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Insurers' Demutualization Decisions @Risk Management and Insurance Review, 2000, Vol. 3, No. 2,135-154 INSURERS’DEMUTUALIZATION DECISIONS Richard J. Butler Yijing Cui Andrew Whitman ABSTRACT Several explanations of why mutual insurers choose to demutualize their businesses are examined with a recent survey of mutual insurers. This study adds to the literature by surveying mutual insurers’ executives on those factors that would lead them to demutualize their companies. Both univariate and multivariate techniques are applied to analyze those responses. Demutualization is most strongly influenced by access to capital markets, increased organizational flexibility, and the chance for company officers to increase their pay, as prior literature has suggested. MUTUALINSURANCE REORGANIZATION Joe Belth, in his The Insurance Forum, suggests four reasons a mutual insurer would demutualize: access to capital, organizational flexibility, avoidance of the income tax setback, and aligning the interests of managers with those of company shareholders. Demutualization provides insurers with access to external capital sources that are currently not available to them. A mutual company’s only means of access to capital markets is through the issuance of surplus contribution notes (Dumm and Hoyt, 1999). Moreover, the issuance of surplus notes is restricted by regulatory requirements. It is subject to ”the prior approval of the regulator in the company’s state of domicile, interest and principal payments are subject to the regulator’s prior approval, and surplus notes are subordinate to the issuing insurance company’s obligationsto policy Richard J. Butler is professor of economics at Brigham Young University, Provo, Utah. Yijing Cui is with the Industrial Relations Center at the University of Minnesota-Twin Cities. Andrew Whitman is professor of insurance at the Industrial Relations Center at the University of Minnesota-Twin Cities. The authors wish to thank the National Association of Mutual Insurance Companies and especially Susan Brudvig for their support in printing and mailing the questionnaires for this survey. Joe Belth, professor emeritus, Indiana University, Bloomington, also kindly provided some useful commentary on mutual insurers and their decisions to reorganize, and Phil Bromiley and the referees made excellent suggestions on previous drafts. Research support from the Industrial Relations Center at the University of Minnesota-Twin Cities is gratefully acknowledged. All shortcomings associated with the questionnaire development and data processing are the authors’ alone. 135 136 RISK MANAGEMENTAND INSURANCE REVIEW owners” (Belth, vol. 24, no. 3, p. 172). A stock company, on the other hand, can raise capital through issuance of additional equity securities.l A second reason for demutualizing is that it provides the insurers with greater strate- gic and organizational flexibility to pursue growth through acquisitions, business combinations, and other strategic alliances. The additional flexibility should better position insurers to take advantage of diversification opportunities that have arisen as the legal barriers between financial institutions and insurance companies have been reduced or eliminated (Belth, vol. 24, no. 3, p. 171).’ A third reason for demutualizing is that the insurers can escape an income tax set- back. In 1984, Congress revised the Internal Revenue Code treatment of the income of life insurance companies. One aspect of the revision has come to be called the ”differential earnings-rate tax” on the mutual companies. Previously, dividends paid to policyholders in a mutual company were completely deductible in the cal- culation of the company’s taxable income. With the differential earnings-rate tax, this deduction was eliminated, eroding an advantage to being a mutual. The mutuals say it is unfair, because they feel that policyowner dividends should be fully de- ductible. A stock company, therefore, can escape this differential earnings-rate tax (Belth, vol. 25, no. 5). A fourth reason for demutualizing is that it may be easier for a stock company to motivate its management team by making stock available to officers and directors so that management interests are better aligned with those of the company. Many believe that the stock form of organizing aligns management and shareholder interests at the expense of policyowners (Mayers and Smith, 1988; Pottier and Sommer, 1997). The issue of agency conflicts is addressed in fairly extensive prior literature, includ- ing: Boose (1990),Scordis and Pritchett (1998),Pottier and Sommer (1997),McNamara and Rhee (1992), Mayers and Smith (1994), Lamm-Tennant and Starks (1993), and Mayers and Smith (1986). Several issues that warrant empirical examination are whether policyholders benefit from demutualization and whether insurance agents are harmed by possible concomitant changes in the distribution system accompany- ing demutualization. While the authors do not examine policyholders’ welfare under demutualization in this article, they do report the most important factors affecting demutualization as Some mutuals may reorganize into mutual holding companies, whereby they choose if and when to issue an initial public offering. A mutual that undergoes a full demutualization is generally expected to issue an initial public offering at the time of conversion. Strategic advantage of the existing mutual structure may explain why some companies do not demutualize. For example, one reason Northwestern Mutual has not demutualized is its objective of providing cash accumulation products to upscale customers, and its existing general agency marketing system needed to serve these customers. The value of the agency force as an important factor in life insurers’ strategic restructuring decisions was noted at a forum on demutualization on April 20,2000, sponsored by Minnesota Center for Insurance Research. INSURERS’DEMUTUALIZATION DECISIONS 137 reported in the authors’ nationwide survey of mutual insurers’ executive^.^ Only Alaska and Hawaii prohibit mutual companies from converting to stock; mutual holding company laws exist in 22 states and the District of Columbia (PricewaterhouseCoopers, 1998). DEMUTUALIZATIONAND FINANCIAL RATING One way in which capital access may be improved by demutualizing is that a company’s financial ratings may impr~ve.~Tables 1 and 2 indicate that recent reorganizations re- sult in little change in the financial rating of mutual insurance companies. Tables 1 and 2 present the ratings of life and health insurance companies before and after demutualization. The list of companies, which either have demutualized or re- organized in the past several years, or announced their intention to do so, was ob- tained from Mutual Companies-A Vanishing Breed (PricewaterhouseCoopers, 1998). Of the 21 life and health groups, 8 have demutualized, 2 have announced demutualizations, and 11 have reorganized to mutual holding companies. The ratings, ranging from A to D, are A.M. Best Ratings, and the 1-9 scale is A.M. Best’s Financial Performance Rating. The authors also examine the subordinate com- panies’ ratings for those groups, which have experienced some change, since strate- gic asset management is undoubtedly set for the whole group rather than subsidiar- ies in isolation. Table 1 (Demutualizations) and Table 2 (Reorganizations) present the ratings for the year of change or announcement and for the three years both before and after the change. Omitted from many companies that are experiencing a recent switch are the “after change” ratings, which are not yet available. Among the 49 life and health insurance companies, 8 do not have financial ratings in all of the 7 years (labeled as NR-1, NR-2, NR-3, or NR-4). In the remaining 41 companies, only 7 experience a slight fluctuation. Although the ratings are somewhat limited in their range (most are from A- to A+++),there is virtually no change over this period: PM Group went from A to A’ and Educators’ Mutual from A to A- the year of the change, but all other insurers experienced no change in their financial ratings. The results for the property-liability insurers given in Table 3 are similar to those for the life and health insurance mutuals. Of the seven mutual property-liability insurance groups and their twelve subsidiaries, five have demutualized, one has an- nounced a demutualization, and one has reorganized. Again, there is virtually no change in their financial ratings. Of the respondents, 31 percent were CEOs/presidents; 30 percent were managers; 25 percent were secretary/treasurers; 6 percent were CFO/COO/Executive VPs; and the remainder were secretaries and vice presidents. For the relationship between insolvency and organizational form, see Pottier, 1998; BarNiv and Hathorn, 1997; Carson and Hoyt, 1995; and Ambrose and Seward, 1988. 138 RISK MANAGEMENTAND INSURANCE REVIEW TABLE1 Life and Health insurance Companies: Demutualizations Years before Year of Years after COMPANY NAME -3 -2 -1 change 1 2 3 DEMUTUALIZED UNION MUTUAL LIFE INSURANCE COMPANY / 1986 UNUM LIFE INSURANCE COMPANY A+ A+ A+ A+ A+ A+ At THE MIDLAND MUTUAL LIFE INSURANCE 1994 COMPANY/THE MIDLAND LIFE INSURANCE A A A- A- A- A- A COMPANY ALLMERICA FINANCIAL CORPORATION 1995 (stock holding company) FIRST ALLMERICA FINANCIAL LIFE INSURANCE 1995 COMPANY (head, demutualized) AAAAAAA ALLMERICA FINANCIAL LIFE INSURANCE AND ANNUITY COMPANY AAAAAAA GUARANTEE LIFE GROUP (stock holding company)* 1995 GUARANTEE MUTUAL LIFE COMPANY / 1995 GUARANTEE LIFE INSURANCE COMPANY AAAAAA-A- (demutualized, and owns
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