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When mutual companies convert: pitfalls for policyholders.

Citing the need to protect their property rights, policyholders are filing class actions to challenge conversion of mutual life insurers to publicly traded stock companies.

Many mutual life insurance companies, including the nation's largest, have "demutualited" or are in the process of doing so as a result of new conversion laws.(1)

A mutual insurance company demutualizes when it converts to a publicly traded stock company. Mutual insurers argue that demutualization allows them greater access to capital markets for business expansion, but current class action lawsuits brought by mutual life policyholders allege that the laws allowing demutualization fail to adequately protect policyholders' rights.

In 1903, policyholders of Germantown Farmers Mutual Insurance Co. in Wisconsin sued the managers of the company, claiming that they effectively stole ownership and control of the business by converting from a mutual to a stock company. The managers' lobbying efforts had led to passage of a statute authorizing the plan of conversion.

The Supreme Court of Wisconsin, in Huber v. Martin, overturned the conversion, holding that the policyholders were the owners of the mutual company and that the statute could not constitutionally authorize the taking of their property by company management for operation of a stock company.(2)

The Huber decision arose in an era of regulatory concern about mutual conversions. In 1909, the National Convention of Insurance Commissioners (today, the National Association of Insurance Commissioners, or NAIC) expressed its fear that mutual-to-stock conversions were becoming vehicles for knowledgeable insiders to purchase an insurance company at a large discount.

They stated:
 Are we going to permit companies that are organized as mutual companies,
 and that use the funds of the policyholders to build up their agency plants
 to get their business established--are we going to permit those companies,
 then, to reincorporate as stock companies and take over, without any
 consideration to the policyholders?(3)

Because of continued widely publicized scandals, several states--including New York--enacted laws prohibiting conversions, and in ensuing years relatively few took place.

By 1985, however, 80 percent of the largest mutual companies were again considering the feasibility of converting to a stock form of ownership.(4) Extensive lobbying efforts by the insurance industry led to a wave of new legislation across the nation in the 1980s and 1990s authorizing such conversions.(5)

The NAIC was notably absent in this process. Although it has promulgated a substantial body of model laws intended to protect policyholders against various insurance practices, it has never established a model demutualization law.

As in the early 20th century, greater access to capital markets is an impetus for conversion. Another impetus comes today from the 1999 Gramm-Leach-Bliley Act.(6) This federal statute eliminated restrictions on mergers or acquisitions among insurers, banks, and brokerage companies by allowing any financial holding company to acquire and retain shares of any other financial services company.

A mutual that converts to a stock company becomes an attractive target for merger or acquisition by another financial services company. State laws generally recognize that control of a stock insurance company is held by any person or group of persons acting in concert who hold more than 10 percent of the outstanding stock.(7) If company managers are able to structure the plan of conversion so that they (and those acting in concert with them) obtain control by purchasing the shares of unsuspecting shareholders at a discount, they are well positioned to "auction" the company to the highest bidder for personal benefit.

Conversion laws typically require the mutual life insurer to submit a plan of conversion to the state insurance regulatory agency, which may approve the plan after a hearing. The plan provides a method for valuing and allocating policyholders' interests in the company and provides for the creation of a new, publicly held stock life company to continue the insurance business. The agency's decision approving or disapproving a plan gives the aggrieved party the right to appeal the decision to a court of law.

Whether the new conversion laws protect mutual policyholders from scandals like the 1903 Germantown Farmers case remains to be seen. Two pending class actions brought by policyholders of mutual insurers allege that they do not.

John Hancock Mutual Life Insurance Co. implemented a conversion plan in January 2000, after obtaining approval from the Massachusetts Division of Insurance. Metropolitan Life Insurance Co. converted to a stock insurer in April 2000, after the New York Department of Insurance approved the transaction. The plans were similar and are being challenged on similar grounds.

The class actions claim breach of fiduciary duty and contract against the newly reorganized stock companies and their managers, alleging that the conversion plans do not provide for just compensation for policyholders' property rights. The lawsuits also assert that, therefore, the state regulatory agencies improperly approved the plans, and that the agencies' decisions must be reviewable by courts.

Just compensation

A primary issue in the current class actions is whether the amount being paid to policyholders for the loss of their mutual membership rights is sufficient. A mutual life company, by definition, is a cooperative enterprise designed to provide its members (the policyholders) life insurance at cost.(8) Insurance benefits are provided by pooling members' premium payments (or equity infusions) into a "participating" common fund, which is administered to provide for the payment of benefits due under the insurance contracts. To participate means to share the company's investment gains and its costs, including the cost of paying death benefits, with all other policyholders of the same class.

Excess premium payments (also known as excess equity or divisible surplus) are periodically returned to members;(9) as a result, they receive insurance at cost. Mutual policyholders are, therefore, both the sole consumers of the company's service and its beneficial owners.

Beneficial ownership means that legal title to property belongs to another, but the property must be utilized for the benefit of the beneficial owner. Policyholders who buy life insurance from a mutual company obtain a contractual interest in the organizational structure of the company. Courts have analogized the rights of mutual policyholders to a cestui que trust in that legal title to the corporate property is vested in the company but is devoted solely to providing life insurance at cost for the benefit of policyholders.(10)

While policyholders in an ongoing mutual life company are the beneficial owners of the corporate assets, once the mutual operation ceases, the policyholders become the legal owners of the corporate assets.(11)

Conversion creates a new stock company designed to provide life insurance for profit to third-party consumers for the benefit of public investors/shareholders. Policyholders' contract rights to a mutual form of operation and to insurance at cost are repudiated. The trust is terminated by demutualization, and policyholders' previous beneficial ownership interests merge into and become legal ownership interests in the corporate property.

Absent statutory authorization, demutualization would constitute a breach of contract and trust because a contract may not be modified except upon unanimous, express written consent of all parties, and a trust may not be terminated except upon consent of all beneficiaries.(12)

Courts considering the constitutionality of conversion laws have applied both the Impairment Clause and the Takings Clause of the U.S. Constitution.(13) The Impairment Clause protects contract rights against retrospective application of state law. The Takings Clause requires payment of just compensation where the government takes, or authorizes another to take, private property for a public use.

Courts have held that a contract right constitutes property but that conversion laws do not result in an unconstitutional impairment and taking, as long as the rights are taken for a public purpose and just compensation is paid.(14) Courts have found the public purpose supporting the conversion laws to be that they preserve the financial viability of the insurance industry.(15)

The just compensation standard requires that property owners be placed in as good a position as if conversion had not taken place.(16) In the context of mutual conversion, this standard requires paying policyholders for the loss of their ownership and assuring continuation of their right to receive life insurance at cost.

In a stock corporation, shareholders are typically compensated for loss of ownership due to fundamental corporate changes by payment of "fair value"; each shareholder receives his or her proportionate interest in the intrinsic, or going-concern, value of the company.(17) This standard is intended to protect shareholders from being "squeezed out" for the benefit of insiders or those in control of the company.

The class actions allege that mutual policyholders are being divested of ownership for far less than the true value of the company. The plans at issue value the consideration to be paid to policyholders according to the initial public offering (IPO) price of the newly created stock companies. In other words, the plans use an early market valuation of the new stock company to measure mutual policyholders' interests. The lawsuits assert that the IPO price is not equivalent to the full going-concern value of the company as required by the "fair value" standard because at the time of initial offering the stock market does not have enough information about the intrinsic value of a converting mutual.

Moreover, the plans incorporate "anti-takeover" provisions to entrench existing management. These provisions are commonly recognized to diminish the market value of the company because they prevent investors from bidding for control of the company and, as a result, reduce investor demand for the stock, causing the stock price to drop.(18)

The lawsuits also question allocation of payment among policyholders. Mutual insurers generally distribute excess premium payments among policyholders according to the "contribution method." That means policyholders are compensated in proportion to the amount of premiums they have contributed to the company.(19)

In contrast, the plans challenged in the class actions allocate consideration under a newly created formula known as the "historic-plus method." This method measures each policyholder's contribution by examining the policy's past contributions to surplus and the estimated present value of future contributions to surplus. In an earlier demutualization proceeding in Massachusetts, actuarial experts concluded that this method tends to apportion more consideration to large pension plans and more recent policyholders than to older, long-term policyholders with smaller policies.(20)

Improper plan approval

The new conversion laws delegate to insurance regulatory agencies the duty to review and approve conversion plans. The conversion laws applicable in the class actions require the state administrative agency to approve the plan where it is determined to be "fair and equitable" or "not prejudicial" to policyholders.(21) The lawsuits contend that the regulatory agencies do not have authority to approve a plan unless property rights are unimpaired and fiduciary duties are honored. The policyholders argue that because the propriety of a plan must be evaluated under contract law and fiduciary standards, the courts--which are designated to decide these rights under the separation-of-powers doctrine--should be the ultimate arbiters rather than the administrative agencies.

Courts have held that the parties' contractual rights and fiduciary obligations must be the applicable standard.(22) But in the John Hancock and MetLife cases, the regulatory agencies did not expressly find that they were required to take into account these rights and obligations.(23)

Ensuring fairness

Recent demutualizations, achieved after mutual companies' lobbying, seek to undermine the longstanding principle of ownership by mutual policyholders. To ensure fairness, courts should apply de novo review to determine whether administrative agencies have properly construed their state's conversion law so as not to impair policyholders' property rights.

A demutualizing company should compensate policyholders according to the fair-value standard and apportion payment according to the contribution method. The pending class actions stand as a last bastion to ensure that these standards are met and the scandalous history of demutualization does not repeat itself.


(1.) See, e.g., MASS. GEN. LAWS ch. 175, [sections] 19E (2000), N.Y. INS. LAW [sections] 7312 (McKinney 2000).

(2.) 105 N.W. 1031 (Wis.1906).

(3.) 1909 NCIC. Proc. 128 (1909), as discussed in Arthur J. Chartrand, Demutualization 5 (1985) (unpublished manuscript, on file with the NAIC Library, Kansas City, Mo.).

(4.) Id. at 2.

(5.) See Gregory N. Racz, Note, No Longer Your Piece of the Rock: The Silent Reorganization of Mutual Life Insurance Firms, 73 N.Y.U. L. REV. 999 (1998).

(6.) Pub. L. No. 106-102, 113 Stat. 1338 (1999) (codified as amended in scattered sections of 12 U.S.C.).

(7.) See, e.g., ARIZ. REV. STAT. [sections] 10-2701.8 (2001).

(8.) Keystone Auto. Club Cas. Co. v. Commissioner, 122 F.2d 886, 890 (3d Cir. 1941), cert. denied, 315 U.S. 814 (1942).

(9.) See Rhine v. New York Life Ins. Co., 289 N.Y.S. 117, 122 (App. Div.), aff'd, 6 N.E.2d 74 (N.Y. 1936).

(10.) See, e.g., Young v. Equitable Life Assurance Soc'y, 99 N.Y.S. 446, 455-56 (Sup. Ct.), aff'd sub nom. Young v. Hyde, 98 N.Y.S. 1052 (App. Div.), and aff'd, 101 N.Y.S. 1150 (App. Div. 1906).

(11.) See, e.g., Ohio State Life Ins. Co. v. Clark, 274 F.2d 771, 777-78 (6th Cir.), cert. denied, 363 U.S. 828 (1960); Huber, 105 N.W. 1031, 1036-37.

(12.) See Dessauer v. Supreme Tent, Knights of the Maccabees of the World, 210 S.W. 896, 897 (Mo. 1919).

(13.) See, e.g., Ohio State Life Ins. Co., 274 F.2d 771, 778-79; Huber, 105 N.W. 1031, 1040.

(14.) See, e.g., United States Trust v. New Jersey, 431 U.S. 1, 29 n.27 (1977); West River Bridge Co. v. Dix, 47 U.S. 507, 531-33 (1848).

(15.) See, e.g., N.Y. INS. LAW [sections] 7312 (McKinney 2000) (historical and statutory notes).

(16.) See United States v. Virginia Elec. & Power Co., 365 U.S. 624, 633 (1961).

(17.) See, e.g., Lawson Mardon Wheaton, Inc. v. Smith, 734 A.2d 738, 748 (N.J. 1999).

(18.) See Amanda Acquisition Corp. v. Universal Foods, 877 F.2d 496, 500 (7th Cir. 1989).

(19.) Rhine, 289 N.Y.S. 117, 124-25.

(20.) See Letter from Milliman & Robertson, Inc. to Mass. Div. of Ins. (May 4, 1994), in administrative record in Proposed Plan of Reorganization of John Hancock Mutual Life Ins. Co. at 3693-3703, No. F-99-1 (Mass. Div. Ins., Dec. 9, 1999).

(21.) See, e.g., MASS. GEN. LAWS ch. 175, [sections] 19E(1) (2000); N.Y. INS. LAW [sections] 7312(j) (McKinney 2000).

(22.) See, e.g., Rowen v. LeMars Mut. Ins. Co., 230 N.W.2d 905 (Iowa 1975); Appeal of Corporators of Portsmouth Sav. Bank, 525 A.2d 671 (N.H. 1987).

(23.) Letter from Milliman & Robertson, Inc. to Mass. Div. of Ins., supra note 20; see also In the Matter of the Plan of Reorganization of the Metropolitan Life Insurance Company (opinion and decision, N.Y. Superintendent of Ins., Apr. 4, 2000).

James M. Pietz and Ellen M. Doyle practice with the Pittsburgh firm of Malakoff Doyle & Finberg.
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Author:Doyle, Ellen M.
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Date:Jun 1, 2001
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