Price It Right.

Traditional methods of determining public-offering prices of converting insurers have generally not resulted in the best pricing for the companies, or their policyholders.

Insurance policyholder rights advocates have referred to the demutualization of mutual insurance companies as "an executive self-enrichment scheme developed by management and their corporate law firms."

So contentious is demutualization that numerous class-action lawsuits have been filed to stop the process. In a recent court case, Butler, et al. vs. Provident Mutual Life Insurance Co., the presiding judge granted an injunction stopping the conversion to a stock company even after the policyholders had voted to approve it.

The Center for Insurance Research has fought similar battles against a variety of insurance company demutualizadons, including those of State Mutual Life Assurance Company of America, Old Guard Insurance Group of Lancaster, Pa., and Allied Mutual Insurance Co.

While much of the litigation to date has involved institutions converting to mutual holding companies, the threat of lawsuits persists even for companies that fully demutualize.

Given this litigious climate, eliminating any perception of unfairness is a critical, yet challenging aspect of a successful demutualization process. In general, debates about the fairness of demutualization have revolved around particular conversion methods, with little or no attention given to the pricing of initial public offerings.

But this oversight has serious repercussions. Traditional methods of determining public-offering prices of converting insurance companies, in which investment bankers use subjective methods and assumptions to derive a public-offering price, have generally not resulted in optimal--or what may be perceived to be "fair and equitable"--pricing for the companies or their policyholders.

Implicitly acknowledging this shortcoming, some demutualizing insurance companies, such as John Hancock Mutual Life Insurance Co., are searching for strategies to strengthen a perception of fairness and equity throughout the conversion process, including the pricing of the IPO.

Entering the Market

The best-known pattern associated with IPO prices is the large run-up in price in the secondary market on the first trading day. The November 1998 IPO of Theglobe.com is an extreme illustration of this pattern. The investment bankers who took Theglobe.com public set an offering price of $9 per share, allowing the company to raise nearly $29 million in capital. However, when the market closed for trading that day, the share price had jumped more than 600% to $63.50. Had the offering price more closely reflected market demand, Thegloble.com would have been able to capture a great deal more capital for itself.

Does this same pattern apply to insurance companies that have demutualized? WR Hambrecht & Co. reviewed the stock-price performance of six mutual life insurance companies that converted to stock companies and sold shares through an IPO and measured the change in share price from the date of public offering to the six-month anniversary of that offering.

The research shows the average first-day appreciation in share price for converted mutual life insurance companies exceeded 12%, demonstrating a fair-market value well above the underwriter's determined price. Furthermore, six months after the IPO, the stock prices had appreciated, on average, nearly 40%.

Given the growing convergence of financial-services companies, the post-IPO stock-price performance of demutualized savings institutions and nonlife insurance companies, including health and property/casualty insurers, also were reviewed. Although not detailed here, a review of the data for these related institutions revealed a similar, even more pronounced pattern.

This similarity is not surprising. In fact, a comprehensive study of more than 13,000 new equity issues from 1960 to 1996 showed that investors who received IPO shares were rewarded with an average first-day return of 15.8%. That study, "The Market's Problems With the Pricing of Initial Public Offerings," coauthored by Roger G. Ibbotson, Jody Sindelar and Jay R. Ritter, appeared in the 1994 Journal of Applied Corporate Finance and was updated in 1997 by Bitter in an article titled "Initial Public Offerings."

While a variety of elements affect share-price movement, the pattern of initial undervaluation is clear and could be of great concern to stakeholders in any demutualization, particularly those policyholders who receive all or some portion of their compensation in cash.

Although such undervaluation adversely impacts all policyholders, those who receive cash compensation instead of stock are typically disproportionately affected. Because the amount of cash and policy enhancements received by policyholders is generally a function of the offering price, their realized compensation has been discounted by an average of 12%. The inability for this class of policyholders to participate in post-IPO share-price appreciation establishes an inherent compensation disparity between policyholder groups. When viewed over a six-month period, the disparity among policyholders grows even larger.

In April 1999, Standard Insurance Corp. transitioned from a mutual company to a publicly traded stock company Goldman Sachs, underwriters of the Standard offering, estimated the value of the company to be "between $665 million and $935 million," or from $20.37 to $28.64 per share, based on the actual shares outstanding at the IPO. According to Standard spokesman John Mangan, Goldman Sachs set the final offering price at $23.75 per share after conducting a series of meetings with analysts and institutional investors around the country.

Based on Standard's book equity of $825.1 million at March 31, 1999, the IPO was priced at about 94% of book value, resulting in an initial market valuation of $775.2 million.

Was this valuation fair to the company and its policyholders? While Standard's IPO fell within the underwriter's valuation range, it priced below book value. And by the close of the first trading day, Standard's market capitalization had climbed close to book value. WR Hambrecht & Co.'s review of other demutualizations shows that, in most cases, the initial per-share valuation of demutualized insurance companies represents a significant discount to actual per-share book value.

The offering prices for the most recent life insurance company conversions were, on average, only 90.9% of book value. Although some comparable companies continue to trade at below-book values in the after market, companies able to improve profitability and withstand public-market competition have been rewarded with higher price-to-book multiples.

By setting the offering price below book value, underwriters are either underestimating a company's prospects or suggesting that those prospects are limited. While many variables determine an offering price, the tendency to set offering prices below book value may, in many cases, be unwarranted. Thus, characterizing such valuations as "fair and equitable" seems questionable, especially in light of first-day and six-month stock-price performance.

The Hancock Solution

John Hancock, which is in the process of demutualizing, has recognized the suboptimal pricing pattern in initial public offerings and has implicitly acknowledged that the pattern is unfair to certain policyholders. John Hancock's "Plan of Reorganization" states:

"In prior major U.S. life insurer demutualizations, the conversion of allocated shares to cash or policy credits has been done at the IPO price.

"In an unprecedented action, John Hancock has incorporated into its plan of demutualization a provision to convert allocated shares into cash or policy credits with a guaranteed minimum of the IPO price, plus a potential premium of up to 20% of the IPO price depending on the average closing price of the stock for the first 20 trading days.

"We are doing this to ensure that policyholders receiving cash or policy credits in the conversion have the opportunity to benefit from any potential appreciation in the stock price during the initial trading period."

John Hancock's policyholder share-value protection plan is the first real attempt to contribute a greater element of fairness to the pricing of demutualized companies' IPOs. John Hancock's strategy acknowledges policy-holders' right to benefit from a fair-market valuation of the company and, in effect, condemns the traditional method of IPO valuations as inadequate and inconsistent with equitable compensation for all eligible policyholders. While John Hancock's protection clause is a welcome and, admittedly, unprecedented step toward policyholder-friendly conversions, a valuation process dictated by supply-and-demand economics would ensure a fairer and even more equitable solution.

Although underwriting of public offerings remains within the firm grasp of investment banks, the model for public offerings is showing signs of change. Companies such as Wit Capital, E-Offering, and WR Hambrecht & Co. have begun the democratization of public offerings, making them more accessible to the retail customer than ever before. Although Wit Capital and F-Offering have contributed to making IPOs accessible to a broader base of investors, they still rely on traditional pricing techniques. WR Hambrecht & Co.'s approach, called OpenIPO, introduces a Dutch auction method to price and allocate IPO shares over the Internet. Through OpenIPO, WR Hambrecht & Co. offers any investor the opportunity to bid for as many shares as desired at the price the investor is willing to pay. The result is an offering price free of traditional fixed discounts and more reflective of fair-market value.

Opportunity for Fairness and Equity

The pending demutualizations of Prudential, John Hancock and MetLife will be among the largest insurance demutualizations ever. As such, consumer advocates will scrutinize these demutualizations to ensure that policy-holders are treated according to a "fair and equitable" standard. Prudential spokesman Robert DeFillippo has acknowledged the imperative of treating policyholders as fairly as possible. Alluding to previous policyholder disputes, he remarked, "After what we've been through, this better be the most consumer-friendly demutualization on the planet."

So the question is: How can such fairness be ensured?

Thus far, analysts' valuations of these companies vary widely. For example, some analysts estimate that Prudential's IPO could be worth up to $30 billion. Others say $15 billion to $20 billion is more accurate. Similar to the wide-ranging valuation estimate for Standard Insurance Corp., the final valuation of these companies and others to follow will have tremendous consequences not only for the companies' offering proceeds, but also for policyholders' compensation and perception of fairness and equity.

Jonathan T. Fayman is a vice president, and Julie Greenberg is editor in chief of WR Hambrecht & Co., an online investment bank.