links to its policyholders. They can play a critical role in communicating to the policyholders the future benefits of the sponsored demutualization, so that the policyholders can vote knowledgeably on the matter. The mutual must make every effort to communicate as much about what is going on as possible to both agents and policyholders, as often the agents will be the ones getting questions about the demutualization plan.

If the policyholders vote "no," the acquisition can't go ahead, so it's in the interests of both the sponsor and the mutual to ensure that the parties closest to the policyholders have all the information they need to talk knowledgeably about the benefits and mechanics of the plan.

Period of Adjustment

Once the sponsored demutualization is approved, the job isn't done. The two companies, which are now one, still have to follow through on all the integration details laid out in the plan they submitted to regulators. Again, this is why the up-front planning is so critical, as the initial plan must be clear in how it addresses the integration.

If they are to be fully integrated, there are very few parts of both companies, but especially of the acquired mutual, that won't experience some kind of impact from a merger. Communications with policyholders, employees and agents, as well as financial reporting, could need adjustments. The technology side might feel the largest impact, as every system of both the sponsor and the acquired mutual should be analyzed to. ensure that the systems provide the information needed to run the combined businesses.

Those mutuals exploring their strategic options need to consider whether they can, over the long term, control their destiny. If they believe, because of either current or long-term business prospects, that the interests of all of their stakeholders are better served by being acquired, they should proactively consider a sponsored demutualization. Failing to do so could result in outside market influences forcing them to consider or accept less desirable options.

RELATED ARTICLE: Current Sponsored Demutualizations

Nationwide/Provident Mutual

Sponsor: Nationwide Financial Services Inc.

Headquarters: Columbus, Ohio 

Mutual: Provident Mutual Life Insurance Co.

Headquarters: Berwyn, Pa.

Details of the agreement: Nationwide will acquire Provident Mutual for $1.56 billion. Eligible members of Provident Mutual will receive Nationwide shares, cash and policy credits.

Changes: Nationwide will become the nation's third-largest provider of variable life insurance. Provident will be renamed Nationwide Provident and receive more resources to grow and remain competitive.

President/chief operating officer of the new entity: Gary D. McMahan

History: Provident Mutual had previously sought to convert to a mutual holding company, but in October 1999, the company pulled the request after litigation and an unfavorable court ruling by a Philadelphia judge.

Completion: Expected on or before Oct. 1,2002

Anthem West/Blue Cross & Blue Shield of Kansas

Sponsor: Anthem Inc.

Headquarters: Indianapolis

Mutual: Blue Cross & Blue Shield of Kansas

Headquarters: Topeka, Kan.

Details of the agreement: Anthem is the Blue Cross Blue Shield licensee for Indiana, Kentucky, Ohio, Connecticut, New Hampshire, Colorado, Nevada, Maine and Virginia, excluding the northern Virginia suburbs of Washington, D.C. Kansas Blues would receive about $321 million if the company is acquired by Anthem.

Changes: The companies say the merger would allow them to take advantage of economies of scale by eliminating duplicative resources and streamlining compliance efforts in an increasingly complex regulatory environment.

What's next: This sponsored demutualization is embroiled in a regulatory and judicial battle. Kansas Insurance Commissioner Kathleen Sebelius has appealed to the state Supreme Court to let stand her decision to block the agreement. Sebelius is appealing a district court decision that let the proposal proceed. She contends that Anthem's takeover would drain the Kansas Blues' reserves.

Thomas Mulhare is a managing director and Michael Talbot is a director for Peterson Consulting in Princeton, N.J. They lead the company's demutualization/transformation practice.