Some mutual property/casualty insurers are responding to the capital demands of a changing world, writes Craig Mortell.

The mutual property/casualty insurer finds itself in a changing world. Change is all about - in new technology, in the placing of new expectations and demands on insurers, and in the anticipated melding of the insurance industry with the banking industry. This article discusses one particularly significant change affecting some mutual property/casualty insurers: the perceived need to enhance their access to capital.

The mutual property/casualty insurer is a venerable American institution. Its history dates back to the founding of the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire by Benjamin Franklin and fellow Philadelphians in 1752. Mutual property/casualty insurers have a long and honorable record of service to the American consumer, and for more than one hundred years they have been served by NAMIC, the National Association of Mutual Insurance Companies. NAMIC has more than 1,200 member insurers ranging in size from the very large to the very small, and it provides its members a variety of services, including governmental advocacy.

For most of this century the world of the mutual property/casualty insurer was sedate and stable. Mutual companies commanded a large share of the American property/casualty market, and they succeeded by employing time-honored business practices while faithfully maintaining their mutual form. Property/casualty insurance products were sold exclusively through face-to-face interaction between agents and purchasers, and insurers gave little or no thought to expanding beyond the field of insurance. When a mutual property/casualty insurer grew, its growth was most likely financed by a steady increase in the insurer's retained earnings.

Today many industry observers foresee dramatic change in the mutual property/casualty insurer's world. The following future developments are predicted:

* Consumers will purchase property/casualty products from massive national firms that offer banking and securities brokerage services as well as insurance.

* A large share of property/casualty product sales will take place through electronic means, without face-to-face interaction between purchasers and agents.

* It will become vital for an insurer, like an insurance counterpart of Coke or McDonald's, to develop consumer recognition of its "brand".

Heeding these predictions, a mutual property/casualty insurer might well decide that it will need extra capital in the future for expansion, diversification, technological advancement, and advertising.

Moreover, there are a number of current circumstances that might lead the officers of a mutual property/casualty company to reflect on the adequacy of their capital:

* Insurers must now meet the risk-based capital requirements of the NAIC, which require the identification of various risks to which an insurer is exposed and the assessment of the adequacy of the insurer's capital in light of those risks.

* Some agents are demanding that the insurers they represent have ambitious growth plans and the strong capitalization needed for growth.

* Competitive pressures may drive some small property/casualty insurers to add new lines of business as a complement to their existing lines.

* And it is increasingly difficult for small mutual property/casualty insurers to obtain a high rating from their rating agency due to the geographical and jurisdictional risks associated with doing business in only one state or a small number of states.

In sum, both present and future factors may stimulate mutual property/casualty insurers to contemplate the adequacy of their capital and to consider means of increasing it. However, by no means are all mutual property/casualty insurers motivated to increase their capital. A great many mutual property/casualty companies - both large and small - have ample capital. They are thriving under the status quo and will continue serving their policyholders in their customary manner and form long into the future.

When the officers of a mutual property/casualty insurer begin thinking about raising capital, they encounter an obstacle arising from the very nature of the mutual form. Mutual insurance companies are unable to raise capital through principal means used by other insurers - they cannot issue stock. However, there are other means of raising capital.

In years past the capital-raising options available to a mutual insurer were quite limited. The predominant method was simply to do business successfully and thereby increase retained earnings. This, however, was not the answer for every mutual in need of capital. An insurer cannot rely on retained earnings if it needs a quick infusion of capital, or if it is not profitable and needs capital to finance a strategy intended to restore its profitability. Another available method was to issue capital notes. However, capital notes also have a drawback as a source of capital - they are debt instruments, and debt must be repaid.

New capital-raising options have become available in recent years. If the officers of a mutual property/casualty insurer are interested in enhancing their company's capital position, they now have several options to consider. Some involve a restructuring of the insurer and others do not. Each option has certain advantages and disadvantages, and the option or options most worthy of an insurer's consideration should be determined according to the insurer's particular situation.

The options attracting the most attention these days are those involving structural change: demutualization and the establishment of a mutual holding company.

Demutualization is, of course, the transformation of an insurer from the mutual form to stock form. It is the option providing the most direct capital-raising solution because it allows a mutual insurer, once demutualized, to issue stock to the public. A demutualized insurer might also be acquired by a private investor.

Under the traditional form of demutualization, the mutual insurer changes its form to that of a stock company and compensates its policyholders in stock, cash, or policy credits for the loss of their membership interests. Under the new "subscription rights" form of demutualization authorized in seven states, policyholders are given subscription rights to purchase stock of the insurer upon demutualization instead of receiving stock, cash, or policy credits.

Demutualization is a laborious and expensive undertaking. And while it allows an insurer access to the capital markets and enables the insurer to offer stock options as an employee incentive, demutualization also carries these drawbacks:

* It can make the insurer susceptible to hostile takeover.

* It can force the officers of the insurer to shift their focus from the long term to the short term.

* It diverts time and attention to matters of SEC compliance and investor relations.

The establishment of a mutual holding company is a relatively new option. It offers a mutual insurer the ability to raise capital through the issuance of stock and yet preserves the insurer's tradition of mutuality. The reorganization transforms one entity, a mutual insurance company, into a multi-level structure that includes a mutual holding company, one or more operating subsidiaries, and possibly one or more intermediate holding companies. Twenty one states and the District of Columbia have enacted laws authorizing MHC reorganizations.

In essence, a mutual holding company reorganization involves a separation of the policyholders' membership rights from their rights as policyholders:

* The membership rights are transferred to the newly formed mutual holding company (MHC). Policyholders of the former mutual insurance company become "members" of the MHC.

* The policyholder rights are transferred to a new stock insurance company, which is a subsidiary of the MHC. The contractual obligations associated with the policies issued by the former mutual insurance company are also transferred to the stock insurance company subsidiary.

The MHC is able to raise capital by selling as much as 49% of the stock insurance company subsidiary to outside investors. However, the MHC must at all times retain control over a majority of the voting shares of stock in the subsidiary.

A mutual holding company reorganization seems to offer several advantages. Like a demutualization, it offers the insurer access to capital through the sale of stock. However, it is potentially simpler and less expensive than a demutualization, and it does not completely terminate an insurer's tradition of mutuality. An MHC reorganization does not deplete the insurer's surplus, as a traditional demutualization could. And yet it enables the insurer to offer stock-based employee incentives and puts the insurer in a position to engage in subsequent mergers and acquisitions.

The MHC reorganization offers mutual insurance companies an additional benefit: preparation for financial services reform. It is widely expected in governmental and industry circles that sweeping financial services reform legislation will be passed by Congress before long. When passed, it will allow insurers to enter the banking business and banks to enter the insurance business through the establishment of a holding-company-and-subsidiary arrangement. (Such an arrangement is contemplated by H.R. 10, the financial services reform bill pending in Congress as this article is being written.) Presumably a mutual insurance company, as a solitary entity, would not be able to establish a banking subsidiary. However, it is anticipated that a mutual insurer transformed into a mutual holding company will be authorized to establish and maintain a banking subsidiary. For this reason, the board of directors of NAMIC has endorsed MHC reorganizations in the context of the entry of banks into the insurance business and the advent of the functional regulation of financial services.

It should be noted, however, that the mutual holding company option is not without drawbacks. If an MHC reorganization includes a public offering of stock, it will commit the insurer's officers to devote time and attention to SEC compliance, investor relations, and the other responsibilities of stock companies. The requirement that a majority of the voting shares of stock in a subsidiary be controlled by the MHC limits the amount of capital that can be raised from stockholders. And the MHC reorganization, like the subscription rights demutualization, is somewhat controversial. Critics question the fairness of MHC reorganizations to policyholders and assert that conflicts will arise between the interests of the stockholders and those of the policyholder/members of a mutual holding company.

Other strategic options through which a mutual insurance company can now raise capital or make more effective use of its capital include the following:

* Establishing a downstream stock subsidiary or holding company.

* Merging with another insurer.

* Establishing a joint venture with one or more other insurers.

* Entering into an affiliation with another insurer.

* Operational improvements (for example, cutting expenses, increasing premium income, or improving investment returns).

* Entering into financial reinsurance agreements (however, the use of this option has been restricted by recent pronouncements of the Financial Accounting Standards Board and the NAIC).

* Issuing surplus notes or capital notes.

* Entering into insurance risk securitization transactions (such as catastrophe or "CAT" bonds).

It is imperative for the officers of a mutual property/casualty insurer, when considering the raising of capital, to become very well informed about the available options. One excellent source of information is Capital Enhancement Strategies for Mutual Property and Casualty Companies, a monograph prepared for NAMIC by PricewaterhouseCoopers and the law firm of LeBoeuf, Lamb, Greene & MacRae. This monograph offers a broad, unbiased overview of the entire range of structural and capital-raising strategies for mutual insurance companies. By allowing the reader to review the entire spectrum of options, it enables the reader to identify the one or two options that may be most appropriate to the reader's particular mutual company. The monograph will be available for purchase from NAMIC soon.

Mutual property/casualty insurers have been a vital component of the American economy for two centuries. Today a number of them are challenged to enhance their capitalization in order to maintain their vitality. For some the challenge may be difficult. However, many strategic options and resources are available. A mutual property/casualty insurer that selects an appropriate strategy and pursues it with the dedication, resourcefulness, and common sense demonstrated by Ben Franklin and his colleagues in 1752 will have an excellent chance of prevailing.

Craig Mortell is the government affairs advocate of NAMIC, the National Association of Mutual Insurance Companies. He is an attorney and a graduate of the University of Notre Dame.