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Seventeen mutual insurance companies have demutualized since 1986 with the largest, by far, occurring this year.

John Hancock Financial Services went public in January 2000, raising $1.7 billion, followed by Metropolitan Life Insurance Co. in April, which raised nearly $2.9 billion but wanted more.

MetLife supplemented its initial public offering (IPO) with an $855 million private equity placement bought in part by Banco antander, a Spanish bank that operates a Spanish insurance company with MetLife, and it sold another $840 million of convertible bonds publicly.

What's happening today in the insurance industry is a function of the convulsions occurring across the entire financial services industry in the United States. Managers atop these companies are ensnared by problems more complex and profound than any within a generation, at least. Every one of these senior executives grapples concurrently with the triple threat of globalization, distribution channel conflicts, and new financial services deregulation. But insurance companies--especially mutual insurers--are arguably the most challenged of all financial services providers.

Chief financial officers, treasurers, controllers, and other financial managers will want to observe how insurers grapple with their industry's dynamics. After all, buyers of financial services are accountable for the performance of their outside service providers.


Historically, the insurance industry has enjoyed high barriers to entry because underwriting insurance policies requires unique competencies--such as actuarial science. Insurers have been further shielded from competition since 1934 by federal law. Provisions of the Glass-Steagall Act precluded banks, mutual funds, and securities firms from insurance underwriting.

Today, insurers are less protected from competition. Last year's Gramm-Leach-Bliley Act repealed Glass-Steagall. Now banks--and anyone else--are allowed to underwrite insurance. Conversely, insurers can go into banking and more--a level field for all. (See Strategic Finance, April 2000, "The Coming of a Financial Services Bazaar?")

Some new-era financial services organizations will mimic the European bancassurance model, following the trail Citigroup is blazing. But the path to a multiproduct financial services manufacturing and distribution organization will require capital--lots of it. And it doesn't matter much whether the company expands by acquisition or alliance, organically or technologically. Continuous access to capital will be critical.


But mutual insurers are tied in a financial straitjacket.

The mutual capital structure is similar to a cooperative much like the original savings & loan associations. The equity funds belong to the customers--the policyholders, who legally own the company. Mutual insurers can only obtain fresh capital from profits, investment returns, or "surplus notes," which are highly subordinated and regulated debt securities. Moreover, recent new regulation requires insurers to maintain higher capital reserves.

One way out of this pickle is a demutualization. Coneptually, a demutualization is as straightforward as a recapitalization. The mutual company floats common stock in the public equity markets, uses some of the proceeds to redeem policyholders' ownership interests, and invests the rest in the business.

But actually doing a demutualization successfully is a bit Herculean. Demutualizing is highly complicated, cumbersome, costly, and, often, contentious. It's fraught with many issues: regulatory, legal, accounting, actuarial, investment banking, and corporate governance. Typically a long process, demutualizing takes 12 to 36 months and is expensive, too, costing $100 million or more.


Still, none of these hurdles is preventing mutual insurers from converting to stock companies. The allure is too great--today's pressure too much. Fully demutualizing liberates insurance companies from the confines of a mutual structure and can finance a competitive new corporate strategy.

The market has been pricing most insurance IPOs at only 60% to 70% of company's book value of owners equity, according to Krupa Subramanian, an assistant professor of insurance and actuarial science at Temple University. Nonetheless, more demutualizations are in the offing. Prudential Insurance, for example, has been working since February 1998 on a demutualization plan and says it will be complete and ready to go public in 2001.

Overall, out of 5,300 U.S. insurance companies today, about 3,940 are publicly owned and 1,360 are mutually owned, according to the National Association of Mutual Insurance Companies.


Being publicly owned provides insurers continued access to the capital markets and market-valued common stock. Both can serve as powerful mechanisms for growth.

Within weeks after its IPO, MetLife, the new parent holding company of its insurance subsidiary Metropolitan Life Insurance Co., said it would expand into consumer banking. A separate operating unit will be developed under the Metropolitan Life Insurance subsidiary that will offer savings, checking, and individual retirement accounts, plus online bill payment by early next year. MetLife's banking endeavor clearly is aimed at capturing more customer assets.

Robert H. Benmosche, MetLife's chairman and chief executive officer, said the banking project will be an "opportunity" for the company to "provide our existing and future customers with greater flexibility, security, and convenience in meeting their financial goals."

Had MetLife raised more than $4.9 billion in net proceeds from its stock and bond offerings this year, it probably would have bought a bank rather than begun to build one. At least that's what Benmosche said in late 1998.

Then analysts estimated MetLife could raise as much as $20 billion in an IPO. But early this year, MetLife's IPO prospectus said it hoped to raise as much as $6.5 billion with shares priced somewhere between $14 and $24 each.

Ultimately, the size of the offering was cut, and shares were priced at $14.25 each, which was 77% of book value of owners' equity (the excess of total liabilities minus total assets). By early last month, MetLife's stock was trading at about $20.50 a share, or 1:2 times book value.


Fully demutualizing can do more than finance new products, form alliances, and acquire companies. It can help buy and retain management talent and be used effectively as incentive compensation. Executives of stock life insurers have higher cash compensation than those of mutual companies, according to research by professors David Mayers and Clifford W. Smith, Jr. Also, stock life insurers whose chief executives have stock options perform financially better than mutuals.

Moreover, a capital structure comprising common stock potentially provides tax savings, investment flexibilty, and myriad ways to restructure. Plus, insurers can become more aggressive competitively by selling services based on core competencies.

Asset and risk management are two core competencies, for example, that successful insurance companies have but which most haven't fully exploited. Securities firms and money managers dominate these markets. But with capital raised from an IPO and subsequent financings, insurers could move more aggressively and competitively into these domains as well.

Getting there is a large endeavor. And once there, legal problems can linger.

MetLife's conversion cost $350 million and took nearly three years. That's before investment banking fees, but it included the cost of all the lawyers who developed the plan. Still, MetLife is now subject to six lawsuits by disgruntled policyholders. They're claiming the conversion was unfair or unfairly compensated them for their ownership interests, or both, says Subramanian.

MetLife's 12 million policyholders had the option of taking stock, cash, or policy credits at the time of the conversion. On average, each got about $1,100, calculates David Schiff, editor of Schiff's Insurance Observer.

All told, MetLife gave policyholders 493 million shares of common stock valued at $14.25 each. But that was only 77% of the book value of equity. The remaining 23% came to about $400 million, one lawsuit charges. But at $20.50 a share, or 1.2 times book value, that particular complaint now seems moot.


A faster and less expensive route to the capital markets is converting to a mutual holding company (MHC). Since the MHC structure was first legalized in 1995, 25 states now allow it, and some 20 insurance companies have converted or plan to convert to one, according to Colin Devine, CFA, CMA, an insurance industry securities analyst with Salomon Smith Barney.

Many mutuals use the MHC structure as a step toward fully demutualizing. Principal Financial Group, for example, converted to an MHC in 1998 and now wants to fully demutualize because the amount of capital that can be raised under an MHC is limited. And the structure itself has been broadly criticized as inequitable to policyholders.

Under an MHC, the insurance company becomes a subsidiary of a stock holding company, which itself becomes a subsidiary of a mutual holding company. Stock in the insurance company is sold publicly, raising some equity capital.

Critics charge that conversion to an MHC dilutes or terminates policyholders' ownership without compensating them. Previously, policyholders benefited exclusively from the company's surplus. But after conversion to an MHC, stockholders are also entitled to the surplus.

Joseph M. Belth, Ph.D., a professor emeritus of insurance at Indiana University and author and editor of The Insurance Forum, an industry publication, believes the concept of a mutual holding company "is fundamentally flawed and should not be allowed."


Regulation of insurance, unlike banking, money management, or securities, is done largely at the state level only. Each state has its own insurance commission, commissioner, and rules. Any company planning to demutualize must submit a conversion plan to its state insurance commissioner for approval, and its policyholders must vote for demutualization by either a 2/3 or 3/4 margin, depending on the state. The key issue for each insurance commissioner is whether the plan equitably compensates policyholders for relinquishing their ownership interests, says Subramanian, whose doctoral dissertation is on demutualization.

A mutual insurance company operates for the exclusive benefit of its policyholders who collectively own the company's assets. But individually, policyowners "have some but not all the characteristics of owners," Belth says. Essentially, they're customers with ownership interests.


How then should insurance commissioners evaluate the fairness of a demutualization plan? If they take Joseph Belth's counsel, commissioners would look for six main ingredients:

* COMPENSATE THE POLICYHOLDERS. Policyholders should be compensated for their ownership interests in an amount that equals the total value of the company--either in cash, policy credits, or shares of stock.

* DEFINE ELIGIBILITY BROADLY. People who have ownership interests should include those who don't share in the company's surplus dividends, such as owners of interest-sensitive policies or policies issued by a mutual company's stock subsidiary. Belth's rationale: These customers indirectly contribute to the value of the mutual parent.

* DISCLOSE THE ALLOCATION FORMULA. In demutualizations to date, the formula used to value and compensate policyholders' interests has been certified as fair by actuaries but not disclosed to policyholders. And "strange" results have occurred, Belth says, such as owners of large policies receiving fewer shares than owners of small policies.

* GIVE POLICYHOLDERS SUBSCRIPTION RIGHTS. When the stock's IPO price is less than the stock's subsequent value, policyholders who opted for stock should also be allowed to buy additional shares at the IPO price. Why? "It was their original premiums on which the company's value was built," Belth adds.

* CREATE A POLICYHOLDERS' COMMITTEE. Most policyholders won't understand the lengthy documentation of this complex reorganization. So a policyholders' committee should be a forum to communicate with fellow policyholders, serve as a policyholders' advocate, have access to management discussions, participate in regulatory meetings, and hire staff (all funded by the company).

* HOLD A FORMAL HEARING. Policyholders should have an opportunity to participate in a formal hearing at which all views may be aired, documents provided in advance, and management and policyholders testify and submit to cross-examination.


Joseph Belth's ideal demutualization plan may carry weight as more insurers opt to demutualize. A full demutualization done cleanly from the outset can finance the future; one done sloppily can invite legal, corporate governance, and public relations problems.

Accordingly, insurance company management will need to focus on developing successful corporate strategies for delivering financial services.

After all, Citigroup, Merrill Lynch, and Charles Schwab & Co. have no capital structure constraints and no customers with intrinsic ownership interests. And they, too, like MetLife, want to continue amassing household assets.
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Publication:Strategic Finance
Geographic Code:1USA
Date:Jul 1, 2000
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