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Capital Callings

In the mutual insurance industry, the new mantra is convert or be consumed.
Russ Banham, CFO Magazine
April 1, 1998

CFO Bob Broatch likes nothing more than the wind at his back, whether it's driving his 27-foot boat, Prime Interest, in Maine's Casco Bay or piloting the financial future of UNUM Corp., a Portland, Maine-based disability and special risk insurance holding company with $4 billion in revenues last year. It has been full-speed ahead for UNUM since converting from a mutual insurance company to a publicly traded insurer 10 years ago. Premium income has doubled to $3.18 billion, operating income has more than tripled to $342 million, and market capitalization is up to $7.5 billion from $1.3 billion a decade ago. In addition, UNUM's 50 percent stock market surge in 1997 made it 39th in shareholder value among the Standard & Poor's 500.

To what does it owe this spectacular report card? "Largely demutualization," says Broatch, who has been UNUM's CFO for the past two years. "Had we remained a mutual, we wouldn't have had access to the capital markets to make acquisitions and build our infrastructure, as well as attract and retain key employees. The capital markets are a wonderful disciplinarian. Every day, you look at your stock price, and if it isn't performing, the onus is on you to get your house in order. Mutuals just don't have that kind of pressure to perform--that kind of accountability. Moreover, they generally have higher expense structures, lower returns on capital, and lower growth rates."

A FLOOD OF INTEREST
When UNUM demutualized a decade ago, it was considered an industry blip, an anomalous development few others would entertain. Today, such conversions are a worldwide phenomenon. In recent weeks, mammoth mutuals the likes of Prudential, Sunlife, and Mutual Life Insurance Co. of New York have indicated their intent or interest in demutualizing. They follow a long list of insurers, mostly in the life sector, that have converted, including Equitable, Royal Maccabees, First Allmerica Financial, and Midland.

Yet, these companies are just the tip of the iceberg, industry analysts contend. "Our prediction is that dozens of mutuals--first life insurance companies and then property/ casualty insurers--will seek a more modern corporate structure," says Michael Blumstein, a managing director and insurance stock analyst at Morgan Stanley Dean Witter in New York. Agrees Gloria L. Vogel, senior vice president and insurance analyst at Advest Inc., a Hartford-based securities broker, "As MetLife and Pru go, the onus will be on the remaining large mutuals, such as Hancock, Guardian, and Liberty Mutual, to follow suit."

Deciding just what form these conversions will take, however, has become increasingly controversial. Full demutualizations, like the one UNUM endured, can take years and cost millions of dollars. The less-involved alternative--creation of a mutual holding company--however, is viewed by many as a vehicle for profiteering corporate executives. Yet, most experts agree that the traditional mutual company has all the makings of a dinosaur. In an industry that has seen rapid consolidation in the past five years--including the mega-mergers of Phoenix Mutual Life Insurance with Home Life Insurance and Metropolitan Life Insurance with New England Mutual Life Insurance--the survivors are going to be those insurers that can garner the most capital. And in the end, the luckiest beneficiaries may be corporate buyers, which will see more abundant and potentially cheaper insurance offerings.

IN SEARCH OF CAPITAL
Mutuals, which are owned by their policyholders, obviously have plenty of cash on hand from ongoing insurance premium revenues. But their lack of access to the equity markets has dampened their ability to expand operations and product portfolios and acquire other companies. "Insurers increasingly need capital to grow and achieve economies of scale, demonstrate financial strength, and offer better value to consumers," says Sue Collins, the managing principal, North America, for Tillinghast-Towers Perrin, a New York-based risk management consulting firm. "With life insurance earnings down considerably from a decade ago because of the soft insurance market, a mutual's ability to grow its surplus has diminished."

The handicap has been particularly apparent in the recent mergers and acquisitions wave. When publicly traded Travelers Insurance, for example, acquired Salomon Brothers last year for $9 billion, it was an acquisition that most mutuals could not even entertain. And Broatch points out that the two acquisitions he has made since going public would not have been possible otherwise. "In today's mergers and acquisitions market, [mutuals have] a serious hurdle to surmount," says Collins.

That lack of growth potential has also been noticed by the industry's rating agencies. S&P, A.M. Best Co., and Moody's Investors Service are loath to give their best marks to insurance companies facing capital growth restrictions. "They've tightened theirstandards and now threaten ratings downgrades for companies with mediocre growth prospects," Blumstein says. "They seem to have a bigger-is-better bent these days, figuring the bigger the insurer, the smaller its chance of failure. With very modest access to the capital markets, the mutuals are limited in their ability to deal with rating agency pressures."


Internally, the mutual structure is frustrating for other reasons. Mutual insurer executives and employees, for example, have missed out on the greatest boom in stock market history because their structure does not allow for stock options or employee stock ownership plans. And the lack of such incentives limits the pool of potential employees, insurers complain.

POLICY DECISIONS
The ability to attract and retain better employees, in fact, is one of the driving forces behind the quasi-mutual/stock structure called a mutual insurance holding company, which is rapidly gaining momentum. Under the concept, the mutual reorganizes as a stock insurer that is owned by a new mutual holding company. The stock subsidiary can go public, but the mutual holding company retains control of a majority of the stock. Iowa was the first state, in 1995, to permit such restructurings. Since then, 15 other states have passed authorizing legislation, and bills are pending in several others (see chart, page 94).

Mutual insurance holding companies have come under attack, however, by consumer groups because policyholders are not given a payout. In standard demutualizations, such as UNUM's and the one planned at Prudential, policyholders--to borrow Prudential's old tag line--"get a piece of the rock." The company, in fact, plans to distribute about $12 billion as cash and stock to its 11 million policyholders while maintaining their insurance benefits. UNUM distributed some $650 million to its policyholders, $130 million as cash and the rest as stock, as part of its conversion into a stock company.

The lack of a payout rankles critics. "These structures are a monstrosity. Policyholders get nothing, but management rakes it in," says David Schiff, an insurance activist and publisher of Schiff's Insurance Observer newsletter. Schiff adds that directors, officers, and employees of mutual stock holding companies stand to make $100 billion over time if the structure becomes the law of the land and the 1,000 or so mutual insurers in the United States belly up. "Directors and officers could get unlimited amounts of stock, options, and other forms of equity because they control 51 percent of the voting stock in the downstream public company," he explains.

Several stock insurance companies are also critical of the structure. They contend that it acts as an antitakeover device and allows the holding companies to avoid the pressures that stock companies normally have to live by. In fact, several stock insurance companies, including Allstate, American General, and Conseco, have banded together as the Companies for Demutualization Fairness to fight laws allowing mutual stock holding companies. "The strategy is unfair," says Paul Verbinnen, the organization's spokesman. "Unlike a true stock company, these companies cannot be acquired, but their management can make acquisitions while escaping market discipline themselves. And because the company cannot be acquired, its shares will trade at a discount, potentially undermining the share values of true stock insurers."

Mutual insurance stock holding companies have their supporters, of course. Tom Moloney, CFO at John Hancock Mutual Life Insurance Co.--one of the main sponsors of the Massachusetts bill to allow the structure--disputes the antitakeover argument. "If a company is interested in acquiring a mutual stock holding company, it can make an overture to the board of directors," Moloney counters. "So it can't make a hostile bid for the company, buying up its stock. So what? The fact is that there has been maybe one successful hostile takeover of an insurance company in the past 20 years. This argument just doesn't hold water."

CONVERSION CHALLENGES
Moloney stresses that despite Hancock's political stance, the company is evaluating both methods of demutualization. In reality, however, mutual insurance stock holding conversions are less costly and less time-consuming than full demutualizations, which can take from 12 months to the 36 months it took UNUM's conversion to reach conclusion.

"A CFO of a mutual endures a series of challenges when a company demutualizes," says Edward J. Parry, vice president and CFO at Allmerica Financial Corp., a Worcester, Massachusetts-based multiline insurer that went the full demutualization route in October 1995. "The actuarial exercise of determining for each policyholder the proper disposition of value is a major hurdle. The decisions are extremely complex and time consuming, as are ongoing communications with policyholders during the process. You must be extremely meticulous throughout."

"It took us 15 months, soup to nuts," adds Martin Sheffield, former president of Cooperative Insurance Co. of Western New York, which demutualized five years ago and today is part of Erie Insurance Group. "You have to develop a plan of conversion that is acceptable to a wide range of constituents, from regulators to board members to policyholders. It's an arduous task, one that, frankly, takes management's focus off running the company." Sheffield currently is the vice president of A.M. Best Co.'s property/ casualty division.

Despite their comparative ease of conversion, mutual holding companies can be costly in terms of public relations. It was a price Prudential, which has been rocked by several selling scandals in recent years, was reluctant to pay. Still, even Prudential, which is going full bore into a traditional demutualization, won't poke holes into the holding company strategy. "We've got nothing against it," says Mark R. Fetting, president of Prudential Investments Retirement Services. "We looked at it but decided to take a different road. Other mutuals looking at their business operations may feel different, and that's OK. If they want to go this route, they should be allowed to."


A CAPITAL IDEA
While the debate over conversion methods continues, many mutuals are destined for demutualization-- one way or another. And that's probably good news for corporate buyers. Newark, New Jersey-based Prudential, the largest life insurer in the United States, with $260 billion in assets, says to expect a much broader array of group life, disability, and even property/casualty insurance products, once their two-year demutualization process is complete.

"Right now, we offer mutual fund annuity products from eight fund providers, as well as our own funds," Fetting says. "That's pretty capital-intensive to pull off, particularly the recordkeeping. With access to capital markets, we'll have an opportunity to buy new technology systems, increase the fund portfolio, and even acquire some fund companies. We'll also be able to offer more affinity business, combining property/casualty and life products into packages that allow CFOs to buy wholesale from us."

A.M. Best is bullish on the conversion, which is expected to consume a reported $300 million in legal, consulting, and other fees before reaching fruition. "Pru has always been able to raise capital through the issuance of surplus notes and debt in its downstream subsidiaries, but they had limits on what they could do," says Larry Mayewski, Oldwick, New Jersey-based Best's senior vice president of life and health insurance. "By converting to a stock company, they will have the financial flexibility to create new products, expand globally, and give policyholders and shareholders better long-term value."

For his part, UNUM's Broatch says the die is cast for the entire mutual industry. "Mutuals are an antiquated capital structure for today's consolidation and growth needs," he says. "Some will survive by focusing on a niche in a particular geographic region, where customers are captive to them. But with an expected onslaught of competition from banks selling insurance, I don't see how they're going to make it unless they combine or demutualize. In the long run, it doesn't matter if they opt for a fulldemutualization or a mutual stock holding company concept--the reality is that both are better than remaining a mutual."

Russ Banham is a business writer based in Missoula, Montana.




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