CHARACTERISTICS OF AN EXCELLENT DEMUTUALIZATION PLAN

(Reprinted from The Insurance Forum, May 2000)

We have written about demutualization in general and about the demutualizations of several mutual insurance companies in particular. The purpose of this article is to identify the characteristics of an excellent demutualization plan--one that provides balanced treatment for the company's policyholders and management. We will indicate the origins of this article, and also discuss the nature of the policyholders' ownership interests in mutual insurance companies.

The Pennsylvania Hearing

On March 2, the Democratic Policy Committee of the Pennsylvania House of Representatives held a public hearing on demutualization. We accepted an invitation to testify, for two reasons. The existing Pennsylvania conversion statute is one of the worst in the nation in terms of protecting the policyholders' ownership interests in mutual insurance companies, and we hope Pennsylvania legislators want to associate themselves with one of the best statutes in the nation.

In our testimony, we mentioned eight characteristics of an excellent conversion statute. Of those, six are discussed in this article because they are also characteristics of an excellent demutualization plan. The other two characteristics mentioned in our testimony do not relate directly to this article. One of those two is a prohibition on mutual holding companies, for reasons we have explained in other articles. (See our December 1997 issue, for example.)

The other of those two characteristics of an excellent statute is a strong standard of review by the insurance commissioner. The existing Pennsylvania statute provides for regulatory approval if the commissioner finds that the plan "will not prejudice the interests of the members." The statute should provide for regulatory approval if the commissioner finds that the plan "is in the best interests of the policyholders."

The Ownership Question

Before we discuss the characteristics of an excellent demutualization plan, we must address the question of who owns a mutual. Most insurance companies are either stock companies or mutual companies. A stock insurance company is a corporation that is engaged in the insurance business, has shareholders who are owners, has policyholders who are customers, and is operated for the exclusive benefit of the shareholders. A mutual insurance company, by contrast, is a corporation that is engaged in the insurance business, has no shareholders, has policyholders who are customers with ownership interests, and is operated for the exclusive benefit of the policyholders.

Note that we refer to a mutual insurance company's policyholders as having ownership interests, rather than saying flatly that they are owners just as a stock insurance company's shareholders are owners. We say it that way because a mutual insurance company's policyholders have some but not all the characteristics of owners. For example, an individual policyholder of a mutual insurance company has the right to vote on certain matters and the right to share in certain distributions, but the policyholder's ownership interest in the company terminates when his or her insurance policy terminates. In short, a mutual insurance company's policyholders as a group own the company, and individual policyholders have ownership interests.

From the beginning of the insurance industry in this country in the middle of the 19th century, many mutual insurance companies have used the ownership concept in marketing efforts. The most familiar example is Prudential's marketing slogan: "Own a piece of the Rock!" In recent years, however, as a trend has developed away from the mutual form of organization, many mutuals have changed their tune. Now they downplay the policyholders' ownership interests or even deny that policyholders have ownership interests, in some cases as part of a plan to terminate those interests without compensation.

The Six Characteristics

We now turn to the characteristics of an excellent demutualization plan. They are not listed in order of importance; rather, they are all needed in a plan that provides balanced treatment for a mutual insurance company's policyholders and management.

Compensate the Policyholders

In a demutualization, the policyholders' ownership interests are terminated. The policyholders should be compensated for the termination of those interests. The aggregate amount of compensation should be the value of the company. The distribution of that value should be in the form of cash, policy credits, or shares of stock in the converted enterprise.

Compensation has been provided in most of the demutualizations to date. However, the existing Pennsylvania statute allows a mutual insurance company to demutualize without giving the policyholders anything more than the right to buy shares of stock in the converted enterprise. Thus a policyholder who decides not to buy stock forfeits his or her ownership interest. To put it bluntly, the statute legalizes theft. That is why we say the existing Pennsylvania statute is one of the worst in the nation in terms of protecting the policyholders' ownership interests.

Define Eligibility Broadly

Each of the demutualization plans adopted to date has defined narrowly the eligibility of policyholders to participate in the distribution of the value of the company. For example, the usual arrangement is to make eligible only the owners of participating policies issued by the mutual insurance company.

A demutualization plan should define eligibility broadly. Many policies that do not mention membership in the mutual company or participation in the company's divisible surplus have attributes similar to those of policies containing such provisions. Interest sensitive policies are one example. They are often designated as nonparticipating, but provide for variations in interest rates and mortality charges. Policies issued by a mutual company's subsidiary, which is a stock company and not a mutual, are another example. The owners of such policies may have contributed to the value of the mutual parent, albeit indirectly. In short, the objective should be to include as many policyholders as possible in the distribution.

Disclose the Allocation Formula

The formula by which the value of the company is allocated among the eligible policyholders should be disclosed to the policyholders. In the demutualizations to date in the United States, the formulas have been certified as fair by actuaries. However, the formulas have not been disclosed to the policyholders, and have produced strange results. For example, in many instances the owners of large policies have received fewer shares than the owners of small policies. (See our May 1999 and January 2000 issues.)

Meanwhile, in the demutualizations to date in Canada, the allocation formulas have been disclosed to the policyholders, have been certified as fair by actuaries, and have produced results that appear reasonable. Secret formulas cannot be justified.

Give Subscription Rights to the Policyholders

A demutualization may be accompanied by an initial public offering (IPO) of stock. The price established for the stock in the IPO may turn out to be lower than what the market subsequently determines to be the value of the stock. When those circumstances occur, investors in the IPO benefit from the rising market price of the stock. The policyholders who built the company should have the opportunity to participate in that price appreciation, not only through the shares allocated to them in the distribution, but also through the opportunity to buy additional shares in the IPO. The number of additional shares a policyholder may buy should be related to the number of shares he or she receives through the allocation formula. Among the demutualizations to date, policyholders have been given the opportunity to buy shares in the IPO only in the case of Standard Insurance Company (Oregon).

Create a Policyholders' Committee

A demutualization is a complex reorganization, and the description of the plan requires a lengthy, complex document. Individual policyholders acting on their own, and without an opportunity to communicate with their fellow policyholders, cannot be expected to understand the implications of the plan.

A demutualization should provide for the creation of a policyholders' committee to perform an advocacy function on behalf of the policyholders. The committee should be created at the beginning of the demutualization process, empowered to hire staff, financed by the company, granted access to management and relevant documents, allowed to participate in all discussions between management and the insurance department, and allowed to communicate with policyholders whenever management communicates with policyholders about the demutualization plan.

The standard objection to the creation of a policyholders' committee is that the insurance commissioner is the policyholders' advocate. That is incorrect. The commissioner should act impartially--not as an advocate--in determining whether the plan should be approved. Management serves as an advocate for itself in communicating with the commissioner, and the policyholders need an advocate.

Hold a Formal Hearing

Although a demutualization usually involves a public hearing at which policyholders may be heard, policyholders and their representatives are not allowed to participate fully. Consequently the commissioner is denied access to the full range of views of the parties affected by the demutualization.

The demutualization plan should provide for a formal public hearing. Relevant documents should be made available in advance of the hearing, and witnesses should be sworn. There should be an opportunity for policyholder representatives (including the policyholders' committee) to cross-examine management representatives, and to cross-examine insurance department representatives who provide advice to the commissioner. Similarly, there should be an opportunity for management representatives to cross-examine policyholder representatives and insurance department representatives.

Conclusion

This article identifies six characteristics of an excellent demutualization plan--one that provides balanced treatment for a mutual insurance company's policyholders and management. We would welcome comments, and would be interested in suggestions on how the list might be improved.