Ownership Structure Changes in the Insurance Industry: An Analysis of Demutualization

ABSTRACT This article focuses on the demutualization process and investigates why certain mutuals undergo this organizational structure change. The primary motivation for conversion is access to capital. By statute, mutual firms are limited in their capital-raising activities while stock firms can attract funds through a variety of stock and debt offerings. By examining the financial characteristics of firms that demutualize, changes in business practices in the years surrounding conversion can be observed. Determinants of the conversion decision are explored through logistic regression. In the years before demutualization, converting property-liability mutuals exhibit significantly lower surplus-to-asset ratios. This capital constraint eases after demutualization. Converting life-health mutuals hold a significantly lower proportion of liquid assets; in addition, they have a higher proportion of separate accounts under management. This liquidity constraint and increased focus on a higher managerial discretion activity drive the demutualization decision. For both property-liability and life-health converting mutuals, support for the access to capital hypothesis is found. INTRODUCTION The insurance industry in the United States is currently experiencing a wave of organizational structure changes as many property-liability and life-health mutual companies are converting to stock charter, a process known as demutualization. Given that this is an industry where mutual firms and stock firms have coexisted for more than 100 years, these conversions are receiving much attention from insurance regulators, investors, and consumers. This research focuses on the demutualization process and by examining the business practices of these demutualizing insurers in the years surrounding conversion, investigates why they undergo this change. A mutual insurer is collectively owned by its policyholders; these ownership rights are accorded upon policy purchase and end with its termination. In a stock insurer, the customer function and the ownership function are performed by two distinct groups. Insurance regulation in almost all states allows a mutual insurer to convert to stock form; a key aspect of the process is determining the compensation that the mutual firm's policyholders receive for relinquishing their ownership. Demutualization activity is occurring in insurance markets around the world. The largest life insurer in the United States, Prudential Life, successfully demutualized in December 2001; the second largest, MetLife, also converted in April 2000. The largest life insurers in Canada have demutualized, as have major firms in Japan, the United Kingdom, and South Africa (Swiss Re, 1999). These widespread changes suggest that the stock ownership form has become more attractive for many mutual insurers. It remains to be seen how these particular firms will be affected by operating under stock charter. In the United States, the heavy conversion activity in the past two decades allows investigation into the motivations for these structural changes, and the effects of conversion on business practices can be observed. This article investigates the determinants of the conversion decision. As indicated by converting insurers in their public statements, the predominant motivation is access to capital (Bailey, 1995; Goldstein and Avril, 1998; Dauer, 1998). By statute, mutual insurers can only increase their capital base through either retained earnings or surplus notes, a form of highly subordinated debt security (Dumm and Hoyt, 1999), whereas stock firms can raise funds through a variety of stock and debt offerings. The characteristics of these demutualizing firms could indicate whether this capital need is motivated by insufficient surplus levels. Capital may also be desired for expansion into new opportunities after conversion. Another attractive aspect of stock charter is the creation of a tradable currency, which allows the financial market to reward efficient behavior and can enhance the effectiveness of incentive compensation plans for management. …