Demutualization of Insurance Companies to Meet the New Challenges of a Business Environment - Term Paper Example

Demutualisation of Insurance Companies Introduction Demutualisation is the process through which organisations like building societies and mutual insurance companies convert themselves into profit making companies. In the case of insurance companies, it was the normal practice to form these companies with the ownership vested on the policyholders as a group. In the recent years there has been an increasing trend for such companies to demutualise, converting the mutual membership to a shareholder ownership base. Generally the policyholders are offered either shares in the new company or cash compensation against their membership rights (SearchCIO). It is advantageous to the members as shares can be traded in the equity or stock markets while the membership rights in the mutual companies can not be traded. Thus demutualisation increases the possibility for the involved parties to make profits and at the same time benefit the economy as a whole. Demutualisation was originally used to signify this specific conversion process of the insurance companies. However this term is being used more broadly to describe the process of conversion of any member-owned organisation to become shareholder owned. Conversion of London Stock Exchange and New York Stock Exchange are some of the classic examples in the direction of demutualisation of companies other than insurance companies. Demutualisation of Insurance Companies The demutualisation of insurance companies is undertaken pursuant a plan of conversion approved by the policyholders and the state legislators Demutualization Claims Clearing House). In the case of mutual life policyholders a time of conversion they may receive stock, cash and/or policy credits in lieu of their ownership rights in the old mutual insurance company. In some cases the compensation is limited only to the subscription rights to acquire shares in the newly formed company. In some other cases the membership rights are transferred to a Mutual Holding Company (MHC) which owns a newly formed subsidiary stock insurance company. Reasons for Demutualisation In the context of the United States the significant changes in the regulatory and competitive environment in the life insurance industry in the recent past were the reasons for the demutualisation of the insurance companies. These changes include: (1) The traditional life insurance products of life coverage and risk transfers were not favourably looked into by the consumers over the period of time. The consumers showed considerable preference in the wealth management/annuity business which showed good potential for new growth opportunities. (2) The large scale deregulation of the financial services industry with the passing of Gramm-Leach-Bliley Act in the year 1999 eliminated the barriers between the commercial banking, insurance business and the investment banking which paved the way for combining all the business in one entity (3) The modifications brought about in the Internal Revenue Codes abolished the tax advantages which were hitherto available to a mutual insurer and (4) There were a number of foreign insurance companies that showed interest in the insurance market of the United States which changed the structure of the insurance companies Similar circumstances prevailed in the European economies augmented the need for conversion of the insurance companies to stock companies from their original form of mutual companies with the membership of policyholders. Mutual Companies and Stock Companies In a mutual life insurance company the company is owned by the policyholders that make them both insureds and insurers. The policyholders are vested with the right to vote to elect the members of the Board of Directors and also to receive the policy dividends. In the event of insolvency and dissolution, they are also entitled to receive the sale proceeds of the assets of the company. The policyholders as members of the mutual company can have their insurance at the lowest possible cost. They do not have to share the profits of the company with the stockholders. But contrastingly in the stock form of organisation the right to elect the Board of Directors is vested with the stockholders and in addition the stockholders can share in the profits of the company in the form of dividends. They also own the assets of the company. Advantages of Mutual form of Insurance Companies The mutual form of insurance organisations has served very useful purpose protecting the interests of the policyholders especially the life insurance policy holders. The mutual form of insurance business offered stability which is a very important requisite for the life insurance business since life insurance policies involve long term contractual obligations. The interests of the policyholders are considered as paramount in the mutual form of organisation. There are no chances of conflicts of the interests of the policyholders with that of shareholders which is more towards economic profits and short term in view. However the mutual form of organisation has also certain drawbacks which need a consideration while studying the demutualisation of the insurance companies. The drawbacks are: (1) Since there is no monitoring by the policyholders the management of the mutual insurance company may be inclined to derive personal benefits out of the insurance business or to indulge in 'expense preference behaviour (Williamson O.E, 1963). A very large number of policyholders dispersed geographically in various locations normally have very limited information about the conduct of the management of the business of the company and also the geographical dispersion of the policyholders make the cost of monitoring the performance of the management of the mutual companies very high and impractical (Greene and Johnson 1980). Further the policyholders are not very keen in following up the managerial performance of the companies. (2) The management of a mutual insurance company is always risk averse to maintain their position safe and also to ensure a longer duration of their offices. (3) In the life insurance business the firms are expected to maintain a minimum net worth to premiums written ratio. Since the mutual companies rely largely on their retained earnings as the prime source of net worth, there is always a limitation on the capacity of the mutual insurance companies to enlarge the revenue earnings. Due to the above reasons the mutual form of insurance companies has always been managed in a conservative way and they seldom strive to indulge in making competitive returns. Advantages of Stock Form of Organisation The alternative to mutual form of organisation, the stock form of organisation has also certain distinct advantages to offer over the mutual form of organisation. The stock form of insurance companies is formed with the main objective of generating economic profits for their stockholders. The management of these companies is monitored individually and collectively through the capital market operations by the stockholders themselves. Wide range of information on the financial and other performance of these publicly owned companies are available and the management has the obligation to be accountable to the stockholders. As a natural consequence the management will be forced to be adaptive to the changes in the competitive environment of the insurance industry. The stock form of organisation has the flexibility to be acquired by other firms as well as the company can acquire other firms. The stock form of organisation also has the advantage of using the capital market to raise additional funds required for acquiring other firms or for any other business purposes. The stock organisation can use its own stock for raising the necessary funds. The stock form of business organisation has the additional facility of issuing equity for enhancing its capital base and thereby it can expand its business volume to new heights. According to a survey conducted on the mutual insurers the prime reason for demutualisation is to gain the ability to mobilise additional capital and also to enter to affiliation arrangements with other financial services firms by forming subsidiary companies. They also prefer the stock form of organisation due to the fact that it is easier to enter into schemes of merger and acquisitions. This form also enables the companies to motivate their managers and compensate them adequately to enhance the business of the firms (Butler et al 2000). Process of Demutualisation The process of demutualisation is lengthy and complex and it also involves high cost. The company which desires to undergo the process of demutualisation has to strictly follow the laws and regulations of the state in which the company is situated. The policyholders and the state legislators have to approve the plan of demutualisation. Since mutual life insurance policyholders accumulate their premium bonuses and dividends over a longer period of time it is necessary that an actuarial valuation is undertaken to determine the amount of surplus to be distributed to the past and existing policyholders. In addition the company may have to determine the amount of 'blocked assets' which is necessary to meet the financial obligations of the company in respect of future dividend interests and other benefits promised to be payable to the existing mutual policyholders. There are two methods by which the demutualisation process can be accomplished. They are partial demutualisation and full demutualisation. Partial Demutualisation Also known as Iowa method is accomplished by forming a mutual holding company (MHC) which owns above 50 percent of a newly formed subsidiary company which will take the stock form of organisation. In this method the interests of the policyholders are converted in to membership rights in the new MHC and the insurance contracts are transferred to the stock insurance company. The policyholders are not provided with any part of the accumulated profits. This method was not favoured by the policyholders, regulators, and investors as they lose the control on the operations of the subsidiary and in addition the policyholders do not get their part of the economic profits of the stock subsidiary. Full Demutualisation The full demutualisation can be achieved by either the subscription method also known as Illinois/Pennsylvania method or the New York method. In the subscription method non-transferable subscription rights are provided to the policyholders. These rights can be used by the policyholders to acquire shares in the subsidiary by paying cash. There is no market value for these rights and they extinguish automatically. In the New York method the policyholders are given stock, cash and/or policy credits in lieu of their membership rights in the mutual company. This has been the most popular and widely used method of demutualisation. Assessment of the Effectiveness of Demutualisation Lal C. Chugh and Joseph W. Meador (2006) in their study have adopted the following quantifiable measures to assess the effectiveness of demutualisation of eleven major insurance companies in the United States. They are: (1) Profitability and Cost efficiency Measures (2) Growth Measures (3) Product portfolio measures (4) Debt Management and (5) Asset risk management According to the authors the process of demutualisation can lead to the creation of economic value due to several reasons. The first among them is that the surplus of the policyholders is transformed into marketable equities and in the process demutualisation makes the illiquid assets in to liquid assets (Merton R.A (1995). "Second, a mutual life insurer's conversion to the stock form of organization can create economic value as the firms implement new competitive strategies, become transparent in reporting and governance structure, and develop opportunities to participate in the international merger and acquisition market" (Lal C. Chugh and Joseph W. Meador 2006). The following tables illustrate the economic values created by the demutualisation of the insurance companies in the United States. Exhibit 1 Unlocking Economic Value in the U.S. Life Insurance Industry Compound Annual Rates of Return, 3 years Post-Demutualization Company Name Month and Year of demutualization Company Returns Dow Jones Industrial Average S&P 500 Index NASDAQ Insurance Company Index AmerUS January 1997 6.58 19.06 23.07 9.46 Canada Life December 2001 3.18 2.37 1.82 12.62 John Hancock January 2000 16.5 -9.71 -15.00 8.43 Manufacturer's Life September 1999 21.03 -9.78 -14.02 3.00 Metropolitan June 2000 10.53 -4.90 -12.50 13.05 MONY November 1998 0.41 2.62 -.70 10.42 Phoenix June 2001 -13.00 -0.21 -2.33 10.46 Principal October 2001 18.82 3.38 2.19 10.62 Prudential December 2001 18.31 2.47 1.82 12.61 Standard Insurance April 1999 34.46 -2.67 -6.05 6.46 Sun Life March 2000 20.21 -9.89 -17.28 4.92 Source: (Lal C. Chugh and Joseph W. Meador 2006) Exhibit 2 Unlocking Economic Value in the U.S. Life Insurance Industry Compound Annual Excess Rates of Return Company Name Excess Returns over DJIA Excess Returns over S&P 500 Index Excess Returns over NASDAQ Insurance Company Index AmerUS -12.48 -16.49 -2.88 Canada Life 0.81 1.36 -9.44 John Hancock 26.21 31.50 8.07 Manufacturer's Life 30.81 35.05 18.03 Metropolitan 15.43 23.03 -2.52 MONY -2.21 1.11 -10.01 Phoenix -12.79 -10.67 -23.46 Principal 15.44 16.63 8.20 Prudential 15.84 16.49 5.70 Standard Insurance 37.13 40.51 28.00 Sun Life 30.10 37.49 15.29 Total Excess Return 144.29 176.01 34.98 Source: (Lal C. Chugh and Joseph W. Meador 2006) It may be observed from exhibit 1 the stocks of nine out of eleven demutualised companies have outperformed the market portfolio as represented by the S&P 500 index and eight companies have exceed the return reported by the DJIA and six companies have performed better than NASDAQ insurance company index. This is contrary to the previous finding about the long run underperformance of the IPOs (Ritter Jay (1998). The comparison of the excess returns of the insurance companies is presented in exhibit 2. The exhibits clearly indicate that demutualisation has largely benefitted the insurance industry as a whole as well as the policyholders. Conclusion The modern era of consisting of a highly evolved and dynamic market with more empowered and sophisticated customers demand wealth management in a fully deregulated financial services industry. In addition the global competition in the insurance industry especially the life insurance business makes the traditional form of life insurance businesses as the main line of business out dated and obsolete. The insurance companies form new strategic measures based on renewed efficiency, more adaptability, rapid growth and new development and multiple expansion of new product lines to meet the new challenges of the business environment. The stock form of insurance business organisation enables furthering this process as the management in the stock form of business organisation can pursue an entrepreneurial role with the competency to undertake more operating, financial and market risks for the wealth maximisation of the stockholders. The stock form of organisation offers wide scope for the evaluation of the managers on the basis of their performance and it becomes easier to compensate them with stock options and such other measures to improve their efficiency. This phenomenon is in complete contrast to the conservative and the expense preference behaviour of the management in the mutual form of business organisation. References Butler, R., Cui, Y., Whitman, A. (2000) Insurers' Demutualization Decisions. Risk Management and Insurance Review 3, 135-54 Demutualization Claims Clearing House 'Lost Life Insurance - Missing Policyholders Claims' Greene, M. R., and Johnson, R. E. (1980) Stocks vs. Mutuals: Who Controls Journal of Risk and Insurance, 47, 165-174. Lal C. Chugh and Joseph W. Meador (2006) 'Demutualization in the Life Insurance Industry: A Study of Effectiveness' Merton, R. A. (1995) Functional Perspective of Financial Intermediation, Financial Management, 24, pp. 23-41. Ritter, Jay R. (1998) Initial Public Offerings, Contemporary Finance Digest 2, 5-30. SearchCIO 'Demutualization' Williamson, O.E (1963) Managerial Discretion and Business Behavior, American Economic Review 53, 1032-1057. Read More