The Pricing of Insurer Demutualization Initial Public Offerings

ABSTRACT This article examines the pricing of the initial public offerings (IPOs) that follow insurance company demutualizations. Insurers that convert from mutual to stock form typically cite the need for capital as a key motivation. Given that capital adequacy is a primary regulatory objective for insurers, one would expect that for a given number of shares to be sold, these firms would price their offerings to maximize proceeds. However, the vast literature on IPO pricing suggests various theories as to why it may be in the issuing firm's best interest to underprice its offering. By examining the initial and long-run stock returns for these conversion IPOs, the existence and degree of underpricing, as characterized by large initial returns, can be determined. It is observed that on average demutualization insurer IPOs post significantly higher first-day returns than nondemutualization insurer IPOs. These gains would accrue to the initial investors and to those policyholders who receive compensation in the form of shares in the newly created stock insurer. Attractive returns are sustained for both groups of insurers during the first few years after IPO. INTRODUCTION In the insurance industry, ownership structure changes from mutual to stock have occurred for many years; only in recent demutualizations have insurers systematically issued an initial public offering (IPO) of common stock. A primary objective given by insurers for undergoing a conversion is access to capital. The funds raised by the IPO may be used to help the firm stay competitive or allow the insurer to expand by engaging in new opportunities. The two main organizational forms in the insurance industry are mutual and stock, which differ in their ownership structure and capital-raising abilities. The policyholders of a mutual insurer collectively own the firm. Ownership rights are granted upon policy purchase and end upon policy termination. Stock insurers have distinct customer and shareholder bases although there could be some overlap of these two groups through separate transactions. A stock insurer can attract capital through a variety of equity and debt offerings whereas a mutual insurer, by statute, is restricted in this aspect. Mutual firms can only increase their capital base through retained earnings or the issuance of surplus notes, a highly subordinated debt security (Dumm and Hoyt, 1999). The desire for both additional capital and future ease of raising funds has induced many mutual insurers, over time, to convert to stock charter (Murray, 1998; Carroll and DeRegnacourt, 2000; Seol, 2001; Boselovic, 2001). Although not all demutualizations result in an IPO, for a mutual insurer to execute such an offering, it must first convert to stock form. By statute, if a firm fully demutualizes, the mutual's policyholders must be given some form of compensation for this organizational change since they are relinquishing their ownership interests. Typically, these policyholders are given shares in the newly converted firm whereas in some states, they are granted priority subscription rights in the offering. Thus, after the conversion and IPO, insurers could have a significant number of policyholder/shareholders. With the conversion and offering, the insurer simultaneously compensates these policyholders as well as generates new capital. Prior studies document access to capital as a key motivation for undergoing demutualization (McNamara and Rhee, 1992; Cagle, Lippert, and Moore, 1996; Carson, Forster, and McNamara, 1998; Mayers and Smith, 2002, 2004; Remmers, 2003; Viswanathan and Cummins, 2003). Across various industries, it may be expected that firms that issue offerings aim to maximize their proceeds. A vast literature exists, however, that documents the underpricing of IPOs across industries, characterized by large initial returns (Ibbotson and Ritter, 1995; Ritter and Welch, 2002). These gains, which could have accrued to the issuing firm had it set its offer price higher, would instead be received by the initial stockholders, hence the term underpricing. …