Debate about the rationality of introducing mutual holding company legislation shows no sign of letting up. Matthew O. Hughes reports.
The United States insurance industry - particularly the life sector - is experiencing some of the most turbulent times in its rich history, and it all began with seemingly innocuous proposals in the agricultural state of Iowa. At issue is a legislative move that allows the state's mutual life insurers to reorganize in what some see as a controversial way. It has divided insurers and consumer advocacy groups, mutual insurers and stock insurers, and even mutuals and mutuals. Perhaps most ominously, it has divided the state insurance commissioners.
Since 1995, mutual insurers in Iowa have had the opportunity to reorganize their operations into a mutual holding company (MHC). Since then, at least 19 other states and the District of Columbia have followed suit. While many of the states' rules may differ in slight respects, they all have similar foundations. These essentially provide for the formation of a quasi-mutual, quasi-stock insurance company.
Every model provides for the formation of three layers of companies. At the bottom of the organizational structure is a stock insurance company (or a number of separate stock insurance companies), which is 100% owned by the next layer company, an intermediate holding company. At the top is a mutual holding company. The MHC can sell up to 49% of the intermediate holding company to the public, but is legally required to hold at least 51% for policyholder benefit.During the transition to the mutual holding company, a mutual policyholder's policy rights are split. His membership rights (voting rights, surplus rights) are ceded to the mutual holding company, while the contract rights (benefits payable) are placed in the stock insurance company, usually in a closed block to protect dividend payments. (See Diagram)
Good for the policyholder - and the company
Proponents claim the bottom line of the legislation is a better, stronger company, which will benefit policyholders and the company alike. The policyholder gains from a more strongly positioned company, while he has a number of measures used to protect his interests. The insurer will, after the conversion, have the ability to sell an as yet inaccessible financial instrument, stock. And whether sold directly on the market or used as purchase currency in an acquisition, many financial analysts agree that in the long term, equity is the most cost-effective way to finance growth.
However, the insurer's ability to sell stock is limited to ensure the policyholder's voting rights are not completely eroded. As mentioned above, the company must hold at least 51% of the intermediate holding company's shares for the voting benefit of the policyholding group. And most if not all models of the legislation require that at least two thirds of the board be outside board members with no employment affiliation with the insurer. Proponents point to these and other measures as sound ways the policyholder is a winner in the end.
Similarly, the insurance company wins. As mentioned earlier, the insurer gains access to a very valuable financing option inaccessible to a traditional mutual. A pleasant side effect, continue proponents, is a strong focus on financial performance, a discipline analysts feel has been weak for many.The argument is usually presented in a way similar to this: Because of access to new and more aggressive capital markets, insurers in the MHC group will face greater financial scrutiny. This will cause the insurer to become more financially responsible, which will lead to a company with stronger financial indicators. This again benefits policyholder and company alike.
Additionally, the move allows insurers to report financial measures under different and more common financial reporting systems. Mutuals in the United States are usually encouraged if not required to report financial performance under Statutory reporting guidelines, rather than the more common GAAP rules. Among the many differences, Statutory reporting requires an insurer to write off goodwill paid against the company's surplus, making large acquisitions difficult or impossible for many mutual insurers (GAAP allows goodwill to be written off as an expense).
Moreover, because Statutory reporting is much less common than GAAP, understanding what the numbers mean can be more difficult for those not familiar with the system. Obviously this could pose problems in accessing outside capital; therefore the ability of reporting under GAAP is seen by many in the industry as a financial advantage.
An oft-overlooked advantage is the time needed to convert to the new structure versus a full demutualization. A conversion to MHC usually takes about six months, whereas full demutualizations tend to take between 18 and 24 months. The reasons for the difference in timing are numerous, but one main reason involves the actuarial work needed to determine how much compensation each policyholder will receive for giving up their membership rights. Compensation can comprise cash, shares in the new company, enhanced coverage, or any combination of the three. The problem can be very complex, as each policyholder's interests must be calculated on an individual basis.
As conversion to MHC status does not involve any payment to policyholders for lost rights, the conversion can proceed more quickly. Timing for MHC conversion is mainly occupied in answering insurance commissioners' questions and holding town-hall meetings with policyholders to explain the process.Company officials of mutuals that are moving to MHC tout the savings involved with a 6-month process in light of the alternative's 24-month process. They also raise the fact that converting to MHC status does not preclude the new company from completely demutualizing later in the future. While MHC status can be seen as an end goal, it may also be seen as a weigh station on the path to full demutualization.
There is another issue involving timing, but in a manner different than above. Under demutualization, an insurer must generally offer shares to the public in an IPO on the exact date specified in the demutualization plan. This is regardless of the state of the market. Therefore a mutual may be offering an IPO during a time when issues in financial companies is bearish.
In contrast, the MHC rules allow the new quasi-public company to create stock immediately and retain it in treasury fashion until the markets are most attractive. This again lends itself to strong financial capabilities.
But the bottom line, argue supporters of the rules, is that in every instance a mutual has presented consideration of MHC conversion to its policyholders, votes received for conversion outweigh votes against by a ratio of over 9:1. The proof is in the response.
However, with issues as controversial as the MHC proposal appears to be, it should not be surprising to find a bipolar situation in the arguments. Therefore, while among the proponents for the conversion legislation are in various insurance groups, opponents include a number of consumer advocacy groups, including the well-known advocate and past presidential candidate, Ralph Nader, and a number of state officials nationwide.
Most of the concern expressed by MHC opponents revolves around issues with membership rights, or more accurately, money. The first argument compares MHC conversion to demutualization. In demutualization, the soon-to-be stock insurer compensates policyholders for their loss of voting rights through distribution of surplus, shares, raising insurance credits (face value of their policy or premium discounts), or a combination of these options. A mutual converting to MHC has no obligation to do any of these. In the eyes of MHC's adversaries, this amounts to theft.
In their eyes, this would be bad enough, but for the opposition, the situation just gets worse. The insurer, after conversion, can proceed to sell up to 49% of the insurer's equity - equity critics argue the policyholders had, until conversion, owned as mutual policyholders. The policyholders are not compensated for their reduced equity position. When combined with the lack any distribution during MHC conversion, opponents view MHC as tantamount to highway robbery.This is not yet the end of the pain. If the insurer decides to sell stock, a policyholder will be obliged to purchase its stock. As mentioned above, critics of the MHC plans see any equity sold as property of the policyholders. For a policyholder to 1) not be compensated for lost equity at the issue, and 2) be required to pay money to gain this equity adds insult to injury.
A further problem critics see with the stock sales situation is apparently most regulations relating to stock sales only relate to voting, or common, shares. If this is the case consumer advocates fear MHC insurers will have the ability to further erode the policyholders' equity base without compensation by issuing preferred stock on unrestrained levels. The sale of preferred shares also raises another specter with those concerned: in the event of company liquidation, there is now another group which can contend for priority in compensation.
If Issue Number One could be defined as the Money Issue, Issue Number Two could, in similar vein, possibly be referred to as the Management Issue. And as with the questions dealing with money and the reimbursement of policyholders for potential loss of equity, this issue has several facets which critics outline.The first of these facets is the overall reasoning involved with what is perceived as only a half-step to the best solution in their mind. When a primary argument of the proponents' side is to allow access to a more efficient channel of capital access, why stop only halfway - actually less than halfway? Why do they not, like other mutuals before and after them, proceed to full capital access, if restraints to capital are such a key issue?
What some in the opposing camp see as the answer is simple: job protection. By gaining access to new capital while ensuring that at least 51% of the company's common shares are held essentially in trust gives mutual executives the best of both worlds. They have access to new money, but, because they and the board control an outright majority of the shares on a fiduciary basis, their jobs are covered. Sure, the argument goes, two thirds of those board members are from outside the company, but if tradition applies here probability practically dictates these members will defer to management's recommendations.A possible exception to the above the critics will acknowledge is if a lucrative takeover arises. But in this case, the opposition contend, management will only sell if it is profitable for them.
The second key element to be filed under the Management Issue is the fear of extravagant use of executive stock options. Once approval of MHC conversion has been granted to a mutual, many fear this will open the floodgates for executives to fatten their pay through discounted purchase rates in the company's shares. This idea becomes all the more deplorable to critics when they realize this will further cement these executives into positions they may well be otherwise better to vacate.
While research has shown no apparent response to the first fear listed here, the second criticism has received some clearly worded statements from the industry. Under the rules of every state researched, there appears to be a mandatory cool-off period between IPO and the time when a company employee would be able to purchase stock, usually six months. A minor loophole does exist, however, if that executive is a policyholder in the closed block, giving him voting rights as an MHC member.
A point of strong ambiguity in all the information public on MHC, though, is what happens to the MHC itself, and the remaining 51+% equity holding, once the last survivor of the closed block dies. There appears to be little on the record to address this, which would apparently fuel some critics' beliefs that states passed legislation too hastily.
And the final argument presented here for the case against addresses the windfall of “Pro” votes. Groups which have expressed concern in the various regulations like to point out that, while it is true that a vast amount of the votes received were in favor of MHC conversion, there is another, more important, perspective to this story. This argument is based on relativism, not absolutes. The key word in the proponents' press releases is “received” which should lead an astute reader to deduce that not all voters cast their decision. But we have not been told absolutely how many people submitted votes, and what percentage of the voting populace that number represents.
If this is the case, while the 9:1 ratio may be impressive, it may not be representative of the genuine feelings of the group, or may simply represent those in the voting group who feel confident enough in their understanding of MHC to cast a vote. In conceptual terms, 100% of the votes received may in actuality represent only 10% of all the votes possible. In this case, few could argue that 9% stated approval is “overwhelming.”
The arguments encapsulated in this article only brush the surface of a complex argument involving a universe of points and counterpoints. So far, only a handful of mutuals have converted, or announced plans to convert, to the MHC organization. Of these, most could be classified as mid-sized mutuals, with assets of $10 billion or less.
Perhaps the degree of controversy is best explained in looking at the largest mutual life insurers. Of these, only two, Principal Life and Pacific Life, have been able to run the gauntlet of consumers and regulators to be able to convert. Other well-known mutual insurers, such as Prudential, John Hancock, and Metropolitan Life, have apparently abandoned the prospect of successfully converting to MHC and have instead announced intentions to fully demutualize. One other notable, Northwestern Mutual Life, has publicly announced it will retain its mutual status, and although it is in the top five largest mutual life insurers currently, it may soon be the largest mutual life insurer by a sizable margin.
But as with any emotional issue, debate about the rationality of introducing MHC legislation is bound to continue well into the future, with its usual entourage of civil lawsuits accompanying it. And similarly with any emotional issue, we can surely find fragments of truth in the arguments of both parties, while the whole truth continues to elude us. The future is typically the best indicator to determine whether MHC laws were successful. But as is usually the case with the future, by then it will likely be too late.
Matthew O. Hughes recently completed a secondment with the International Insurance Council (IIC), a Washington, DC trade association promoting free global insurance commerce. Prior to his appointment to the IIC, Mr Hughes accumulated over five years' experience with the international unit of a US life insurer with over $75 billion in assets under management, serving as a research analyst for Latin American and European expansion and support. Mr Hughes is also a Fellow of the Life Management Institute.
Note: The author presents many arguments for and against the concept of mutual holding company conversion. While the author does have personal views on the issue, the goal with this article is to present the prevailing public arguments. The reader should not attribute any of the comments above as the author's personal position, with the exception of the introduction and conclusion.